October 6, 2020 | Expert Perspective
How the Fed could rewrite the rules for fixed income
After more than a year of public discussion, and hints and foreshadowing by officials, the Federal Reserve unveiled a significant new approach to managing inflation at the September meeting of the Federal Open Market Committee. While the shift may appear modest, or even simplistic, actually implementing this new approach could rewrite the rules around fixed income investing and have implications for client portfolios.
Up till now, the Fed has pursued a let-bygones-be-bygones strategy regarding inflation. Meaning, no matter what the prior inflation rate was, the Fed only looked forward in terms of setting policy to hit a 2% inflation target. The change means that the “bygones” are now important. The Fed no longer commits to act in advance of inflation, to prevent it from running too high over its 2% target. Instead, the Fed will try to manage inflation so it averages 2% over time, letting it rise above that target for potentially long periods in order to make up for times when it falls below 2%.
The Fed calls this "average inflation targeting," which sounds simple but may be difficult to pull off. This new policy may change the market response as well. The investing maxim "don’t fight the Fed" now takes on new meaning since it is less clear what the Fed is actually going to do in response to new economic data. Interest rate increases—which have been as foreseeable as a winter cold front—now become less predictable.
Average inflation targeting is broader and more subjective, variable, and flexible than the current policy. A whole new communications approach from the Fed may be necessary, fostering a cottage industry of analysis and prognostication. It may take years for the Fed’s anticipated change to fully play out and be priced into assets.
The growing Fed consensus for the new approach emerged over the past two years in a series of research papers and public statements from Fed officials and the presidents of the Federal Reserve Banks. The long-discussed change will become a permanent part of the postpandemic landscape. With the U.S. government grappling with a large budget deficit because of the spending to address the COVID-19 crisis, the Fed may be reluctant to raise interest rates and increase the country’s burden with higher annual debt payments.
Moreover, this policy can also be seen as part of the Fed’s recent efforts to broaden economic gains to all sections of society.
If the Fed’s new approach works as intended, we believe it could potentially lead to:
Lower federal funds rates for longer time periods and steeper U.S. Treasury yield curves.
Under the new paradigm, coming out of a recession, the Fed is less likely to raise rates quickly, in essence allowing the economy to heat up, and run hot, for longer. This could result in a longer period of credit outperformance. Also, as the U.S. economy improves postrecession (assuming that the Fed commits to not raising rates), the yield curve will probably steepen as the term premium rises, given the uncertainty around potential Fed action.
Higher inflation uncertainty.
If the policy change functions as well as the Fed hopes, there will likely be more uncertainty about future inflation. The value of strategies that protect against that uncertainty should also rise. If inflation is unknown, investors may demand a greater premium to hold traditional nominal bonds.
There are implications for advisors and their clients as well
Finding true alpha will be key, and actively managed fixed income funds should prove their mettle.
As the market reacts to the new paradigm, which essentially will result in a more dovish Fed, at least initially, it will be tempting to chase yield and to expose funds to market beta rather than true alpha, i.e., above-market returns based on security selection, long-range insights, and value opportunities. Strong credit analyst teams will weigh the financial strength of issuers as a differentiator between bonds. Fund managers adept at weighting sectors and duration will help add value. Fixed income teams that are deeper and possess greater expertise will have the opportunity to prove themselves in the new environment. At Vanguard, we believe that our top-down macroeconomic view combined with our bottom-up analysis will enable the analysts, traders, and portfolio managers on our fixed income team to add value to our robust lineup of active taxable and municipal bond funds.
Holding extra cash may not help.
Some advisors fear—or are waiting for—interest rate hikes that may be a long time coming or not come at all. Some have kept a large portion of client assets in money markets or short-term bond funds for this reason. While short-duration products have their place, advisors who make an active decision to sit on the sidelines and wait for potential rate hikes may be disappointed.
Monthly Core Personal Consumption Expenditures Price Index
Year-over-year change, 2000–2020
Rampant 1970s-style inflation will not return.
The easy-money policies of central banks worldwide have helped push up gold prices and spawned, in some quarters, fears of a return of runaway inflation. The Fed’s new inflation messaging may help stoke those fears. But aging demographics in developed markets, technological innovations, and the likely slow economic recovery as a result of the COVID-19 crisis should limit inflationary pressures. Vanguard believes inflation could trend gradually higher but will probably remain below the Fed’s 2% target.
We all rely on our prior experience to inform our current decisions. Yet while experience is valuable, sometimes the economic environment and the rules can shift in new ways that change the game and surprise us. When seen in hindsight, the Fed’s new inflation policy may become one of those watershed events that changes valuations and expectations. While Fed officials have ruled out the possibility of implementing negative interest rates, the Fed’s policy change could keep rates on Treasuries below reported inflation for longer periods.
Because bonds often buffer equity market turbulence, they still hold an important role in a portfolio despite their current overall low yields. For investors who are wise about their choices, opportunities for higher fixed income returns, relative to the return of the broad bond market, exist without taking undue risk.
This article was updated from a previous version published on August 25, 2020.
- Past performance Is no guarantee of future results. All investing is subject to risk, including possible loss of principal.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.