The Transparent Fed

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.