- The Federal Reserve announced it will be adopting a new Flexible Average Inflation Targeting (FAIT) approach to determine the future path of interest rates.
- Although inflation has been elusive during recovery since the Global Financial Crisis, the Fed has conveyed through economic projections that they expect Core PCE to reach 2 percent by 2023.
- For investors, be prepared for low rates for longer. There is little chance the Fed will be hiking rates before it unwinds the asset purchase programs put in place at the beginning of the pandemic.
This month’s main article examines how the Fed’s new approach to inflation targeting may affect the future of interest.
Twist of FAIT
Jon Schwartz, Senior Portfolio Manager
The Federal Reserve announced its new approach to inflation targeting at the September Federal Open Market Committee (FOMC) meeting. FAIT, or Flexible Average Inflation Targeting, is going to be the determining factor with respect to the future path of the Fed Funds rate. Put simply, the Fed is now less inclined to act pre-emptively to combat inflation.
The Fed has set an inflation target around two percent, and they expect that level to be maintained and exceeded for some time so the average inflation rate is two percent over time. To quote Chairman Powell, “Following periods when inflation has been running persistently below two percent, appropriate monetary policy will likely aim to achieve inflation moderately above two percent for some time.” This framework shift is based on the idea that if long-run inflation expectations are too low, this can negatively affect consumption. In turn, that can pull actual inflation even lower, “resulting in an adverse cycle of ever-lower inflation and inflation expectations,” according to Powell.
In lay terms, this means the Fed is trying to set the expectation of higher inflation in the future, but it will be driven by keeping rates lower for even longer than they otherwise would have under the old framework. This is evident, given the current low level of inflation and the Fed expectations for when core personal consumption expenditures (PCE) will hit their 2 percent target. According to the Fed’s Summary of Economic Projections, core PCE is not expected to approach two percent before the end of 2023, and if inflation needs to run above this level for “some time,” there will be no expectations for rate hikes until we reach 2024 or beyond.
In recent years, inflation has had challenges getting to that two percent target with only a few brief stints above this level since 2009.
The Fed certainly didn’t predict the pandemic we are currently in, but this crisis has had a very significant impact on spending in the services sector. Social distancing makes it virtually impossible for the same number of people to consume and spend in the same ways prior to the pandemic. Social consumption sectors, such as restaurants, entertainment, hospitality and travel, have been hit particularly hard. Interestingly, there have been pockets of rising consumption, as evidenced by the rebound in retail sales. For example, have you tried to buy a car or bicycle lately? Good luck! Supply chain slowdowns on the back of the crisis have had a significant impact on inventories. Thus, both the demand and supply side forces are having an impact on pricing power and have driven the recent uptick in inflation seen in the past few months. This is also evident in the increase in commodity prices, which have rebounded from the troughs of early 2020 as global consumption and growth have been recovering toward pre-pandemic levels. Nevertheless, we still remain well below the levels seen in 2019.
Another dovish adjustment by the Fed came when they announced how they will only respond with policy adjustments to shortfalls in the employment outlook, rather than simple deviations below the natural level of unemployment as they have done historically. In plain English, this means the Fed will no longer hike rates if unemployment gets too low, but rather they will likely only adjust their policy response when the employment outlook is too weak. This is a significant detour from the historical stance of the Fed and is quite dovish for the direction of interest rates. The Fed will leave rates lower for longer, even as the employment outlook improves.
As a result, this makes inflation as the primary factor to justify a liftoff of the Fed Funds rate, whenever that might be. Keep in mind, a key component of inflation is wage inflation. It can be argued that wage inflation has been largely absent in recent history, which has hurt the spending power of the American worker. The tightening policy actions by the Fed — driven by signs of inflation, even as inflation expectations approached their two percent target — slowed both inflation and wage growth. If the current framework regarding inflation had been in place during the recovery from the Global Financial Crisis in 2008, it’s quite likely that policy would have remained accommodative for longer, and this might have impacted growth positively. Fed Governor Lael Brainard stated in a speech at the Hutchins Center in September 2020, “Had the changes to monetary policy goals and strategy we made in the new statement been in place several years ago, it is likely that accommodation would have been withdrawn later, and the [employment] gains would have been greater.”
This all reiterates the message that the Fed will be keeping rates lower for longer. It should be highlighted that there is little likelihood of the Fed hiking rates before they slow, or even completely unwind, their asset purchase programs put in place at the beginning of the pandemic in March. Maybe this time will be different, and the Fed will achieve inflation levels that have historically proven to be elusive, but there should be no doubt that we will be in this low-rate environment for years to come.
Paula Solanes, Senior Portfolio Manager
Investors continue to diligently watch incoming data this month, not to mention handicapping the polls leading up to an anxiously awaited US presidential election. Overall, there has been a swift rebound from the sharp economic downturn back in March. However, pandemic uncertainty still looms, and we continue to monitor data closely for signs of another slowdown.
As many expected, job growth has slowed this autumn, with the US adding only 638,000 jobs in October vs. expectations of 672,000 new jobs the prior month. The good news, however, is that the unemployment rate continues to move lower and is currently at 6.9 percent. The effects of the pandemic have weighed most heavily on those without a high school diploma where the unemployment rate is higher at 9.8 percent. This compares to an unemployment rate of only 4.2 percent for those with a college education. Average hourly wages decreased slightly to 4.5 percent, still above the historical average of 3.0 percent and much lower than the recent high of 8.0 percent back in April. The unusual reading from earlier this year reflected the gap in the labor force as lower-paying jobs in the service sector were being eliminated rapidly and skewing the data. Finally, the labor force participation rate has also staged a recovery to 61.7 percent from a low of 60.2 percent. Despite this positive reading, we still have a ways to go to regain the pre-pandemic labor participation rate of 63.5 percent.
Although the retail sector has been a bright spot during this economic bounce, it also may have begun to moderate in the last few months. US retail spending increased 1.9 percent in September, which was better than expected and showed improvement from the prior month. Interestingly, as pandemic life drags on, spending patterns are evolving, and some areas are doing quite well. In fact, retail sales (except food services and drinking establishments) are higher than pre-pandemic levels. In September, we saw broad-based improvement in areas such as apparel and sporting goods and even better numbers out of brick-and-mortar stores. But as we head into the cold winter months, it would not be surprising to see a reversal in these trends.
The housing sector continues to be another bright spot for the economy, thanks largely to all-time low mortgage rates. The pandemic is also driving people to look for more space, including outdoor space and locations outside of city centers. Existing home sales rose to 6.54 million, surpassing the 6.3 million estimate, while new home sales slipped to 959,000. Despite this drop, home sales remain approximately 50 percent higher than the five-year average. Additionally, the National Association of Home Builders (NAHB) reported its housing market index (HMI) was up to 85, reflecting the highest confidence levels since 1985. Shortages in lots, construction materials and labor have been moderating this slightly, which is extending the time it takes to build new homes. Home prices have rebounded five to eight percent on a year-over-year basis, according to the August S&P CoreLogic Case-Shiller 20-City Home Price Indices and the Federal Housing Finance Agency (FHFA) House Price Index (HPI).
Finally, third-quarter GDP rebounded sharply, rising a record 33.1 percent on an annualized basis from the record contraction of 31.4 percent in the second quarter and 5 percent contraction in the first quarter. This bounce was as expected and was driven by residential investment, followed by consumption and nonresidential fixed investment. The real question is whether the bounce we have enjoyed thus far will continue into the fourth quarter.
Tim Lee, Senior Credit Research Officer
Winter is just around the corner and investment-grade industrial companies have been busy preparing for any possible tough times ahead. Ever since spring when the first global wave of the pandemic struck, these companies have been stockpiling cash and boosting liquidity. This has helped them stay relatively unscathed after eight months of shelter-in-place orders around the globe.
Studying the issuers represented in the ICE BofA US Industrial Index as of October 30, 2020, 90 percent experienced no change in their Moody’s rating when compared to the same time in 2019. For issuers that did have a rating change, four percent benefitted from an upgrade, while six percent received a downgrade. Overall, most companies have made adequate financial adjustments to largely maintain their financial health despite the pandemic.
While agency ratings have held steady, there has been a financial impact. Sales have fallen 5.3 percent when compared to the same time period last year, based on aggregate trailing 12-month sales totals for index issuers. Lower sales, fixed costs and higher expenses to deal with the pandemic have contributed to a 17 percent decline in earnings before interest, taxes, depreciation, and amortization (EBITDA). As a result, the median net leverage for the index constituents has risen to 3.1 times in October 2020, from 2.5 times in the prior year, based on data analysis from Bloomberg.
However, it’s not all bad news, as many companies have taken aggressive actions to protect their balance sheets and cash flows by cutting expenses and capital expenditures. As a result, net debt has only risen 1.5 percent from the prior year, while free cash flow is essentially flat. Cuts to dividends and repurchases have also helped support balance sheets.
Companies have also been preparing since spring for a possible protracted economic downturn by extending their liabilities and paying down shorter-term maturities.
Perhaps most importantly, companies have shored up their liquidity positions by stockpiling cash. These reserves should allow most investment grade industrial companies to safely hibernate through the upcoming winter’s COVID-19 restrictions and emerge prepared for an economic rebound in 2021.
Hiroshi Ikemoto, Fixed Income Trader
Even after the presidential election, questions remain. Will Congress approve additional stimulus to extend the economic recovery? What will the trajectory of the pandemic look like during the fourth quarter and beyond, especially now that cases are spiking in some locations? And will all this shape future rates?
In the days leading up to the election, the bond market was relatively quiet — with rates trading in a very tight range — as if it were taking a wait-and-see approach. The yield on the two-year benchmark Treasury note held steady at 14 to 15 basis points (bps) throughout October, while activity in the Treasury bill market remained low, as no firm signals have come when (or if) the Treasury department will be issuing additional bills to fund another stimulus package. With no certain relief date, rates in the bill market remained in a range of 7 to 12 bps in that month, depending on the maturity.
In the investment grade corporate bond market, flows were a bit muted ahead of the presidential election, with spreads to Treasuries flat for the month. The three-month London Inter-bank Offered Rate (Libor), the index used to price commercial paper, floaters and other money market instruments hit an all-time low of 0.208 percent mid-October, and commercial paper rates fell with this index. Even with such low rates, investors keep piling into these instruments, perhaps an example of yield-stretching behavior in this environment. We are still seeing continued outflows in both government and prime money market funds, where rates in the funds are grinding down to a single basis point in government funds and in the low teens for prime.
In these historically uncertain times, we continue to be disciplined and are adhering to our established and vetted investment philosophy. We believe our independent analysis of issuer credit quality, diversification across sectors, and duration allocations we set for the portfolios combine to provide ample liquidity for clients, while still generating incremental returns no matter how the rate environment evolves.
|Treasury Rates:||Total Returns:|
|3-Month||0.08%||ML 3-Month Treasury||0.01%|
|6-Month||0.10%||ML 6-Month Treasury||0.01%|
|1-Year||0.12%||ML 12-Month Treasury||0.00%|
Source: Bloomberg, Silicon Valley Bank as of 10/30/20