The Fed's Next Move

April 20, 2012

The Fed's Next Move?

"If everything seems under control, you're not going fast enough"—Mario Andretti.  If you're an investor, you might hope that policy makers in the developed world would heed the wisdom of Mario Andretti. After a burst of confidence in the first quarter, when things appeared to be running smoothly, the markets have re-focused on the challenge of trying to reduce government debt in the absence of economic growth. Here in the U.S., the next opportunity bond investors will get to observe shifts in policy will be the Federal Reserve's next meeting on April 24-25th. The Fed may feel reasonably confident that they're "in control," but it seems less likely to us that they'll feel we're going "fast enough."

• We don't expect any change in policy at the Fed's April 24-25th meeting. But the market will be scrutinizing the Fed's economic projections for hints about further quantitative easing, the end of Operation Twist and the length of the Fed's commitment to low interest rates. At the January FOMC meeting, the committee made the historic decision to publish forecasts on rates and economic measures from the 17 committee members, along with the "central tendency" (i.e. where the bulk of the projections reside.) It's the range that we'll be watching most closely for signs of shifting expectations.
• Projections for GDP growth are likely to indicate a moderate, but not exceptional, growth rate. The range is likely to remain in the 2.5% to 3.0% range, in our view. Based on the January projections, the range of forecasts for GDP wasn't very wide, though there was a wider range of views on inflation and unemployment. Positive growth is encouraging, of course, but the pace of growth remains sub-par compared to a more robust recovery.
• The unemployment rate has already fallen to the low end of the Fed's range, based on the January projections. Therefore, it seems reasonable to anticipate that range will be lowered from the 8.2% to 8.5% projections published in January. FOMC members appear to disagree on the reasons for the recent path of unemployment. Fed Chairman Ben Bernanke and the more "dovish" Fed members (meaning, they favor lower rates and more accommodative monetary policy) suggest that the drop in unemployment is largely due to discouraged workers dropping out of the labor force. In contrast, some more "hawkish" members (those who tend to lean toward a tighter monetary bias) believe that unemployment is high due to a structural mismatch of skills with job openings. It's no surprise to report that the Bernanke "dovish" camp is still driving policy.
• On inflation, the views also diverge between the hawks and doves. The January Fed report showed a wide dispersion of projections for the deflator for personal consumption expenditures (PCE, one of the Fed's preferred inflation measures) between 1.3% and 2.8% for 2012. The central tendency narrowed to 1.4% to 1.8%, but clearly this is where there is some disagreement on the outlook. The more dovish Bernanke camp, expecting lower inflation, will hold sway here (in our view) as well, until data showing higher prices driven by increased lending and/or wage growth clearly changes.
• We don't expect that the Fed will hint at or announce further quantitative easing. GDP appears to be growing at 2% to 2.5% rate or higher, unemployment is falling and core inflation is holding near the 2% level. Lending growth is improving, pointing to a more stable banking sector and adequate liquidity in the financial system. Returns from each round of easing appear to be diminishing. However, we also expect that Bernanke will leave the possibility of QE3 (i.e. a third round of bond buying from the Fed designed to help keep interest rates low) on the table. He has consistently said that the Fed is prepared to do more if economic conditions warrant it.
• What would warrant more action by the Fed? We're encouraged by stronger signs from the U.S. economy, as well as efforts to stabilize the European credit crisis. But two risks we worry about are the upcoming fiscal tightening that may happen in 2012—the so-called "fiscal cliff"—as well as a worsening of the European debt crisis.

1. On fiscal stimulus. Bush-era tax cuts are set to expire, automatic spending cuts are set to trigger and stimulus programs are winding down. Cuts to stimulus alone even with an extension of tax cuts will likely be a drag on the U.S. economy in the short-term. The effect of this is estimated to be in the vicinity of 3% of GDP by many economists.
2. On Europe. If European sovereign debt problems threaten to spread over to the U.S. banking sector and affect U.S. growth, the Fed may be pushed to respond with some form of monetary stimulus.

• Bottom line. While we don't expect an official policy change at the upcoming FOMC meeting, the release of a new set of economic expectations, if they vary greatly from the last projections in January, could be a market moving event. For bond investors, there's nothing to indicate to us that the tilt won't remain toward accommodative rate policy until 2013 and beyond until there's rate of change in growth speeds up.

Central Tendency of Fed Forecasts—January 2012

Source: Federal Reserve, January 25, 2012.  Numbers in the table are year-over-year percentage change for real GDP, PCE inflation, and core inflation.

Moody's Downgrade of GE

While it may not have been a major news event to most market watchers, Moody's downgraded the debt ratings for General Electric Company (GE) to Aa3 along with the rating on its wholly-owned financial subsidiary, GE Capital Corporation (GECC), to A1. GE was once one of the seemingly 'untouchable' Aaa/AAA-rated industrial corporations, so the changes aren't insignificant. In Moody's view, GE still has "many AAA-like credit characteristics." But their view also reflects the "heightened risk profile inherent to finance companies like GECC," they say, a significant part of GE's operations. The broader takeaway to us is not so much a comment on GE specifically. We are not making a company-specific comment or investment recommendation. It's more about the inherent sensitivity of lending and financial companies to smoothly functioning financial markets as well as access to money when they need it.

• The credit crisis continues to reveal the risks in market funded financial institutions, a risk that rating agencies and markets strive to understand. Moody’s indicated that the GE downgrade was a reflection of risk stemming from its financial arm, GECC. While the downgrade isn’t good news for investors, it’s not a major surprise. On March 19, Moody’s revised its global rating methodology for financial institutions and warned that others may be downgraded as well, some, potentially, by several rating notches. Their views, they say, reflect ongoing market and structural developments as well as insights gained from the recent global credit crisis and 2007-2009 recession.
• "During the credit crisis, [credit] markets were unreliable for even the strongest issuers." While oversight has improved, the sensitivity of banks and financial firms to market conditions is still a fundamental part of the business model of finance firms. Financial institutions, including GECC, involve risks associated with a "high reliance on confidence sensitive funding," even though, in Moody's view, GECC is "one of the strongest finance companies in the world." Even with its fundamental strengths, and connection to General Electric, GECC still "relies on the capital markets" to fund its portfolios.
• For investors, be careful about credit quality and too much exposure to a single sector or security. Most banks and financial institutions have taken steps to build capital and strengthen reserves. Regulatory scrutiny, including Dodd-Frank and the Volker rule, are seeking to put rules in place to manage and limit risk. Other banks continue to deal with legacy issues from the financial crisis. Still, this is an area to be wary of lower-rated issuers and investing based on higher yields only.
• We divide corporates broadly into financial institutions, industrials and utilities. We're not committed to the notion that investors should strictly benchmark their exposure to individual bond sectors, such as corporate bonds, to an index or snapshot of the market. But it's helpful to understand the composition of markets as a whole as a reminder to spread out investments in a way that provides diversification and limits exposure to any single sector alone.  The table below shows this market balance, over time, using the widely-followed Barclays US Corporate Bond index.

Composition of the U.S. investment-grade corporate market by sector

Source: Barclays U.S. Corporate Bond Index, daily data as of April 17, 2012.

Financials including banks currently account for roughly 35% of the U.S. investment-grade corporate market, a level that’s fallen from nearly 50% prior to the 2008 credit crisis. Industrials, including conglomerates like GE and a wide range of other non-financial issuers excluding utilities, now accounts for 54%.

• Yields should be higher, in our view, compared to similarly-rated industrials and utilities. This is market pricing in compensation for ratings volatility, the potential for future changes in regulatory policy and methodology from the rating agencies as well as fundamentally leveraged, market-reliant business models. The chart below shows these yield spread over time. Currently, it looks to us that investors are generally being compensated, relative to the risks, if they can stomach some price volatility and diversify adequately against risk in any single issuer. Whether you are receiving adequate compensation for your needs should be an individual decision, depending on your risk tolerance and the role in the rest of your portfolio.

Yield Spread of the U.S. investment-grade corporate market by sector

Source: Barclays U.S. Corporate Bond Index, daily data as of April 17, 2012.  Option-adjusted spread (OAS) is the basis point spread relative to Treasuries, net of the cost of any embedded options.

The Growing Divide in Muni Bonds

The direst predictions about muni defaults haven't materialized. The revenue picture for state and, to a lesser degree, local governments, is stabilizing in our view. Still, municipal governments are caught in the bind of rising social service needs and employment costs and the "age of austerity"—the fundamental need, as well as the political tide, of limited revenue and taxing ability. We think that we're well into a process of divergence in credit quality in state and local government muni bonds—that is, the division between the vast, silent majority that are managing challenges and the vocal minority who are not. It's our view that defaults in state and local government bonds will remain isolated events. But issuers have become less homogenous, less interchangeable with each other without investigation or credit analysis.

• We think the top priority for municipal governments will be managing multiple stakeholders and obligations. This is generally the case for the wide range of 50,000+ state and local municipal bodies, whether they're active bond issuers or not. That's the reality of a tight revenue climate and a tough balance of employment and healthcare costs, service obligations, and other obligations like employee pensions that have been promised and funded. This is a much tougher task when resources are limited. It's not a surprise to see debate and headlines focused on these issues. This will be a challenge for the next decade or more, in our view. We'll likely see more idiosyncratic cases of these pressures leading to distress. For the most part, we expect that that the impact to bondholders will remain isolated, but not zero.
• Stockton, California and others are case studies. What happens, exactly, when a municipality reaches the end of its rope and needs help? We're finding out, with the widely-publicized examples of Vallejo, CA, Jefferson County, Alabama and now Stockton, CA. As we said, there will be exceptions. And other issuers will watch the cases to see if they're "successful." Note: Vallejo, CA is one example that has been widely cited as an example of the enormous expense, and limited benefit, of a municipal bankruptcy filing. The city was able to negotiate very few concessions with stakeholders including unions. And individual bondholders—not the primary source of most of Vallejo’s problems—were largely unaffected.
• Pay close attention to the bonds you buy, and own. There's more and more information available every day to help with this, thanks to ongoing reforms from municipal security governing bodies such as the Municipal Securities Rulemaking Board (MSRB). The MSRB's website, EMMA, has links to current municipal bond disclosures. But the consistency and quality of the disclosures is being watched closely by the MSRB and other rule-making authorities. Even with current disclosure, investors must also have some sense of how to use the information they receive. This is still a challenge, given the complexity and idiosyncrasies of municipal credit analysis.
• Few municipalities will broadcast in plain English pending credit stress. Unlike corporations, municipalities aren't profit-seeking organizations. And they don't have quarterly reporting requirements, their budget processes can be opaque and they don't have publicly traded equity as a measure of current and future success. (The flip-side to this, we'd note, is that you’d have to work hard to find a way for a municipal government to shut-down and disappear. This is not the case with corporations where liquidations happen regularly.) As a result, you won’t hear much in plain English about credit risk unless you're well-trained in reading between the lines and finding the fine line between ordinary business and signs of real stress.
• Outsourcing credit analysis using funds and professional managers is still a good option, for many. Professional managers, whether for funds or managed accounts, can help look for problems, but also provide the variety of individual muni issuers to diversify against idiosyncratic, issuer-specific risk. We don't expect that we'll see a widespread shift in defaults, as we’ve said previously. But credit analysis and active monitoring may be increasingly important in the “next phase” for the historically stable, but strained, universe of state and local government bonds.

Diversification and Bond Benchmarks

What's a good benchmark to build a bond portfolio around, and is it adequate as a starting point in the current market for most investors? The Barclays U.S. Aggregate Bond Index is a commonly-used taxable bond index. Over time, it has become heavily skewed toward government bonds, with very low yields and limited exposure to other sectors. Does this provide enough diversification for most investors focused on a broader range of investments as well as income now?

• The Barclays U.S. Aggregate Bond Index is now dominated by Treasuries and government-backed securities. Since the financial crisis, a concern we have is that the index has a greater proportion in government bonds, including agency-backed securities, many of them mortgage bonds from Ginnie Mae as well as Fannie Mae and Freddie Mac. Both Fannie and Freddie mortgage bonds, a multi-trillion dollar part of the U.S. taxable bond market, are currently supported by the U.S. government. Only about 20% of the index represents corporate bonds. Note: This index does not include tax-exempt muni bonds. Many investors could consider using highly-rated munis, in our view, as the foundation for a core bond portfolio in taxable accounts.
• The index is now more concentrated in one issuer—the Federal government—and has been delivering a lower yield than many clients may want for an income-oriented portfolio. It will be no surprise to most fixed income investors, but the yields on government bonds remain low, with the yield for the Aggregate Bond Index 2.1% as of April 16, 2012. The average maturity of bonds in the index has also become slightly longer, currently at 7 years. This may be longer, with lower yield, than many investors will be comfortable with, even in their core holdings.  Keep in mind that the Aggregate Bond index does not incur management fees, costs and expenses and cannot be invested in directly.
• One strategy is to diversify into other sectors of the bond market, subject to need and risk tolerance. We continue to favor credit (i.e. investment-grade corporate bonds) in the current climate, for up to 30% or so of a core bond portfolio, as well as certain types of municipal bonds in taxable accounts. In the current climate, a core portfolio may benefit from "tilts" in credit away from an 80% exposure to Treasuries and government-related mortgage bonds. The key point to us, as always, is diversification and not pushing the boundaries here too far. A "core and explore" strategy, starting with bonds with low credit risk, supported by exposure to intermediate-term corporate and muni bonds using ladders, still makes sense to us for most income-oriented investors in the current climate.
• We also continue to believe that investors can also "expand the core" using mutual funds or exchange-traded funds to build a diversified bond portfolio. For examples of portfolios using funds, clients can log-on to Schwab.com and go to Products, then Portfolio Solutions, and then look for the Schwab PortfoliosTM link. They'll find an online tool they can use to view a pre-set list of mutual funds allocated according to the risk profile they select.  Consider using the list as a starting point, boosting diversification using other funds—such as credit-specific exchange-traded funds (ETFs) or multi-sector and world bond funds—to expand your portfolio.

For additional help or a look at the mix of maturities and credit in your portfolio, talk with your financial consultant or a Schwab Fixed Income Specialist at 800-626-4600.

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