The End of an Era of Free Money & the Impact on Fixed Income Markets

by Chris Ryon, CFA, & Sweta Singh – Portfolio Managers

A recent headline proclaimed that no one under the age of 40 has ever seen an aggressive Fed. It’s an interesting observation and is hopeful for those of us over 40. But this environment calls for experienced managers who have seen one or two full interest rate cycles. Now more than ever, a methodical approach to fixed income markets is needed. It is clear that the Federal Reserve is poised to tighten.

The need to act is clear. The headline Consumer Price Index (CPI) accelerated to a year-over-year gain of 7.5% in January—a 40-year high—while the Core CPI (excluding energy and food) and the core personal consumption expenditures price index remained well above the Fed’s 2.0% target rate. Meanwhile, producer prices jumped 9.7% in 2021, the largest calendar-year increase in the index’s history. Are these readings sustainable? We think not. Is the Fed target of 2.0% achievable? We think not — at least not in the medium term.

Central banks take hawkish tone.

Bloomberg.com recently reported that Christine Lagarde, President of the European Central Bank (ECB),  “delivered surprisingly hawkish comments” at the ECB’s February 3 policy meeting:           

“Concern was across the board,” [Ms. Lagarde] said, explaining officials’ reaction to another record reading for euro-zone inflation released the previous day. “Our March meeting, and then later on, our June meeting will be critically important to determine whether the three criterias of our forward guidance are fully satisfied.”    

The Fed agrees. In a statement from its January 26 meeting, the central bank stated ,“it will soon be appropriate to raise the target range for the federal funds rate,” possibly as early as March. If policymakers follow through, it will be the first-rate hike since December 2018 and the end of an era of free money.

In addition to hinting at the possibility of three rate hikes in 2022, policymakers signaled that the central bank’s monthly bond-buying is expected to end in March. The Fed also talks about managing down its balance sheet of some of the securities it purchased during the pandemic. That could be through roll down (allowing these securities to mature) or an active sale program. Both these actions should steepen the slope of the yield curve.

We believe these policy shifts make logical sense. If the Fed raises short-term interest rates and does nothing else, the curve may flatten or invert, sending a signal to the market of an impending recession. The current economic picture does not seem to be at risk of a near-term recession. Actively reducing (versus rolling off) securities on the central bank’s balance sheet limits that false recession signal and gives the Fed dry powder for future interventions.  

Indeed, the new year has started with a bang.

Treasuries

Source:  Bloomberg, City Different Investments Calculations

Municipal bonds

Source:  Bloomberg, City Different Investments Calculations

Investment grade bonds

Source:  Bloomberg, City Different Investments Calculations

What can we take away from all of this?

The pandemic has brought about many changes to the economy. The good news: The economy is resilient. The not-so-good news: There is no playbook for the aggressive actions the Fed took to combat the pandemic and the long-term impacts these actions will have. However, our playbook remains the same – in this or any environment:

• Stay diversified between stocks and bonds.
• If you are not getting paid to take risk in the markets, take less. For the bond market that means maintain lower durations (yields after adjusting for inflation/real yields are negative) and take less credit risk, as credit spreads are very narrow.
• Understand your investment horizon and invest accordingly.

For additional insights on inflation and other topics, visit our blog. 

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