Analyses
Where to Go From Here? Reimagining the Fed’s Policy Response Function
|
|
Market Pulse
|
• |
août 21, 2020
|
Where to Go From Here? Reimagining the Fed’s Policy Response Function
|
août 21, 2020
|
Where to Go From Here? Reimagining the Fed’s Policy Response Function
Where to Go From Here? Reimagining the Fed’s Policy Response Function |
|
It has been said that investors are short a “Fed put” because the Fed will add accommodation to support assets in times of stress. But there’s more! At the September FOMC the Fed may move toward policies that are skewing the distribution of outcomes in favor of higher asset prices in order to provide increased policy support at the zero lower bound. For investors, this is the functional equivalent to be short an “in-the-money-put” that has more value and provides greater incentive for investors to align with the policy response function.
This is how Fed policy may be reimagined with their upcoming Statement on Long-Run Goals and Monetary Policy Strategy as they complete their framework review at the September FOMC meeting.
Why is this important? Because since the start of the pandemic, Fed policy has had significantly greater impact on asset prices than economic fundamentals.
- As a next step, we expect the Fed to communicate its Statement on Longer-Run Goals and Monetary Policy Strategy at the upcoming September FOMC meeting.
- At the zero lower bound the Fed’s policy reaction function needs to be reimagined.
- At the September FOMC, we see this culminating in an Average Inflation Targeting (AIT) approach. This approach signals that in order for the Fed to correct for undershooting their 2% inflation target, policy rates will be kept low - even while the economy runs hot - in order for inflation to overshoot its target and an “average inflation target” of 2% is reached.
There are other monetary policy strategies under consideration that we believe will be less impactful:
- Yield Caps or Yield Curve Targets (YCT) were not ruled out but seen as suboptimal at this time, producing only a marginal benefit.
- Forward-based calendar guidance that links changes in policy to metrics like the unemployment rate and inflation. This approach may be too slow and purely reactive, compared with proactive Fed policy.
- Utilize asset purchases in a more directed way to ease financial conditions.
*** Important *** Fed policy may shift toward skewing expectations or the distribution of outcomes through using an AIT approach.
- By using AIT, a strategy designed to tolerate upside potential in the economy and inflation without taking action, the Fed is effectively supporting an upside in asset prices.
- At the same time, downside participation is likely mitigated through asset purchases, a commitment to low rates and liquidity and funding support programs.
- Combining these two suggests the Fed is reshaping, or skewing the distribution of asset prices to the upside (toward the right) while “skinny-ing” down the left tail. For investors this means they are short the equivalence of an “in-the money-put,” which has more value due to increased unconventional Fed support.
- Investors are therefore incentivized to align with the policy response function, which should broadly support asset prices and ease financial conditions.
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 that the value of Portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. 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 a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. 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).
|
Managing Director
Global Fixed Income Team
|