At the conclusion of its June meeting, the Federal Reserve is expected to raise its benchmark interest rate for the fourth time since the financial crisis (market implied probability currently at 100%). In our view, the market’s attention has been more squarely focused on the Fed’s plans for its $4.5 trillion balance sheet. The consensus view at the central bank is that with the U.S. likely at or near full employment, it is only a matter of time before tight labor market conditions (wage inflation) lead core inflation towards its targeted level of 2%. As this phenomenon has yet to evolve, there are those committee members who question it, most notably James Bullard who recently commented that there are risks to the Fed being “pre-emptive” in removing stimulus, stating that the notion of low unemployment leads to increased inflation is not supported by economic history. Thus far, the data supports his position as inflation, as measured by the core PCE gauge, has undershot the Fed’s target for 58 straight months, even as the unemployment rate has halved. Nevertheless, Chairman Yellen continues down the path of incrementalism now rather than be forced to implement policy at an accelerated pace later. From the standpoint of transparency and the orderly functioning of markets, we tend to agree.
According to minutes released Wednesday, May 24th from the Federal Open Market Committee meeting earlier this month, the central bank sees a system where it will announce cap limits on how much it will allow to roll off its balance sheet each month without reinvesting. Any amount it receives in repayments that exceeds the cap limit will be reinvested. Similar in concept to when the Fed “tapered” its purchases of securities under quantitative easing (QE), it will now set a limit to the amount of securities it will let roll off. Caps will be set at low levels initially, then gradually increase every three months, according to the meeting summary. The cap level would reach a limit that would be designed to take the balance sheet down to a certain level — perhaps around $2.5 trillion, according to some reports. “Nearly all policymakers expressed a favorable view of this general approach,” the minutes stated. In our view, this is a very benign outcome for U.S. mortgage-backed securities.
Elsewhere on the policy front, European Central Bank President Mario Draghi stated that structural headwinds and weak inflationary pressures continue to warrant “extraordinary support” despite some resurgence in the European economy. The staff was largely unanimous in its view that resource underutilization continues to present a challenge to achieving medium term inflation targets.
Despite the persistent flow of news across a multitude of topics, ranging from U.S. monetary policy through rather shocking displays of political commentary from “celebrities,” fixed income markets continue to digest these factors in an orderly fashion. While the appointment of a special counsel to investigate the possibility of foreign interference in U.S. elections sparked one sloppy trading session, it did little to change the direction of U.S. credit markets. Primary issuance remains robust as the demand for investment grade corporate securities has shown no signs of waning. In our view, this reflects both strong global demand for U.S. dollar fixed income and a stable corporate earnings profile with few signs of disruption visible over the intermediate horizon.
That being said, the market is not without some factors which give us pause. For example, Moody’s lowered China’s sovereign credit rating one notch to A1 on May 24th, citing concerns over the country’s debt burden and lending standards. Additionally, the Chinese sovereign yield curve briefly inverted preceding this action, a phenomenon the bond market always views with a skeptical eye as it reflects a view of weakening growth (the previous inversion was the U.S. yield curve in 2005.) It was similar concerns that led to significant market volatility in 2015, which sent shockwaves through credit and commodity markets alike.
In summary, while we are constructive on the fundamental backdrop for U.S. corporate issuers, we have found more value in intermediate-term securities. In our view, the shorter spread duration profile better balances the risk-reward relationship, particularly as longer-dated securities have richened, relatively-speaking. On the duration front, we come back to the old adage of “don’t fight the Fed.” Though we have been patiently waiting for the U.S. inflationary picture to catch up to unemployment, and we also recognize that history is not entirely on that theory’s side. In our view, the market has too heavily discounted the Fed’s outlook, if not looked past it altogether.