On November 3, the Federal Reserve Bank announced it will begin tapering bond purchases later this month – reducing monthly Treasury purchases by $10B and mortgage-backed securities by $5B. While the news may spark a few fireworks in the media, it represents merely the first of what may be many well-telegraphed Fed moves to pull back on its accommodative monetary policy. This announcement followed hard on the heels of its September 22 meeting, in which the Fed communicated a more “hawkish” outlook and warned the market that tapering (reduction in asset purchases), “may soon be warranted.” The fixed income market’s reaction has been stark. The following table summarizes the rate changes from various segments of the fixed income markets from the close of business on 9/21/21 to the close of business on 9/30/21, right after the September Fed announcement:
|Change in Investment Grade Corporate Rates||Change in AAA General Obligation Municipal Rates|
The market’s reaction was higher rates and steeper yield curves (increase in the amount of income investors demand to buy longer-maturity securities).
Investors have little cause to act surprised at volatility—and not only because the Fed warned about tapering at its September meeting. We have long felt that all fixed income markets are overvalued. Real yields (yield of a fixed income instrument less an inflation measure) are negative across the maturity spectrum.
We have long felt that all fixed income markets are overvalued.
This is a by-product of the Fed’s ultra-accommodative monetary policies. In response to the economic impact of the COVID-19 pandemic, the Federal Reserve cut short-term interest rates to zero on March 15, 2020 and restarted its large-scale asset purchases (more commonly known as quantitative easing, or QE), including $120B of asset purchases per month ($80B of Treasury securities and $40B of mortgage-backed securities). We believe that these policies have pushed investors out the risk curve. Investors have moved out the maturity spectrum and the credit curve in search of income.
Unfortunately, history has taught us that this is generally not a good long-term investment strategy. In the short term, it can be successful – see the Bloomberg US Corporate High Yield Index year to date 9/30/2021 returns of 4.53%, one of the only positive return numbers when looking at a list of Bloomberg Indices. Inflation, enemy number one for the fixed income investor, is running well above the Fed’s long run target of 2.00%. August’s core personal consumption expenditure price index (the Fed’s favorite inflation measure) was 3.6%.
Most recently, Fed officials stated that these high inflation rates are “largely reflecting factors that are expected to be transitory” and will subside with time. The drivers of these high inflation numbers are continued supply chain disruptions and employers offering higher wages and benefits or signing bonuses to attract workers. Currently, there are approximately 8M Americans unemployed and 11M job openings. It is likely the impact of COVID-19 on families and schools is driving some of these imbalances.
We at CDI think that inflation is not as transitory as the Fed believes. Once companies and workers think that they have pricing power (demanding higher wages with these costs passed along to consumers) these forces will continue. Couple this with the high valuations for most fixed-income securities, and you have a formula for a correction in valuations.
We at CDI think that inflation is not as transitory as the Fed believes.
In a coda to this story, the Fed’s move was not the only important decision made this week. Tuesday was also an election day in which the Administration’s political allies underperformed in races around the country. As we have noted elsewhere, the muni market has grown very rich from investors seeking refuge from potential tax increases. Recently, cash flows had already begun moving in the opposite direction. That outward momentum may accelerate, now that the election seems to have consigned the most ambitious tax plans to the bonfire.