The Trans­par­ent Fed

Feb­ru­ary 2, 2012

by Rob Williams
Direc­tor of Income Plan­ning, Schwab Cen­ter for Finan­cial Research

and Kathy A. Jones
Vice Pres­i­dent, Fixed Income Strate­gist, Schwab Cen­ter for Finan­cial Research

Last week, the Fed unveiled a new com­mu­ni­ca­tions strat­egy. They pro­vided fore­casts for growth, infla­tion and inter­est rates for the next sev­eral years. The neg­a­tive bias in the rate fore­casts sur­prised bond mar­kets. They point to the like­li­hood, given cur­rent infor­ma­tion, that the Fed will keep short-term inter­est rates at zero until the end of 2014 due to expec­ta­tions of slow growth and sub­dued infla­tion. One view on these fore­casts is that it's too dif­fi­cult to fore­cast so far into the future and that the Fed might be wrong and be forced to reverse course. Another view (ours, for the record) is that increased trans­parency is good, a pos­i­tive in an open market.

• The Fed's move is con­sis­tent with the trend toward open­ness. From appear­ances on "60 Min­utes" to press con­fer­ences after the meet­ings of the Fed­eral Open Mar­ket Com­mit­tee (FOMC), Chair­man Bernanke has tran­si­tioned the Fed from opaque­ness under Alan Greenspan to more trans­parency. These steps bring the U.S. in line with other cen­tral banks that have pro­vided long-term rate fore­casts, such as Swe­den and the U.K. By pro­vid­ing more infor­ma­tion, the argu­ment goes, the Fed can help busi­nesses and indi­vid­u­als plan more clearly for the long-run and dampen mar­ket volatil­ity. The trans­parency of fore­casts gives them a tool to change their views more flex­i­bly and reduce the num­ber of "sur­prise" pol­icy changes.
• The Fed also announced an explicit 2% infla­tion tar­get for the first time in its his­tory. This explicit infla­tion tar­get also helps reduce uncer­tainty about pol­icy long-term. The Fed will use the 2% annual tar­get, based on changes in per­sonal con­sump­tion expen­di­tures (PCE) as their mea­sure. The cur­rent year-over-year increase in PCE is 1.8% in the lat­est num­bers. So they're still a touch below those tar­gets. Bernanke was asked in the press con­fer­ence fol­low­ing the meet­ings, "why PCE and not the con­sumer price index?"  One rea­son is that in CPI, hous­ing has a far greater weight.  It appears to have under­stated infla­tion dur­ing the hous­ing bub­ble and may over­state it now that rent­ing is more pop­u­lar than buy­ing. The PCE is also adjusted more flex­i­bly to chang­ing con­sump­tion pat­terns. Fed crit­ics might also argue that annual increases in PCE also tend to be lower than changes in the CPI.

Mul­ti­ple Mea­sures of Infla­tion Still Below Target

Note: The Con­sumer Price Index (CPI) mea­sures changes in the price level of con­sumer goods and ser­vices pur­chased by house­holds. The CPI in the United States is defined by the Bureau of Labor Sta­tis­tics as "a mea­sure of the aver­age change over time in the prices paid by urban con­sumers for a mar­ket bas­ket of con­sumer goods and ser­vices."  Core infla­tion (Core CPI) is a mea­sure of infla­tion which excludes cer­tain items that face volatile price move­ments, notably food and energy. The pre­ferred mea­sure by the Fed­eral Reserve of core infla­tion in the United States is the Core Per­sonal Con­sump­tion Expen­di­tures Price Index (PCE), which is put out by the Bureau of Eco­nomic Analy­sis of the Depart­ment of Commerce.

Source: Bloomberg, using monthly data as of Decem­ber 2011.

• Notably, the Fed did not announce a pol­icy tar­get for the sec­ond part of their dual mandate—employment. They explained this by say­ing that a host of other fac­tors, includ­ing pro­duc­tiv­ity, demo­graph­ics and pub­lic pol­icy, might change the level of max­i­mum employ­ment over time. Today unem­ploy­ment is 8.5%, unde­ni­ably above the level of struc­tural unem­ploy­ment con­sid­ered opti­mal now. The improv­ing trend in unem­ploy­ment may seem incon­sis­tent with the Fed's indi­ca­tion that pol­icy will remain "extremely accommodative"—meaning, they'll use every tool pos­si­ble to keep rates low. But they do have a long-run esti­mate (not a tar­get) for full employ­ment at a rate closer to 5.5%. We think this leaves the door open to more quan­ti­ta­tive eas­ing in the sec­ond or third quar­ters of this year.
• The Fed's growth fore­casts were below con­sen­sus expec­ta­tions. In the past, the Fed has released eco­nomic pro­jec­tions based on indi­vid­ual fore­casts from the 5 Fed Gov­er­nors includ­ing Bernanke and 12 Fed­eral Reserve Dis­trict Bank pres­i­dents. They present the cen­tral ten­dency, or aver­age, of 17 par­tic­i­pants. Despite a run of good eco­nomic data over the last few months, the cen­tral ten­dency (i.e. aver­age) of the fore­casts low­ered the esti­mate for 2012 GDP growth to a range of 2.2% to 2.7% from the pre­vi­ous esti­mate of 2.5% to 2.9%. They also low­ered their expec­ta­tions for 2013 to between 2.8% and 3.2%, from 3.0% and 3.5% in Novem­ber, and increased them slightly for 2014.
• Trans­parency should decrease uncer­tainty over what the Fed is watch­ing and why. One side of the debate says to “keep it to your­selves.” We don’t want to know, in par­tic­u­lar that your range of fore­casts varies so widely. Another per­spec­tive is that it allows us to see what the Fed is watch­ing most closely. And they can change their pol­icy and con­sen­sus more flex­i­bly. A crit­i­cal point that the pro­jec­tions make clear: There is no sin­gle pro­jec­tion, and there are dif­fer­ent views that can change over time on the com­mit­tee depend­ing on the data. We believe that the vot­ing mem­bers of the Fed will gladly change their posi­tions, if eco­nomic con­di­tions (in their view) war­rant it.

Earn Your Coupon

Cor­po­rate bonds have surged out of the gates in the first month of the year, ben­e­fit­ing from the post-holiday rush of con­fi­dence in U.S. equity mar­kets, stronger appetite for risk and Fed state­ments that they'll keep their poli­cies accom­moda­tive. In fact, the riskier sec­tors of the cor­po­rate mar­ket, includ­ing much-maligned U.S. bank debt, have out­per­formed their "safe-sector" gov­ern­ment coun­ter­parts. What’s our view of the prospects from here?

• We con­tinue to see investment-grade cor­po­rate bonds as a place to look for yield. We've been one voice advo­cat­ing this, and main­tain that view. The over­all fun­da­men­tals, in our view, such as reduced cor­po­rate lever­age, improved profit mar­gins and declin­ing finan­cial mar­ket volatil­ity are pos­i­tives. You can see thoughts from Kathy Jones on bank bonds in the "A Sec­ond Look at Bank Bonds" arti­cle in Novem­ber. How­ever, given the mag­ni­tude of the rally in recent weeks and ongo­ing risks ema­nat­ing from Europe, we sug­gest near-term caution.
• Long-term, we expect 2012 to be the year of "earn­ing the coupon" as com­pared to 2011, when much of the return in bonds came from price appre­ci­a­tion. Even with the extremely accom­moda­tive pol­icy stance by the Fed, we believe that the poten­tial for fur­ther price appre­ci­a­tion in bonds is lim­ited. We'd sug­gest adding new posi­tions dur­ing the pock­ets of time where pric­ing is more attractive.
• Higher risk sec­tors, such as finan­cials, have rebounded the most. U.S. banks in par­tic­u­lar have ben­e­fited from the rel­a­tive calm injected into the Euro­pean bank­ing sec­tor by the Euro­pean Cen­tral Bank's (ECB's) move to increase liq­uid­ity in the finan­cial sys­tem through their recently launched Long Term Refi­nanc­ing Oper­a­tion (LTRO). This pro­gram pro­vides very low-cost loans to Euro­pean banks, with very per­mis­sive guide­lines on the col­lat­eral required to back those loans, for up to three years. This has less­ened the pres­sure on Euro­pean banks and helped increase demand for yield in U.S. bank bonds.
• Higher risk sec­tors are still vul­ner­a­ble to neg­a­tive shocks. Even with increased liq­uid­ity in the Euro­pean bank­ing sys­tem and improved U.S. investor sen­ti­ment, more aggres­sive, higher yield­ing sec­tors are still the most vul­ner­a­ble to neg­a­tive sur­prises from the Euro­pean debt cri­sis and domes­tic econ­omy. With growth in the devel­oped world still frag­ile, in our view, bank and finance bonds are likely to remain the most volatile. We think util­i­ties, con­sumer sta­ples and other less cycli­cal sec­tors are likely to be rel­a­tively more stable.

Prices Rise for Cor­po­rate and Bank Bonds

Source: Bloomberg, using monthly data as of Decem­ber 2011.

State Rev­enue Watch

The Rock­e­feller Insti­tute of Gov­ern­ment pub­lishes widely ref­er­enced quar­terly reports on state rev­enue trends, includ­ing their lat­est this week. In Q3 2011 and pre­lim­i­nary Q4 2011, state tax rev­enues increased sig­nif­i­cantly "while the over­all econ­omy has been grow­ing at a rel­a­tively slow pace." The rev­enue trend is encour­ag­ing. But "such a dis­par­ity" between rev­enue col­lec­tions and the real econ­omy "is not sus­tain­able over time," in their view. This may be just fine, in our view, assum­ing state leg­is­la­tures stay on the broad course of bud­get dis­ci­pline. In con­trast, the full impact of the Great Reces­sion on local gov­ern­ment tax revenue—2/3 of which, on aver­age, come from prop­erty taxes—for many issuers will con­tinue to lag.

• State rev­enues grew for the sev­enth con­sec­u­tive quar­ter. Total tax rev­enues were up 6.1%, accord­ing to the Rock­e­feller data, in Q3 2011 from the prior year. How­ever, the decline start­ing in late 2008 was severe, so there's been a lot of ground to make up. Nation­wide, col­lec­tions are still 5.3% lower than three years ago in real terms (i.e. adjusted for infla­tion.) The pace of rev­enue recov­ery has been dra­matic, off the extreme lows of Q3 2009. But the pace has slowed, lev­el­ing out below prior peaks as expen­di­tures rise.
• Local gov­ern­ment rev­enues have faired less well. Local gov­ern­ments rely more heav­ily on prop­erty taxes, which account for more than 2/3 of total rev­enue for local gov­ern­ments, com­pared to the heav­ier reliance on sales and income taxes for state gov­ern­ments. As we've men­tioned in pre­vi­ous updates, the impact on prop­erty taxes, par­tic­u­larly after a cri­sis so heav­ily dri­ven by real estate, is gen­er­ally slower. Nation­wide, real (inflation-adjusted) tax rev­enues for local gov­ern­ments fell 2.0% over the last four quar­ters end­ing in Q3 2011, com­pared to 0.2% growth from Q3 2009 to Q3 2010, accord­ing to the Rock­e­feller report.
• Aus­ter­ity and tight bud­get man­age­ment remain the themes for now. While state rev­enue trends are strength­en­ing, a par­al­lel report from the Cen­ter on Bud­get and Pol­icy Pri­or­i­ties points to con­tin­ued expen­di­ture pres­sures, focus­ing on U.S. States. Twenty-nine states project bud­get gaps in 2013, and health care, edu­ca­tion and enti­tle­ment costs are ongo­ing chal­lenges. The expi­ra­tion of 2009 Recov­ery Act stim­u­lus spend­ing adds to these pres­sures. State and local gov­ern­ments are required by statute or their con­sti­tu­tions to deliver bal­anced bud­gets. But that doesn't make cuts any less painful, polit­i­cally. For the most part, how­ever, states are mak­ing adjust­ments to keep bud­gets balanced.
• Multiple-notch down­grades. The notion of multiple-notch down­grades for some munic­i­pal issuers has gained mod­est media atten­tion lately. As we wrote in the Jan­u­ary 20th edi­tion, rat­ing down­grades out­paced upgrades in the last half of 2011. Moody’s also reported late last year that the num­ber of "multi-notch" down­grades has also increased, though they remain a rel­a­tively small pro­por­tion of the num­ber of rat­ing actions. Often the cause is issuer-specific, related to lack of pro-active bud­get cuts lead­ing to a sharp decline in finan­cial reserves and cash bal­ances. We expect that we'll see more of these down­grades, espe­cially for smaller, local gov­ern­ments and issuers who haven't acted as aggres­sively to raise rev­enues or cuts costs. This is an issue for investors who hold these bonds, of course, but not, in our view, the broader mar­ket. We con­tinue to believe that diver­si­fi­ca­tion by issuer or pro­fes­sional man­age­ment using funds or man­aged accounts can help investors with these challenges.
• Cur­rent val­u­a­tion. Investors have been clam­or­ing for new muni bonds in the first part of the year. Sup­ply of new issue munis has remained tight, how­ever, push­ing yields down to a touch above his­toric lows. The ratio of munic­i­pal to trea­sury yields has also fallen to under 100% for AAA-rated matu­ri­ties under 10 years. Gen­er­ally, we still like munis for core port­fo­lio posi­tions for the com­bi­na­tion of credit qual­ity and tax-exempt yield. But in the same vein as the com­ments about cor­po­rates above, we'd also sug­gest adding posi­tions dur­ing pock­ets of weak­ness for buy-and-hold investors with favor­able long-term views. Con­sider look­ing for yield in the mid­dle of the curve or in cred­its a step down (but not too far down) the lad­der from AAA, such as the high end of the "A" range in credit, min­i­mum, or higher qual­ity issuers with matu­ri­ties from 7–15 years in lad­dered portfolios.

Muni Prices Peaking

Source: Bar­clays Cap­i­tal, daily data as of Jan­u­ary 30, 2012.

What About CDs?

Many savers are being forced to accept the painful real­ity that returns on cash in check­ing and sav­ings accounts may remain quite low for some time. Some investors had grown accus­tomed to alter­na­tives such as Cer­tifi­cates of Deposit (CDs) for slightly higher yields. Like other fixed income invest­ments, the CD mar­ket has grown in com­plex­ity. Find­ing the right CD invest­ment can be chal­leng­ing. We think it’s worth high­light­ing the major ques­tions we hear with thoughts on how to help investors through this market.

• What dri­ves CD rates? Pri­mar­ily, short-term rates and chang­ing sup­ply in the CD mar­ket. CD rates, like other fixed income prod­ucts, will often depend on how many banks are in need of cap­i­tal and what they're will­ing to pay com­pared to the alter­na­tives. In other words, more com­pe­ti­tion for the same assets could mean higher rates offered to investors, and vice versa. More­over, inter­est rates on CDs and other cash invest­ments are dri­ven by the yields on short-term Trea­suries and the Fed Funds rate. Trea­sury yields are low and effec­tively zero in short-term matu­ri­ties. So are the rates offered on CDs with shorter maturities.
• We don't expect that rates on CDs will move much higher in 2012, given the Fed's low rate poli­cies. Fed Chair­man Bernanke has noted when­ever asked that the Fed acknowl­edges the dif­fi­cul­ties for savers. His response: the Fed's man­date is employ­ment and infla­tion. If those remain con­sis­tent with eco­nomic strength, then savers, in their view, will ben­e­fit. This isn't par­tic­u­larly encour­ag­ing. But it's the real­ity short-term savers may con­tinue to face for some time.
• What are bro­kered CDs? CDs are bank prod­ucts, not invest­ments. That is, they're the oblig­a­tion of a bank, sim­i­lar to cash. But meth­ods of dis­tri­b­u­tion of indi­vid­ual CDs may vary. "Bank" CDs are usu­ally sold directly to a cus­tomer from a local branch. "Bro­kered" CDs are sold in the "bro­kered" mar­ket with wider distribution.
• One pri­mary dif­fer­ence between bank and bro­kered CDs… is how a CD buyer might sell them in the event they wanted their money back before matu­rity. Although not required by law, most bank CDs can be redeemed early, usu­ally after pay­ing an early redemp­tion fee. There are no for­mal guide­lines gov­ern­ing the penalty amounts. Bro­kered CDs are gen­er­ally traded on the sec­ondary mar­ket. While there is gen­er­ally no early-redemption fee, the price a seller might receive is depen­dent on the price a buyer is will­ing to pay.
• What about CDs from for­eign banks? Some for­eign banks with US branches offer CDs to U.S. savers. For all prac­ti­cal pur­poses, there isn’t much dif­fer­ence com­pared to a CD from a U.S. bank. The key fea­ture, we believe, is FDIC pro­tec­tion. If a for­eign bank fails, the FDIC promises to make the investor whole, up to cov­er­age lim­its. In our view, for­eign bank CDs with this fea­ture can be com­pared on equal terms (all other terms being equal) to CDs offered by domes­tic banks with FDIC coverage.
• Other fea­tures may mat­ter as much as yield. For most investors, yield and matu­rity are gen­er­ally the most impor­tant issues. How much will you be repaid, and when? Other fea­tures, such as calls, a vari­able inter­est rate or estate fea­tures may also be valu­able. Given the wide range of pos­si­bil­i­ties, pur­chasers, in our view, should look care­fully at the other char­ac­ter­is­tics, if they want them, and how they may serve their needs.
• What role should CDs play in the cash invest­ment and fixed income por­tion of an investor’s port­fo­lio? Unfor­tu­nately, CDs and other cash invest­ments have recently been less effec­tive income pro­duc­ers in most investors' port­fo­lios than they have been his­tor­i­cally. Yields are low and may not rise soon. Pur­chasers may be able to find slightly higher yields in CDs with longer matu­ri­ties. Like a bond, the investor com­mits to the lower rate should rates rise, poten­tially with lower liq­uid­ity. Also keep in mind that CDs can be sub­ject to inter­est rate risk and even issuer credit risk if you’re already over the FDIC pro­tec­tion lim­its. But for some, CDs with an above aver­age rate may help sup­port the more secure por­tions a fixed income port­fo­lio. For more insight, see SCFR's "What about Cash" and "Choos­ing CDs and Other Cash Invest­ments" arti­cles at schwab.com/marketinsight under Invest­ing > Cash.

Please visit www.schwab.com/onbonds for more fixed income per­spec­tive from the Schwab Cen­ter for Finan­cial Research. If you have ques­tions or con­cerns about the issues raised in this pub­li­ca­tion, please speak to your Schwab representative.

Impor­tant Disclosures

Fixed income secu­ri­ties are sub­ject to increased loss of prin­ci­pal dur­ing peri­ods of ris­ing inter­est rates. Fixed income invest­ments are sub­ject to var­i­ous other risks includ­ing changes in credit qual­ity, mar­ket val­u­a­tions, liq­uid­ity, pre­pay­ments, early redemp­tion, cor­po­rate events, tax ram­i­fi­ca­tions and other fac­tors. Income from munic­i­pal bonds may be sub­ject to the Alter­na­tive Min­i­mum Tax (AMT), and cap­i­tal appre­ci­a­tion from dis­counted bonds may be sub­ject to state or local taxes. Cap­i­tal gains are not exempt from fed­eral income tax.This report is for infor­ma­tional pur­poses only and is not an offer, solic­i­ta­tion or rec­om­men­da­tion that any par­tic­u­lar investor should pur­chase or sell any par­tic­u­lar secu­rity or pur­sue a par­tic­u­lar invest­ment strat­egy. The types of secu­ri­ties men­tioned herein may not be suit­able for every­one. Each investor needs to review a secu­rity trans­ac­tion for his or her own par­tic­u­lar situation.All expres­sions of opin­ion are sub­ject to change with­out notice in reac­tion to shift­ing mar­ket con­di­tions. We believe the infor­ma­tion obtained from third-party sources to be reli­able, but nei­ther Schwab nor its affil­i­ates guar­an­tee its accu­racy, time­li­ness, or completeness.International invest­ments are sub­ject to addi­tional risks such as cur­rency fluc­tu­a­tions, polit­i­cal insta­bil­ity and the poten­tial for illiq­uid mar­kets. Invest­ing in emerg­ing mar­kets can accen­tu­ate these risks.Past per­for­mance is no guar­an­tee of future results.Diver­si­fi­ca­tion strate­gies do not assure a profit and do not pro­tect against losses in declin­ing markets.Funds deposited at an FDIC insured insti­tu­tion are insured, in aggre­gate, up to $250,000 per depos­i­tor, per insured insti­tu­tion based upon account type by the Fed­eral Deposit Insur­ance Cor­po­ra­tion (FDIC). The FDIC con­sid­ers any other deposits you may have with an issu­ing bank. CDs you pur­chase from a par­tic­u­lar bank are aggre­gated with any other deposits you may have with the issu­ing bank for deter­min­ing FDIC insur­ance cov­er­age (e.g., if you already have deposits of $250,000 with a bank, don't pur­chase CDs from the same bank in the same own­er­ship cat­e­gory).Bar­clays Cap­i­tal Munic­i­pal Bond Index con­sists of a broad selec­tion of investment-grade gen­eral oblig­a­tion and rev­enue bonds of matu­ri­ties rang­ing from one to 30 years. It’s an unman­aged index rep­re­sen­ta­tive of the tax-exempt bond mar­ket.Bar­clays Cap­i­tal U.S. Cor­po­rate High-Yield Bond Index cov­ers the USD-denominated, non-investment grade, fixed-rate, tax­able cor­po­rate bond mar­ket. Secu­ri­ties are clas­si­fied as high-yield if the mid­dle rat­ing of Moody's, Fitch, and S&P isBar­clays Cap­i­tal U.S. Cor­po­rate Bond Index cov­ers the USD-denominated, invest­ment grade, fixed-rate, tax­able cor­po­rate and non-corporate bond mar­kets. Secu­ri­ties are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the mid­dle rat­ing of Moody's, S&P, and Fitch.Indexes are unman­aged, do not incur man­age­ment fees, costs and expenses and can­not be invested in directly.The Schwab Cen­ter for Finan­cial Research is a divi­sion of Charles Schwab & Co., Inc.

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