PM Corner: In conversation with Andrew Norelli
As Fed policy shifts, fixed income strategies need to manage changing correlations between risk assets and duration.
2022 was the most challenging year on record for fixed income returns, and investors are assessing the impacts of aggressive central bank policy tightening. What are you seeing?
Knowing the effects of monetary policy are realized on a lag, and given the speed and magnitude of tightening thus far, we don’t yet know the cumulative impact of 2022’s actions. However, we’ve seen some evidence that the Federal Reserve’s (Fed’s) hawkish response is delivering the intended disinflationary impulse and that demand is falling victim to tighter financial conditions. In recent communications, the Fed seems to be transitioning to a more nuanced approach whereby fighting inflation remains a priority, albeit not at the expense of an outright economic crash.
While the jury is still out on the future path of inflation, the Fed’s recent shift in tone is a subtle acknowledgement of downside growth risk previously absent from its rhetoric. Barring a red-hot inflation print over the next few months, investors will continue to shift focus by assigning higher importance to the trajectory of unemployment data as the ability to engineer a soft landing is questioned.
Throughout the past year, we have positioned 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?
Coming into 2022, we felt the transition from quantitative easing (QE) to quantitative tightening (QT) would have a significant impact on markets. At a high level, we proposed that if QE caused financial asset price inflation then QT would run that dynamic in reverse, resulting in lower prices across financial assets – at least at first. Looking back, markets indeed spent much of the past year in this period of painful, wrong-way correlation – our framework’s Phase 1, detailed below – on a path to resetting equities lower and bond yields higher.
However, we believe the resulting tighter financial conditions have a real-world impact on economic data. While more observations are needed, it is possible U.S. inflation will slow in the coming months – particularly as components like food and shelter come off the boil – and markets will turn attention to the evolving growth outlook. Against the backdrop of decade-high yields and growing recession risks, we may now be nearing a period of transition back to a more typical, right-way correlation between stock and bond returns – Phase 2 of our framework.
In an environment of shifting correlations between risk assets and high-quality duration, it is important to be able to dynamically adjust duration, yield curve positioning, sector allocations and overall risk positioning.
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 2022 (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 (and 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): In our initial development of the Three Phases Model, we envisioned a final stage where the Fed acknowledges that its 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.
That said, we acknowledge a transition to Phase 3 may be (significantly) delayed given the current backdrop, where aggressive policy transmission is lagged and the ultimate evolution of inflation data is uncertain. While Phase 3 envisions a policy “relent,” it is possible the Fed will continue its aggressive QT and rate hikes beyond what is necessary to rein in inflation, rather than stopping before inflation fully stabilizes at or near its target. Risk therefore remains that either the Fed inaccurately forecasts policy lag and/or inflation’s recent sequential cooling doesn’t continue.
How does the model inform your approach to the fixed income environment ahead?
In the beginning of 2022, the model helped us anticipate the uncomfortable transition from QE to QT, informing our earlier decision to be short of duration in portfolios. Now, we acknowledge we may be nearing a period of transition – one where duration again serves its traditional, beneficial role – as markets attempt to project the lagged effects of monetary policy and potentially shift focus from inflation to growth. In an environment of shifting correlations between risk assets and high-quality duration, 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.