Institutional Perspectives
The Fed’s Job, Already Tricky, Is About to Get Harder
Stabilizing markets and ensuring liquidity was only the beginning. Now, the U.S. Federal Reserve needs to chart a challenging course on inflation.
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Though the U.S. Federal Reserve (Fed) made its first move to support the coronavirus-stricken economy and financial markets in early March, the two-plus months that have elapsed may seem like a policy lifetime. During that time, the Fed has supported market functioning through aggressive balance sheet expansion, allowing the financial system to deleverage amid an unexpected volatility shock and a sharp increase in demand for U.S. dollar-denominated funding. Excess reserves are, once again, ample.
The Fed’s Balance Sheet: “Expansion” Is an Understatement
U.S. Federal Reserve Bank assets, July 2, 2008-April 29, 2020
Source: U.S. Federal Reserve Bank of St. Louis.
But the Fed has also been relatively successful in giving the market forward guidance that has convinced investors short-term interest rates will stay low for the next few years; the spread between a one-month U.S. Treasury bill and a three-year Treasury note was only 17 basis points (bps) on May 8, according to Bloomberg data. At the same time, the market appears to be getting increasingly comfortable with the idea that the economy will recover enough over the medium-term for short-term rates to rise eventually; the spread from the three-year/10-year Treasury spread has steepened to 48 bps.
Investors May Be Expecting Short-Term Rates to Trend Upward
U.S. Treasury yield spreads (as indicated), January 31, 2018-May 11, 2020
Source: Bloomberg. Data as of May 11, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Increasing confidence in short-run economic stabilization and medium-term recovery, along with new lending facilities from the Fed that provide financial support for corporate debt markets, have encouraged substantial spread tightening, even before the Fed has made any purchases. The tightening even extends into the lower quality rungs of the U.S. high-yield market, where the Fed is unlikely to buy anything other than what is embedded inside an exchange-traded fund (ETF).
Spreads Recently Tightened on Lower-Quality U.S. Debt
Option-adjusted spread on indicated rating categories within the Bloomberg Barclays U.S. High Yield Index, May 23, 2014-May 7, 2020
Source: Bloomberg Barclays Indices. Data as of May 7, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Even as balance sheet expansion continues and new lending facilities come on line, the Fed’s task is evolving. The central bank needs to transition from assuring market functioning during a substantial economic shock to implementing monetary policy that can prevent inflation expectations from falling and re-anchor them at its stated 2% medium-term objective. (The May 12 report from the U.S. Bureau of Labor Statistics showing a 0.4% decline in the core consumer price index for April lends added urgency to that job.)
With short-term rates at the effective lower bound (not far from 0%), this will prove a more difficult undertaking than what U.S. policymakers have accomplished over the past couple of months. It seems the Fed, which has already rewritten the policy playbook in the past few months, will have to get very creative to repeat its recent successes.
The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.
The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option. Typically, an analyst uses Treasury yields for the risk-free rate.
The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.
Bloomberg Barclays Index Information:
Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
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