The Fed needs to Lead not Follow

August 21, 2019

The U.S. Federal Reserve (Fed) can lead or follow. But today, we firmly believe they need to be proactive and lead, and not be reactive, in order to get ahead of this relative global decline in policy rates.

If they follow we believe they will continue to be behind the curve and yields will likely continue to decline.
- Why? Because the market believes the slower the Fed reacts today, the more they will need to cut in the future.
If the Fed leads by cutting rates proactively (sooner and by more), then the market will restore term premia and confidence in its future outlook for economic growth.
- This can potentially slow, and even reverse, the long-term decline in yields.
Success for the Fed would be reflected by a steeper yield curve and a weaker U.S. dollar (USD), according to the market.
The USD is an important risk barometer, as a stronger USD is a significant headwind to global growth and financial conditions in general.
- The Chinese yuan (CNY) fixing is a key metric to watch, but as long as the USD/CNY fixing continues to trend higher, yields will trend lower because it shows a continuation of market stress.
- This fixing is also an indicator of U.S.-China trade risk
Other important macroeconomic factors:
- Fiscal stimulus becoming hip and fashionable again (Germany is warming to it).
- U.S. is headed in the same direction (easier to pay for it with 50-year and 100-year bonds, which has been hinted.).
- Globally, countries are less worried about spending, given how low rates are.
- All this talk about fiscal stimulus could stabilize markets for the time being. U.S.-China trade is the key.

Investment Themes

We remain long duration and high on quality
- High yield:
  - Likes – Building materials, transports, select retail. BB rating bias.
  - Concerns - Energy, healthcare, Bs, CCCs.
- Investment grade:
  - Likes – Financials, utilities, communications.
  - Concerns – Healthcare, pharmaceuticals
  - Risk – Pace of delevering is slowing as low interest rates make refinancing more attractive.
- Emerging markets:
  - Opportunities – Brazil (reforms, rate cuts), Central and Eastern Europe/Poland (European Central Bank play, central banks have room to ease), Mexico (cutting rates but still political risks), South America (high-beta emerging market, similar to Mexico).

RISK CONSIDERATIONS
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging-market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).

August 2019

Jim Caron

Managing Director

Global Fixed Income Team

The Fed needs to Lead not Follow

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