How will the Fed’s forward guidance impact bond investors?
June's FOMC's meeting signaled the Federal Reserve remains quite cautious about the rebound and will continue to use all of its tools to insure the recovery is on solid footing.
Listen to On the Minds of Investors
The Federal Open Market Committee (FOMC) met this week and provided investors with a fresh set of economic and interest rate projections after a six month hiatus. At the meeting, the committee also voted to maintain the current Federal funds target rate at a range of 0.00%–0.25% and the interest paid on excess reserves (IOER) rate at 0.10%. Going forward, revised estimates suggest the committee will remain accommodative well into the economic recovery.
The release of the FOMC’s Summary of Economic Projections (SEP) and median interest rate projections (“dot plot”)—both of which are normally revised once a quarter— are key policy tools that help to anchor interest rate expectations according to baseline assumptions on economic growth (real GDP), employment and inflation dynamics. This forward guidance helps businesses and consumers in their spending and investment decisions by providing a degree of clarity on where interest rates are likely headed over the near- to medium-term.
As highlighted in the table below, relative to its December estimates, real GDP growth was revised down to -6.5% y/y in the fourth quarter of 2020 and adjusted up in 2021 to a modest 5%, suggesting a more muted bounce back in economic activity next year. The unemployment rate was revised higher to 9.3% and 6.5% for the fourth quarters in 2020 and 2021, respectively, signaling considerable expected slack in the labor market; given the projected longevity of the pandemic and some degree of social distancing, these numbers may be optimistic. Both core and headline PCE inflation are expected to trend towards 1% through the end of the year and continue to fall short of the Fed’s 2% target through 2022, likely reflecting the committee’s expectation of above trend unemployment dampening demand well into next year, and a welcome sign for investors worried about stimulus-related inflation emerging in the next few years.
Broadly, these forecasts support the FOMC’s statement, which calls the outlook highly uncertain and with “considerable risks,” and acknowledges the steep declines in economic activity, the surge in job losses, the collapse in oil prices and all other consequences of the social distancing efforts put in place to combat the public health crisis.
Also shown in the chart below, the median federal funds rate projection—as measured by the “dot plot”—implies no rate adjustments over the forecast period, with market expectations pricing in a similar outcome. Notably, all 17 FOMC participants voted for no further changes to rates this year and next and only two members voted for rate hikes in 2022, suggesting the committee is in broad agreement on an “on-hold” approach to policy over the foreseeable future. Importantly, no member voted in favor of negative rates, dismissing the notion the Fed might consider bringing rates below zero.
For investors, short rates are likely to remain anchored at near zero while back end yields may rise, albeit gradually, as the economy recovers. With the potential for a steeper curve in the months ahead, investors may be tempted to abandon duration altogether. However, with traditional equity valuations signaling a bit of exuberance, investors should maintain balance within portfolios, with exposure to high-quality duration as a hedge against equity risk and exposure to high-quality floating-rate bonds to hedge against rising yields.
Moreover, with interest rates expected to remain at near zero for at least the next two and half years, the need for income will be greater than ever. Given this, bond investors will need to accept greater risk in order to achieve their income targets. This means higher exposures to high-quality credit and municipal debt; introducing private assets like real estate and infrastructure to the portfolio; and considering hybrid securities like high-quality preferred and convertible bonds.
In closing, while recent data suggest economic activity may have bottomed in April, June’s FOMC meeting signaled the Federal Reserve remains quite cautious about the rebound and will continue to use all of its tools to ensure the recovery is on solid footing.
Federal funds rate exceptions
FOMC and market expectations for federal funds rate