Episode 29:What are the Fed’s options to normalize policy, and what do they mean to fixed-income investors?
CFA, Director, Portfolio Manager
Listen to fixed-income portfolio manager Jim Dudnick discuss why he thinks that Fed Chairman Jay Powell deserves a place in the “central bank Hall of Fame,” and how Powell’s management and communication style has provided the Fed plenty of options to normalize monetary policy depending on how growth and inflation evolve. Also: What does this Fed “optionality” mean to fixed-income investors and portfolios?
The Investment Intelligence Podcast: What are the Fed’s options to normalize policy, and what do they mean to fixed-income investors?
Notes, quotes and references:
J.P. talks with Jim as a fixed-income portfolio manager regards US Federal Reserve Chairman Jerome Powell as a “central banking Hall of Famer” because of how Powell’s management and communication style has provided the Fed optionality to normalize monetary policy depending on how growth and inflation evolve. They also discuss the implications for fixed-income investors and portfolios.
Some key thoughts and topics from this episode:
How do you evaluate Powell’s performance at the Fed?
“We’d give him a five-star review. We very much hope that he’s reappointed to a second term as Chairman of the Fed… He’s on his way to being a first ballot ‘central banking Hall of Famer’ in our mind.”
How do you view monetary policy, in terms of the Fed being ahead of or behind the curve?
“What I think the Fed is trying to communicate right now is that they want optionality … to normalize policy, based on not only the public’s response to coming out from, let’s call it a hibernation off the pandemic, but also policymakers’ response. So, it’s really hard to say that the Fed is behind the curve right now: Data on jobs and inflation in the coming months are going to give us more clues as to where we are… (but) the Fed’s strategy now is to always be slightly behind the curve.”
Do current conditions mean the Fed no longer needs to buy bonds like mortgage backed securities?
We now have a market “environment where banks have excess capital. If you look at the access to the Fed’s reverse repo facility … banks have a significant amount of capital to be doing the lending and the asset purchasing that the Fed has been doing.”
Could we be in a liquidity trap, meaning there’s too much money and not enough yield?
“I don’t see that. We do see opportunities as abundant. What we do see is, quite frankly, better rules, and better guidance on placement of that capital… What a lot of US companies learned from the pandemic is, ‘Maybe I should have a larger rainy-day fund. Maybe I should have more liquidity into the next downturn.’ That’s going to be a really interesting change in psyche for some companies.”
Are you concerned that corporate tax rates could rise?
“If tax rates rise, when they rise, (corporations) are not going to deprioritize having more liquidity and paying down any excess liquidity they took during the last nine months of 2020 to make it to the other side of this pandemic. That may change in the future, but for at least the next year, we expect a rapid deleveraging of certain balance sheets that share this priority.”
How should fixed-income investors adjust their portfolios for current conditions?
We expect to see “a bear flattening (of the US Treasury yield curve,) where all yields are rising, and the front-to-intermediate part of the curve could rise a little bit faster than the long end… I think on an active management basis, (investors should) have some credit spread to compensate portfolios, if and when there is this bear flattening, so fixed-income portfolios can still generate income. You also want to watch the premiums that you pay for securities right now in the secondary market because … you may be introducing mark-to-market downside and volatility that has nothing to do with credit risk. Even if there’s just a sharp increase in rates, you’re going to get a rapid adjustment, or even outflows from an asset class, at some point in time.”
The full episode has even more details on the topics above. Check it out.
J.P. recommends Stephen Soderberg’s latest streaming movie, No Sudden Move, which Rolling Stone magazine describes as “a thrill ride from a director who, recently prone to intriguing, one-off experiments, knows we didn’t exactly need reminding that he’s still got it, but reminds us anyway — flaunting what he has because, well, he can.”
Jim has been taking his daughters out to surf at his favorite beach, Beacons. He recommends new, surf accessories that are making it easier to hang ten, from apps to check the waves before heading to the beach, balance boards to learn at home, and internet videos about what to expect on the water.
Creativity and editing: Peter Lennox.
Production: Mark Egan.