G. David MacEwen, Chief Investment Officer of Fixed Income, outlines the views of the fixed income portfolio management team at American Century Investments® regarding the monetary policy changes announced Sept. 21 by the Federal Reserve, and their potential impact and implications.
- The U.S. Federal Reserve (the Fed) announced a new monetary policy program involving the purchase and sale of U.S. government securities that, like a similar program 50 years earlier, is intended to stimulate the stagnant U.S. economy.
- In particular, the program, labeled “Operation Twist” by market participants and the financial media, is supposed to further reduce long-term interest rates and induce more borrowing, lending, refinancing and spending activity.
- We question whether this program can be successful because we believe the lack of borrowing and lending activity has more to do with other fundamental economic and regulatory conditions than it does with interest rates.
- We examine how bond market sectors are being affected by the Fed’s announcement.
- We also review our broad bond portfolio positioning and performance at American Century Investments.
What monetary policy changes did the Fed announce on Sept. 21, after the conclusion of its two-day Federal Open Market Committee meeting?
The Fed announced, as expected, another monetary policy program designed to stimulate growth in the U.S. economy, which has stalled and is threatening to slide back into recession.
The Fed’s policy options are limited. Policies targeting short-term interest rates have been rendered ineffectual because the short-term rates that the Fed can influence with its open market operations are already at or near 0%. There’s little or no room at the short maturity end of the Treasury yield curve where the Fed can maneuver.
So the Fed has been forced to set its policy target further out on the yield curve, aiming to reduce longer-term interest rates and to keep them low, especially lending rates for homes and other “big ticket” items.
With that objective in mind, the Fed announced plans to rebalance its balance sheet—the Fed intends to buy and sell equal amounts of government securities in targeted Treasury maturity sectors.
More specifically, the Fed intends to sell $400 billion of its short-maturity Treasury securities holdings (aiming to increase market supply of those securities) and buy an equal amount of longer-maturity Treasuries (with the objective of reducing market supply in that maturity sector).
Why are the financial media, economists, and analysts calling this “Operation Twist”?
This strategy resembles one employed 50 years ago, during the Kennedy administration. It was labeled “Operation Twist,” both in reference to Chubby Checker’s popular song and dance of that era, and because it was intended to “twist” the Treasury yield curve, forcing it to flatten or even invert (reducing or reversing the yield difference between short- and long-maturity Treasuries by boosting short-maturity interest rates and reducing longer-maturity rates).
What are the objectives of the 2011 version of “Operation Twist”?
From a broad macroeconomic vantage point, they’re basically the same as those 50 years ago—stimulating a stagnant U.S. economy by reducing longer-term interest rates and flattening the Treasury yield curve.
In theory, this is supposed to:
- Boost the struggling housing market (by reducing mortgage interest rates and stimulating home purchase and refinancing activity).
- Help stimulate the purchase of other “big-ticket” items (cars, boats, motor homes, etc.)
- Increase investment demand for higher-risk assets—such as stocks and high-yield bonds—because government bond yields will be so low.
Will these objectives be achieved?
That’s the trillion dollar question. The original Operation Twist didn’t appear to be very successful—it lowered long-term interest rates by just 0.15 of a percentage point, as mentioned in a Bloomberg editorial on Sept. 20. The Bloomberg commentary also pointed out that Bernanke co-authored a 2004 paper that suggested that the original Operation Twist didn’t have sufficient size to succeed—it was approximately $8.8 billion, according to one source.
The scale of the Twist program is larger this time, and lower interest rates could help the economy marginally. But they don’t really address the biggest problem, in our view.
Consumer spending remains the primary driver of the U.S. economy. Sustainable consumer spending is highly dependent on employment and housing market conditions, which are still struggling below levels required for a healthy, vibrant economy.
To us, the ability and/or desire of individuals and companies to borrow further has been severely compromised. Our research indicates that individuals and companies of good credit quality are still reducing their debt burdens, not adding to them, and we don’t think they will be enticed to borrow more just because rates are lower.
Less credit-worthy borrowers might potentially borrow more if they could, but, in this tighter regulatory environment, no financial institutions would likely lend to them.
We see a vicious cycle at work here—the housing market, which is supposed to benefit from Operation Twist and help drive its success, is itself a major obstacle to the increase in lending activity that Twist is designed to trigger. That’s because it’s increasingly difficult for individuals to qualify for new loans as loan collateral values (home prices) continue to decline.
We don’t believe the Fed is entirely unaware of the potential shortcomings of its strategy—it’s simply stuck between the proverbial rock and a hard place. To us, the Fed’s toolbox appears to be nearly empty. We think the Fed announced a “Twist Revival” because it is running out of good policy options, but it doesn’t want to appear to be “fiddling while Rome burns.”
Recognition that the Fed is running out of options under challenging circumstances is clearly weighing on the risk markets. In our view, that’s a key reason why stock and corporate high-yield bond prices are down and Treasuries are rallying.
How are other bond sectors being affected by the Fed’s announcement?
We’ve already mentioned the two extreme cases in terms of bond performance—Treasuries (especially longer-term securities) on the plus side (on further flight to quality, and reduced supply), and corporate high-yield (which is highly correlated with stocks) on the minus. We believe other sectors will likely fall in between these two.
We’ll briefly provide our views on other popular sectors:
- Investment-grade corporate securities—These securities are influenced by many of the same factors that affect their high-yield corporate counterparts. We believe these bonds are likely to lag if stocks and high-yield corporate bonds continue to struggle.
- Investment-grade mortgage-backed securities (MBS)—This sector has favorable factors going for it but it’s not a simple story. On one hand, it has many high-quality securities that can provide positive performance when Treasuries perform well. Also, MBS yields are relatively high compared with other high-quality sectors. And part of the Fed’s policy announcement included the message that the proceeds from maturing MBS in the Fed’s portfolio will be reinvested in more MBS, instead of Treasuries. That’s good. On the other hand, falling interest rates mean increased refinancing activity, which returns capital invested in MBS earlier than expected, and forces investors to reinvest at lower rates. And MBS tend to perform better in stable rate environments than volatile. So it’s a mixed bag for MBS.
- Inflation-linked securities, including Treasury inflation-protected securities (TIPS)—TIPS are Treasuries, so they tend to rally when conventional Treasuries rally. However, falling inflation expectations have caused inflation-linked securities to lag conventional Treasuries. Coming government inflation reports will be important in crystallizing actual inflation risks.
- Investment-grade municipal securities (munis)—They tend to rally with Treasuries. But they can be credit-sensitive, like corporate securities (which can affect demand in weak economic conditions) and be refinancing sensitive, like MBS (municipalities tend to refinance their debt, like homeowners, when interest rates decline). So it’s a mixed bag for munis too.
How has this played out in the bond portfolios managed by American Century Investments?
Our broad bond portfolio positioning as we entered September reflected the following economic and market viewpoints of our Fixed Income Macro Strategy Team:
- The U.S. economy appeared to be on a slow, subpar growth path. Not a recessionary path, but not a strong recovery path either. Growth rates of 1-3% were projected.
- Near-term inflation expectations were modest.
- The Fed was expected to hold short-term interest rates at historically low levels into 2013.
- The Treasury yield curve, which had been historically steep for much of the year, was expected to flatten.
- Intermediate-term interest rates were expected to be range-bound.
As a result, many of our portfolios had yield curve flattening positions, which involved investing in combinations of securities that would produce net gains as the yield difference between shorter- and longer-term Treasuries declined. These positions performed well as the yield curve indeed flattened, and we were able to exit the positions after taking profits.
It also helped that our core diversified taxable bond portfolios remained allocated to Treasuries, which performed well. Portfolios in the industry that did not hold Treasuries or held severely underweighted Treasury positions tended to underperform.
Our security selection in the corporate and MBS sectors also helped us avoid some volatility. We weren’t perfect—corporates in general and commercial MBS (CMBS), where we had overweight positions, experienced volatility, along with the stock market. While these overweight positions detracted from performance in the recent Treasury rally, we believe they will contribute positively to performance in the future when the markets eventually stabilize.
While seeking return opportunities, we continue to focus on risk management. This means that while we’re constantly working to add value, we’re also striving to contain risk in a range that we view as appropriate for fixed income investing.
We aim to provide consistent performance from our bond portfolios. This means that we seek to avoid establishing overly aggressive credit, duration, or sector positions in our core, diversified bond portfolios that could cause them to behave more like stocks.
As in 2008, we believe aggressive overweights to higher-risk, higher-yielding sectors of the corporate bond market in 2011 could translate to volatility, underperformance, and increased correlations with stock behavior for bond portfolios. We think taking on stock-like risk and return characteristics like that in our core, diversified bond portfolios runs counter to what we strive for.
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The opinions expressed are those of G. David MacEwen and the fixed income portfolio management team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
Diversification does not assure a profit, nor does it protect against loss of principal.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
Investment income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax (AMT). Capital gains are not exempt from state and federal income tax.