Weekly Market Update
The Federal Reserve (the Fed) recently took the unprecedented step of declaring their interest rate policy for the next two years—they will be holding their short-term rate target essentially at zero well into 2013. We’ll give our perspective on why the Fed has taken this unusual step, and what these policy decisions tell us about the state of the economy, inflation, and the bond market. Finally, we’ll address potential solutions for income-oriented investors in today’s environment of record-low bond yields.
The Fed’s Rationale: Provide Certainty to the Markets
We believe the key reason the Fed openly declared its policy intentions for the next two years was to provide some certainty to jittery financial markets. It is a truism that markets hate uncertainty. Providing a clear statement about future monetary policy was the Fed’s attempt to address those concerns.
All the volatility in stock and bond markets in recent weeks can be traced to this fear of the unknown: Stocks have seesawed by 3% or 4% a day or more and the yield on the 10-year Treasury touched its lowest level in decades because of uncertainty on the economy and the European sovereign debt crisis, as well as the debilitating political wrangling in Washington, among other factors. While the Fed has little or no control over many of these issues, we believe their aim was to provide markets some assurance in the one area firmly under their purview—monetary policy.
Another important consideration is that low short-term rates are beneficial to the banking sector, which typically borrow short and lend long. Keeping short-term rates low in relation to longer-term bond yields is a way for banks to earn their way back to health. Finally, low yields on cash-equivalent investments is a disincentive to saving—rather than see consumers stockpile cash, the Fed would prefer to see that money put to work in the economy and financial markets.
Recession More Likely, but Still Not Probable
Related to the Fed’s decision and the recent market volatility is the downturn in the economy. From jobs and manufacturing to consumer confidence and spending, entire swaths of the economy look more fragile than they did just a few months ago. Weaker economic numbers have many market participants fearing a double-dip recession, which explains in part the dramatic volatility in stocks and recent rally in Treasury bonds (which are often thought of as a “safe-haven” investment).
Our own view is that the probability of a recession has increased, but that it is still not the most likely outcome. So while the likelihood of recession is greater, we continue to adhere to our oft-stated view that the most likely outcome is a “recovery with headwinds” scenario with economic growth in the range of 1% to 3%.
Inflation Rising, but Not Out of Control
Inflation has clearly increased in recent years. The government’s primary measure of consumer inflation is the Consumer Price Index, or CPI. CPI increased at a 3.6% annual rate through the end of July. Prices at the wholesale level, as measured by the Producer Price Index, or PPI, were up 7.2%. Key factors behind the increase in CPI are higher commodity prices and owners’ equivalent rent (CPI measures shelter costs not in terms of home purchase prices but in terms of rental costs).
Nevertheless, a weak job market is acting to keep a lid on wage pressures. Similarly, excess capacity in manufacturing and other sectors should help keep inflation in check because any increase in pricing is likely to be met with an increase in supply.
In our view, inflation is likely to remain contained (which we define as running in a range from 1% to 4%) for the next several years. Longer-term, though, the Fed and Treasury have provided significant monetary and fiscal stimulus to support the economy. We think it is possible that these actions run the risk of creating even higher inflation than is currently priced into the market.
How to Explain the Treasury Rally
We began this article by talking about how much markets hate uncertainty. Nowhere is the proof of that statement more clear than by looking at the rally in Treasury bonds, a traditional safe-haven investment. A litany of concerns about global economic growth and sovereign debt, questions about the possibility of a third round of quantitative easing (QE3), and the dramatic sell-off in stocks all sent investors running toward the relative safety of Treasuries. As a result, the yield on the 10-year note dipped briefly below 2% on Thursday, August 18, a level last reached in the 1950s.
Another reason 10-year yields fell so substantially is speculation that the Fed might change the focus of their open market operations from T-bills to longer-term notes and bonds. The Fed typically manages the money supply by buying and selling T-bills, the shortest-term Treasury securities. But investors have begun to speculate that the Fed may look to drive down yields on 10-year Treasuries (a key lending benchmark for mortgages and other loans) by selling short-term securities and buying these longer-term bonds.
Implications for Income Investors
Record-low interest rates present very real challenges for income-oriented investors. In addition, uncertainty around the health of the economy raises questions for some credit-sensitive investments. In that environment, we are focusing on investment-grade corporate bonds, or select high-yield corporate issuers that we believe have the wherewithal to stand up to a subpar recovery. Indeed, as a result of the recent Treasury rally and sell-off in riskier assets, high-yield corporate bonds now offer what we believe are compelling yields over Treasuries.
This positioning meets the first requirement of income investors in that yields on corporate securities are attractive relative to those available on Treasuries. We also believe investment-grade corporate securities are attractive because of their overall credit quality—corporate America is enjoying record profits, holds an unprecedented amount of cash, and has been working diligently to cut costs and pay down debt. In addition, large, multi-national corporations offer diverse revenue streams and exposure to overseas economies, which may fare better than the U.S. and Europe. With respect to high-yield bonds, the market has effectively priced this sector for recession, which we believe is out of line with the likely course of economic growth and doesn’t reflect the favorable corporate outlook.
This view is consistent with our positioning in American Century Investments’ core fixed-income portfolios, where we have been favoring corporate credits over Treasuries and mortgage-backed securities for some time. As a result, investors can gain exposure to what we believe to be attractively valued corporate securities through a core bond portfolio (which has exposure to the broad sectors of the fixed-income market) or dedicated corporate bond allocation.
Nevertheless, we should remind investors that high-yield bonds carry heightened credit risks. In addition, the sector typically moves closely with the stock market and correlations actually increase when stocks sell off. Therefore, we would caution investors to view a high-yield position as part of the “supporting cast” rather than as a core holding.
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The opinions expressed are those of the chief investment officer and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice.
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