PM Corner: In conversation with Andrew Norelli
As Fed policy shifts, fixed income strategies need to manage changing correlations between risk assets and duration.
In a challenging start to the year for fixed income markets, investors are coming to grips with the start of a rate hiking cycle, inflation at 40-year highs and newly hawkish central banks. Where are we now?
Almost nothing is a foregone conclusion at this point. I can envision plausible scenarios that could result in the Federal Reserve (Fed) ultimately hiking rates to a level beyond the market’s expectation. Or, in contrast, the Fed could fail to achieve the magnitude of policy tightening that it (and the market) currently expect will be needed. If forced to choose which scenario is more likely at this point, I’d say the latter, primarily because I think the Fed underappreciates the impact of its quantitative tightening program on demand destruction through tighter financial conditions.
I don’t think the pathway to either outcome will be straight, however. That is because the Fed has shown its willingness to adjust policy in response to incoming data even if such adjustments are sometimes late. We’re positioning (and re-positioning) portfolios dynamically according to a framework that tries to make sense of the intersection of quantitative tightening, rate hikes, tighter financial conditions and, eventually, a responsive Fed.
Can you describe the framework and what it implies for dynamic positioning?
We take as a given that quantitative easing (QE) causes asset price inflation. That point is debatable but consider the following simple explanation. As we see it, the world’s wealth can be stored in only two buckets: cash and everything else (non-cash assets). At any point there is an equilibrium global asset allocation between the two buckets.
Think of QE as a giant swap that impacts that equilibrium. QE inserts cash (reserves) into the economic system and removes non-cash assets (government bonds, mortgages, and sometimes corporate bonds and ETFs). During QE, when the supply of cash goes up and the supply of non-cash assets goes down, the aggregate price of non-cash assets needs to go up to restore equilibrium to the global allocation between cash and non-cash assets.
Quantitative tightening (QT) should run this process in reverse, at least at first. The resulting asset price deflation (rapid tightening of financial conditions) then starts to affect the underlying economy, which should provoke a response or course correction from the Fed. To envision how this cycle might play out, we developed our Three Phases Model. Most importantly, this model helps us think critically about the unstable relationship between risk assets and duration during QT. It acknowledges there will be periods of right-way correlation (when duration hedges risk assets) and wrong-way correlation (when it doesn’t).
The transition from QE to QT will likely lead to shifting correlations between risk assets and high-quality duration.
Using your Three Phases Model, how do you foresee the role of duration in portfolios evolving throughout QT?
Here is a high-level summary. A more thorough explanation of the model can be found on our fixed income blog.
Phase 1 (wrong-way correlation): QT removes cash and increases the supply of non-cash assets, which initially pushes financial asset prices lower and financial conditions tighter. During this phase, duration fails to hedge risk assets, as bond prices fall (yields rise) while risk trades poorly. Arguably, we entered Phase 1 early, in January (for arcane reasons explained in the blog). We favor being short of duration during this initial phase.
Phase 2 (right-way correlation): Tighter financial conditions eventually affect underlying economic performance and a deteriorating economic backdrop continues to weigh on the price of risk assets. But government bond prices begin to rise (yields fall) as markets anticipate that a dovish course correction from the Fed is warranted. Importantly, a more traditional negative correlation between risk assets and duration takes effect. Investors can reduce portfolio risk by adding high-quality duration.
Phase 3 (right-way correlation): Ultimately, the Fed acknowledges that its actual (and still-projected) tightening has had a negative impact on economic performance. It slows its policy normalization (in other words, it makes a dovish course correction). During this period, we envision continued negative correlation between risk assets and duration, but in the opposite direction from Phase 2. That is, risk assets recover while government bond prices fall (yields rise). In this final phase, we prefer to shift back to being short of Treasury duration as rates sell off amid improved risk sentiment.
How does the model inform your approach to the fixed income environment ahead?
The model underscores that the transition from QE to QT will likely lead to increased volatility across all asset classes, with shifting correlations between risk assets and high-quality duration. Especially in this type of environment, it is important to be able to dynamically adjust duration, yield curve positioning, sector allocations, and overall risk positioning. That flexibility is at the heart of our approach to fixed income markets.