by Brad Tank, Chief Investment Officer—Fixed Income, Neuberger Berman
While the policies may not have changed at last week’s U.S. Federal Reserve meeting, the messaging certainly did.
Following weeks of highly coordinated dovishness, a string of hot economic data, including last month’s print of year-over-year consumer price inflation at 5%, appears to have prompted some recognition of the risk that current inflation may turn out to be more than “transitory.”
The central bank raised its inflation forecast for 2022 and Chair Jerome Powell acknowledged that “inflation could turn out to be higher and more persistent than we expect.” The “dot plot” of governors’ rate expectations showed a median expectation of two hikes in 2023, up from zero. Eight voters now anticipate a fed funds rate above 0.75% by the end of 2023. And on the topic of asset purchases, Powell confirmed that the Fed is now “talking about talking about” tapering.
In response, fed funds futures brought their forecast for the first hike forward from April to January 2023 and U.S. Treasury yields jumped, with the 10-year rising 11 basis points.
Even so, the 10-year yield quickly fell back to pre-meeting levels under 1.5%, well below the highs it reached at the end of March. That is remarkably low, given the prevailing economic conditions.
To us, this reaffirms that low yields in Treasuries and investment grade corporate bonds owe less to markets buying into the Fed’s “transitory inflation” narrative, or to expectations around the future of asset purchases, and more to technical flows and liquidity conditions.
Overseas demand for U.S. dollar assets has strengthened: It has been years since hedging dollars back to euros or Japanese yen has been as cheap as it is today, which means U.S. assets provide some yield pick-up for non-U.S. investors. Pension funds appear to be shifting assets into bonds to lock in higher funding ratios after a year-long equity market rally.
But perhaps most important for credit investors and asset allocators is the possibility that the very nature of investment grade paper—sovereign and corporate—has been changed by the Fed’s decision, 15 months ago, to include corporate bonds in its asset purchases.
There now appear to be two types of asset in financial markets: those eligible for major central bank purchases, and those not.
We think we can see this new bifurcation when we look at how the volatility of investment grade bonds has evolved compared with that of other assets. Volatility in general has been suppressed by central bank interventions over the past decade, but that of investment grade has collapsed over the past year, while risk-asset volatility has responded more to the recovery in economic conditions.
We believe this affects investor behavior in two ways, each of which knocks on to asset allocation decisions.
First, when confidence grows that a price-insensitive buyer is ready to support the investment grade market in the event of a severe sell-off, a liquidity crunch or a spike in volatility, we think that makes investors a little less price-sensitive and a little less concerned about downside risk, too.
Second, as the historical volatility of an asset class declines, it generally causes asset-allocation models that seek to optimize between expected returns and the potential distribution of returns to recommend larger and larger allocations to that asset class.
For an unlevered fixed income portfolio, that optimization effect is likely to be relatively modest. For multi-asset class portfolios, however, and particularly for multi-asset class portfolios that are mandated to use leverage in pursuit of higher returns, it could result in substantially larger allocations to investment grade bonds, at the margins.
This is what we may be seeing, as models recalibrate to the new risk-and-return characteristics of investment grade. And remember, this is a feedback loop: The lower volatility falls, the more modelled allocations increase, the more assets are allocated at the margins—and the lower volatility falls again.
It is difficult for us to see what can break this loop beyond an explicit statement by the Fed that it will no longer buy corporate bonds (which seems unlikely, given the disruption it might cause) or the central bank losing control over inflation. Should last week’s change of tone put some of those inflation concerns to rest, it may extend the current regime of extremely low volatility in investment grade and force asset allocators to revisit their models.