August 31, 2020
Central bank policy is being pushed to new, unprecedented limits as the Fed keeps the floodgates open to manage the sledgehammer economic blow inflicted by Covid-19.
The Fed has made it clear that it is set to keep rates at the so-called ‘zero bound’ (potentially for years) as it implements a new policy targeting an ‘average’ rather than an absolute inflation level of 2%, implying scope to let inflation run slightly hot if it ever returns. Its theoretically infinite Quantitative Easing (QE)1 program is also still in play, and the Fed has made clear that it will up its purchases if financial conditions take a turn for the worse.
This round of policy has been dubbed “QE infinity”2, although with the Fed also dipping its toe into buying credit and high yield assets for the first time this year, it may be more accurately referred to as ‘QE infinity and beyond’.
Officially, the Fed is now avoiding the ‘QE’ label in its official communications but impact of the policy on financial asset prices since March is undeniable, even if this may not be reflected in inflation any time soon, according to Gautam Khanna, senior portfolio manager of the BNY Mellon Core Plus Strategy. The Fed is committed to near-term monthly purchases of at least US$40bn in mortgage-backed securities (MBS) and US$80bn in treasuries.3 It has open purchased more in weeks than it did during the entire QE program that followed the 2008 global financial crisis.
“The Fed’s current actions are bigger, broader and faster than they’ve ever been. At the start of this crisis, in March and April, treasury purchases peaked at over US$300bn per week.” 4
The Fed has been forced to implement an unprecedented level of policy actions to calm markets and extinguish the economic fire started by Covid-19. In other words, it’s had to react quickly with its back to the wall—and longer-term implications of the unorthodox policy have been a secondary concern.
Some do think that, as the stimulus is so large, and the situation so unique, that the Fed could eventually overshoot its inflation target to a level that would be difficult to control. But for Khanna, this is unlikely for the time being.
“While inflation is a longer-term concern given the massive injection of liquidity, this is not front of mind as unemployment remains elevated for now and there is enough slack in the system, which makes it less of an immediate concern,” Khanna says.
Additionally, as the Fed will now have more tolerance for above-target inflation (by switching to the 2% average target)5 to make up of for years of weaker inflation, the Fed itself appears to concur. According to Khanna. “In theory, this will give it more room to let its balance sheet moderate naturally, instead of having to clamp down on inflation as soon as it reaches 2%.”
When to step back
At a time when unemployment is still high and businesses are struggling to survive, it’s hard to imagine hitting 2% inflation in the near term. But if, for some reason, inflation did suddenly increase, Khanna says he would allocate towards floating rate instruments, which act as defense mechanisms against rising rates. He would also consider higher exposure to spread assets, which he says:
“Underlying default probabilities would likely recede as it became easier to grow into existing debt loads and delever through growth in EBITDA and earnings, which in turn would lead to spread compression.”
But that’s not the case just yet. For now, he’s managing his portfolio with a balance of income generation (from exposure to credit and securitized sectors) and ballast (from government-oriented sectors). This— together with constant reassessment of staying power from portfolio constituents—and the analysis of Covid-19’s long-term effects on industries, is how Khanna says he’s positioning against future risks. While inflation may not be expected in the short term, it will eventually happen and weaning the market from QE won’t be easy, according to Khanna. However, when the Fed does start to unwind its balance sheet, it will likely occur slowly, over a prolonged period of time, he says.
“Unwinding the balance sheet will be a deliberate process that will likely take a long time and be difficult to achieve,” he says. “The Fed’s buying and selling could have a significant impact on market technicals and the supply/demand balance so it needs to be considered carefully.”
In the past, the Fed has preferred to let its portfolio mature and not fully reinvest proceeds.6 Khanna says it will likely follow a similar path but will hold off until post-2022.
For now, how the Fed unwinds its balance sheet is a longer-term issue. A more immediate concern is how it will deal with the growing deficit as a result of such sizable stimulus?
“The Fed’s treasury purchases with newly created dollars is financing most of the deficit,” Khanna says. “If the long end of the yield curve steepens, the Fed can do another operation twist or purchase more long bonds to keep a lid on rates and minimize the government’s borrowing costs.”
In other words, the Fed can decrease government borrowing costs by using debt monetization. This is when the Fed purchases more long treasuries as part of its QE operations, which then takes those bonds out of circulation, ultimately decreasing overall supply and increasing the value of remaining bonds. As a result, both yields and interest rates on government debt go down. According to Khanna, private sector savings and demand should help keep a lid on rates as well.
However, because the Department of Treasury faces a US$2.8 trillion deficit,7 there will likely be increased treasury issuance next year.8 Khanna says this could increase the Bloomberg Barclays US Aggregate Bond Index’s9 weighting to treasuries by 3-5% depending on issuance from other sectors.
Ideally, quantitative easing should incentivize lenders and prompt corporations to issue more debt. During the current cycle, the Fed has flooded markets with capital via its asset purchases, which includes a plan to buy US$750bn in corporate bonds.10 As of the end of July, corporate debt only comprised US$3.6bn of its balance sheet.11 But even so, the purchases seem to be having their intended effect. Khanna says banks have extended over US$900bn of credit,12. They’ve also increased lending to coprorations by U$250bn and increased MBS holdings by U$150bn.
“2020 issuance year-to-date exceeds the total in most calendar years, at nearly US$1.5 trillion. A large amount of debt has been termed out and maturities have been pushed out,” Khanna says. “The duration of the investment-grade corporate index has lengthened to almost nine years as a result and the default probabilities of issuers in this category has improved from the depths of the crisis.”
But while QE may be working, the current crisis is still creating a clearer divide between winners and losers. Therefore, portfolio diversification and investing with an emphasis on balance sheet strength and staying power is as important as ever, Khanna says.
“Default rates are projected to rise in areas directly impacted by Covid-19 as well as less obvious spaces,” he says. “As bond investors, we need to assess the credit worthiness and sustainability of the capital structure, and the stability of underlying ratings and default probabilities. “This is always important but more so today when leverage ratios are on the rise and the underlying economy is still in the recovery phase.”
Right now security selection is just as important as industry selection. While online may win against brickand- mortar, and supermarkets may win against restaurants, there are still important differences at the issuer level that call for a strong security selection process, he concludes.
1 Quantitative Easing is defined as a form of monetary policy, in which a central bank purchases longer-term securities from the open market to increase the money supply and encourage lending and investment.
2 Seeking Alpha: QE infinity – so it begins, March 24, 2020.
3 CNBC: Fed sees interest rates staying near zero through 2022, GDP bouncing to 5% next year. June 10, 2020.
4 St. Louis Fed: Assets: Securities Held Outright: US. Accessed August 20, 2020.
6 Fox Business: How the fed’s unwinding will work, September 19, 2017.
7 The Wall Street Journal: US Deficit totaled 2.8 trillion from October through July, Treasury says. August 12, 2020.
8 Wolf Street: End of QE, Week 8: Fed’s assets fall by -$4 billion for the week…, August 6, 2020.
9 The Bloomberg Barclays US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the US.
10 Fortune: The Fed reveals which companies make its corporate bonds shopping list. June 29, 2020.
11 Martketwatch: Fed slows corporate debt purchases to trickle. August 11, 2020.
12 Federal Reserve: Assets and Liabilities of Commercial Banks in the United States. Accessed August 21, 2020.
All investments involve some level of risk, including loss of principal. Certain investments have specific or unique risks. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. Mortgage-backed securities: Ginnie Maes and other securities backed by the full faith and credit of the United States are guaranteed only as to the timely payment of interest and principal when held to maturity. The market prices for such securities are not guaranteed and will fluctuate. Privately issued mortgage related securities also are subject to credit risks associated with the underlying mortgage properties. These securities may be more volatile and less liquid than more traditional, government backed debt securities.
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