Bond Bulletin
30-07-2020
GFICC Investors
Regime change
While the July meeting proved to be uneventful, we anticipate that the Federal Reserve (Fed) will change its inflation-targeting approach. For bond investors, history may be about to become a less reliable guide.
Fundamentals
Federal Open Market Committee members have hinted that a shift in the Fed’s inflation-targeting approach to outcome-based forward guidance may be on the cards. The Fed has a dual mandate of employment and price stability, with the price stability part of the equation currently represented by a 2% core PCE inflation target. However, this target has been more of a guide, as the Fed has raised rates when PCE has been below 2%. Under outcome-based forward guidance, there would be no hiking until inflation moved sustainably above 2%. In fact, only one of the three hiking cycles in the US over the past 25 years would have happened under such a regime. Therefore, the shift could have meaningful repercussions for policy decisions. Not only would it mean that the Fed could remain on hold for a significant period of time, but also that policymakers may need to use further accommodative tools to avoid falling short of their inflation target.
The Fed has previously hiked rates without core PCE being sustainably above 2%
Source: Bloomberg, U.S. Bureau of Economic Analysis, Federal Reserve; data as of 31 May 2020. Core PCE is the core personal consumption expenditures price index – the Fed’s preferred measure of inflation.
Quantitative valuations
Government bond markets have already been pricing in the expectation that rates will remain low for some time. The US benchmark 10-year government bond yield, which started the year at 1.92%, has fallen meaningfully to 0.58%. For credit markets, a shift to outcome-based forward guidance means we can’t necessarily compare current valuations to historical levels as an indication of fair value. Current spreads for US investment grade and high yield markets, at 140 bps and 529 bps respectively, are both close to longterm averages. These levels may seem relatively meagre given the recessionary backdrop, but could actually present opportunity for further compression under the new regime. (Data as of 28 July 2020).
Technicals
The technical implications of a shift to outcome-based forward guidance stem from the potential for rates to stay low for several years. Under such a regime, the search for yield would persist, which may mean that investors continued to look to spread products to generate income. In turn, this could mean that issuers took advantage of strong demand to issue new debt, whether for refinancing or other purposes. The balance would need to be watched carefully, as technicals are currently the main driver of the strong rebound in credit markets. With the Fed being a natural buyer through its corporate purchase programme, further liquidity injections from additional easing measures or an expanded toolbox could bolster demand even more.
What does this mean for fixed income investors?
The implications for bond investors of a shift to an explicit outcome-based forward guidance from the Fed are twofold. First, Fed policy could become even more accommodative as policymakers attempted to reach their inflation target. Second, the discussion about what fair value looks like for credit markets would be reopened. Under a new regime, looking back through history may become less valid as a way of assessing current valuations.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum