Word Up - August
The US Federal Reserve Chairman, Jerome Powell, has stated that the central bank will tolerate higher future inflation and lower unemployment to a much greater extent than it has done in the past without having to raise interest rates. For those that don’t obsess over the words of central bankers this may not seem a big deal. But to those of us that do and make our livings trying to be successful investors, this is huge. The six-year period in which the Fed kept rates at 0.25% last decade might seem like a blip in the coming cycle if inflation doesn’t turn up. In the meantime, there is a case for inflation-linked bonds, for borrowing to invest and for watching whether pricing power can become a key factor in equity performance if the Fed’s strategy does work.
Last week I discussed the US interest rate complex and the nuances involved with monetary policy being at the zero-lower bound. My key message was that a significant steepening of the yield curve would only be possible if inflationary expectations were to rise. Well, lo and behold, inflationary expectations are up. At least those that are represented by the break-even inflation rate in the US Treasury Inflation Protected Securities (TIPS) market. Why so? Well, the Chairman of the Federal Reserve Board (Fed), Jerome Powell, made a major speech on Thursday at the Kansas City Fed’s annual economic symposium (held remotely of course this year but still referred to as the “Jackson Hole” conference). In that speech, Powell introduced part of a longer-term review of monetary policy strategy, focussing on the Fed’s monetary policy goals. Simply put, the Fed will now target an average inflation rate of 2.0% over time allowing it to tolerate periods when inflation is above 2.0% to compensate for periods when it has been below. That means it won’t simply tighten monetary policy when its economists forecast an increase in inflation to 2%. It will need to see inflation above 2% and for some time before rates are raised. This means rates will remain low for even longer.
The obvious trade on the back of Powell’s speech is to buy US break-even inflation (buy TIPS versus conventional US Treasuries). The break-even inflation rate is the difference in yield between conventional Treasury securities and TIPS and indicates market-based expectations of inflation over different maturities. The current 10-year break-even is 1.75%. A week ago it was 1.65%. At the height of the coronavirus market crisis the rate was just 0.55%. If we believe the Fed, the 10-year break-even rate should be at least 2.0%. A further increase in the break-even is most likely to be achieved by a 30bps rise in conventional Treasury yields. Such a move would be consistent with the reflationary theme and would be a signal for value stocks to outperform in the equity market. Last week I said that rising longer-term yields might be a problem for the credit markets, a 30bps move is not likely to cause too much concern.
More in September
There is a lot more to come from the Fed. This Jackson Hole speech was just a preview of a more comprehensive review to be announced in September. The obvious thing missing from yesterday’s Powell speech was how the Fed is going to get inflation higher. It has a large tool box already but the market will be keen to hear if there are any new developments to look forward to – such as the type of yield curve control practised by the Bank of Japan in recent years. What we can infer is that the barrier to raising interest rates has become higher. In addition to average inflation targeting, Powell also suggested that the Fed will be willing to tolerate much tighter labour markets in the future. Historically, with the Phillips Curve as a guide, central banks have played off labour market indicators against expected inflation – when unemployment rates fell to or below estimates of the natural rate of unemployment, central banks raised rates to dampen any inflationary pressures coming from rising wages. That trade off doesn’t seem to be as clear these days – the Phillips curve has flattened. In practice then, the Fed now thinks it can tolerate unemployment falling to very low levels (or employment being at a maximum) for longer without having to tighten monetary policy. Indeed, Powell seem to suggest looking at it from a different point of view. If there is a shortfall of employment relative to an estimated maximum level, monetary policy will remain supportive of growth and job creation. Again, the barrier to raising rates is higher.
Today some fear deflation
Only time will tell whether economic behaviour will respond to this profound shift in monetary policy. Many commentators are more inclined to think the world faces deflation rather than inflation. Even if the Fed is successful it will take time for inflationary expectations to shift. However, if economic agents do believe that a slightly higher rate of inflation will be tolerated going forward, this could eventually impact on the timing of consumption and investment decisions and boost aggregate demand. Of course, more is needed from the Fed. It has to be very clear in its forward guidance what the new approach means for rates. It has to be clear what the role of asset purchases and the balance sheet will be. It also as to be clear that monetary policy will tolerate much bigger government budget deficits (which was not always the case historically). And all of this needs to be made clear against the backdrop of an economic situation that is potentially disinflationary.
The more dovish approach from the Fed will encourage even more debt growth. Why not? If borrowing costs are to remain very low and the central bank is encouraging inflation to be higher, the real cost of debt will fall. This should be positive for the US housing market and hopefully encourage corporate America to actually invest in capacity and new technology, rather than just borrowing money in the bond market to shore up balance sheets and purchase equity. From the markets point of view, it’s a signal to stay with risk. Having money in cash will be eroded in real terms and government bonds are not likely to offer much real return either (apart from Treasury Inflation-Protected Securities). So credit and high yield and equities should take the bulk of savings.
As I say, the market will be keen to see more from the Fed particularly as there is well understood scepticism about the ability of central banks to actually get inflation to go up. Inflation, measured by headline and core consumer price inflation, is running closer to a 1% rate this year rather than 2%. However, it has averaged just above 2% over the last twenty years. So, it is not that ambitious a target on the basis of realised inflation over the recent past. Still, inflationary expectations have been lowered and the current huge shock to the economy will make it hard for them to rise quickly. However, in the meantime the power of policy should mean we are likely to have somewhat higher US Treasury yields. Higher yields will activate global duration buyers so they might not be able to move that much higher (1% may be a target). Moreover, markets are likely to become more consumed with the election in the next few weeks and that is likely to be the major source of any volatility. The Republican National Convention this week provided little solace to the view that the political atmosphere in the US could become extremely toxic in the coming weeks.
Love the linker
Regular readers will know that I am a big fan of inflation-linked bonds. They offer an option to preserve real returns if inflation does rise, certainly relative to nominal bonds with very low yields. Moreover, they offer strong diversification benefits in a multi-asset portfolio, generally providing a negatively correlated return profile to equities (because of the duration characteristic). There are lots of technicalities in the inflation-linked market, and the strong demand seen historically from defined benefit pension funds – especially in the UK – is not likely to be as important an influence on the market going forward. However, it will remain significant and I suspect that if there is any chance of the Fed being successful in raising inflationary expectations, the demand for inflation-linked bonds should broaden and deepen. A 5-year inflation-linked bond in a 2% inflation world will deliver much stronger compound returns than a 5-year nominal bond with a yield to maturity of just 0.3%.
If the stars align
At risk of being a Cassandra, there probably has not been a more likely time for inflation to rise with the obvious caveat of the effects of the pandemic driven rise in unemployment in the US and other major economies. Policy is super expansionary with both fiscal and monetary balance sheets expanding. The Fed’s new approach is actively encouraging inflationary expectations to rise – maybe it should grant all its employees an inflation busting wage increase to set the example! There could also be a green element to all of this. It is becoming increasingly obvious that a more comprehensive global system of carbon pricing is needed to accelerate the switch away from fossil fuels to renewable energy and reduced emissions. The price of carbon, where there is one, is far too low. If carbon prices are to rise this will also impact inflation for a period of time until consumption and investment patterns shift far enough away from old sources of energy. The carbon transition is not effectively priced yet and inevitably it will mean some increases in costs to firms and consumers if it ever does become so. If successful, of course, energy costs will tumble in the future with the shift towards alternative fuels, but the transition will be disruptive. I am not sure Powell had any of this in mind but one can paint a picture of various influences coming together to get to his 2% average quite easily. There could also be an impact from potential shifts in global labour supply and supply chains that may materialise from a generally more protectionist global landscape and the effects of the pandemic.
It’s arguably a strange world when the most important central banker on the planet is actively encouraging inflation to rise and promising not to raise interest rates for a long time. He wants lower real interest rates in a world that hasn’t conformed to conventional economic models for some time. He’s effectively saying: fill-your boots, borrow now because it won’t cost you much in interest and the debt will be worth less in real terms when you pay it back. If the state can continue to put pressure on banks to lend to finance investment and consumption, then having a higher level of debt and a few zombie companies surviving is probably a price worth paying. The portfolio that will benefit from this working will be the one with inflation exposure through bonds, and through companies that can leverage pricing power through the cycle and are highly operationally geared. But it should also have FAANGS still, just as a hedge and to keep exposure to the structural long-term themes and the potential scarcity of growth.
I remain in Cornwall for the time being and as I look out of the window, I am reminded of the unusual times we remain in. Docked in Falmouth harbour is a huge cruise ship called “The World” (have a look here). It is like no other cruise ship – it’s a floating residence with “apartments” owned by the rich and famous. Usually, it is sailing the oceans providing its residents with all kinds of luxury and experiences. But today it is empty and docked beside a naval frigate in for repair. If pre-COVID life was “normal” and this ship was part of that “normality” I am not sure we will ever go back to how things were. Yet if one day I walk down to the docks and pass people not wearing face masks to find that “The World” has sailed off into the wild blue yonder, the crisis will be well and truly over.