Macroeconomic determinants and investments
The Fed’s stunning about face on quantitative easing (QE) tapering in September caught markets by surprise and has created a credibility gap. In the summer we were confused by the Fed’s aggressive tone regarding tapering in September. Then, as now, inflation is low and decelerating, and labour markets remain slack in spite of falling unemployment rates that are largely the result of individuals leaving the labour force.
It was our view that perhaps Fed thinking was changing regarding the efficacy, risks, and need for QE. That change in thinking appears to be tabled for the first quarter of 2014 with Janet Yellen nominated to lead the Federal Reserve, and the renewed Hatfield-McCoy-like feud between Congressional Republicans and the White House.
Strong arguments can be made against the appropriateness and need for QE given that ‘extraordinary measures’ have yet to create a normal economic recovery in terms of employment, earnings growth, and lending. Additionally, a Federal Reserve balance sheet of $3.7 trillion creates risks of its own. In our view, 3 percent or greater GDP is needed to create substantial labour market demand and we don’t see that on the horizon.
The lack of wage price pressure, subdued bank lending, and conservative balance sheet management by consumers and corporations will continue to hold inflation in check. We estimate that QE tapering will now occur in the first quarter of 2014, but that short-term interest rates will continue to remain low for the foreseeable future.
Politicisation of the Fed
Clearly, the Fed wants stimulus to be effective, but it does not appear to be working as planned. Corporations and consumers seem to have perspectives on risk other than the Fed would prefer. Corporations have large cash balances and operations are being managed tightly. The new Dodd-Frank rules—while arguably necessary—are a headwind as they mandate less leverage and tighter lending standards for banks.
Consumers are not running up large amounts of debt, presumably because of employment fears and a memory of being over-leveraged in 2008. Put simply, those with money and credit lines are unwilling to lend or spend. The Fed continues to fight a ‘liquidity trap’, but throwing cash at the problem is not creating sustainable growth despite financial market prices continuing to rise.
A dangerous new line of thinking may be evolving regarding ‘extraordinary measures’. While it’s clear that the economy may no longer be in crisis, QE has effectively become a new form of government entitlement for the economy and markets. During times of financial crisis, extraordinary measures are usually used sparingly to spur growth or avoid catastrophe. We believe this dynamic has changed, as politicians and government academics seem to believe they can and should control every ebb and flow in the business cycle.
Furthermore, continued ‘extraordinary measures’ have led our politicians to believe in a Fed backstop, which seems to encourage poor policy decisions and brinksmanship. Attempts to micro-manage short-term economic flows are analogous to those of controlling the natural cycle of forest fires. We do a good job suppressing minor fires, while underbrush continues to grow and often creates larger problems in the future. Employment and growth problems seem to be structural in nature and we question whether monetary policy is the appropriate tool.
We expect heightened financial market volatility due to the delicate nature of future Fed policy messaging, and continued chaos in Washington. We expect no significant shifts in monetary policy until the first quarter of 2014, and as always this will be dependent on GDP, employment, and inflation. Tapering before year end is unlikely for now.
The captive picture
There are several strategies that captives may employ to help protect fixed income portfolios from the negative impacts of higher interest rates. A generic solution is to transition the portfolio to a shorter strategy whereby the investor sells the intermediate and long-term securities and purchases shorter maturity securities that are less sensitive to interest rate movements.
Unfortunately, there is no free lunch, as this method may reduce interest rate risk by about 47 percent while giving up 60 percent of the yield to maturity.
An alternative to this, however, would be to use US Treasury futures contracts to shorten the overall portfolio duration and thus help reduce the level of interest rate risk inherent in the portfolio. This method has the potential to reduce interest rate risk by nearly 90 percent while giving up only approximately 40 percent in yield to maturity. Important to note is that futures in this strategy are used for risk reduction only and not speculative purposes.
Also, for those captives that have a surplus, another potential choice would be to increase the normal allocation to equities. This may make some sense given that, historically, when interest rates are lower than 5 percent, rising interest rates generally lead to rising equity markets. We have certainly seen that play out so far this year.
Of course, we believe active portfolio management with a disciplined approach to yield curve positioning, sector and issue selection is key to navigating through this uncertain environment. Currently, Munder Capital’s fixed income team continues to remain significantly underweight in US Treasuries, and overweight in spread sectors, such as corporate bonds, commercial mortgage backed securities, and asset-backed securities. Further, we continue to remain nimble and vigilant with regards to interest rate exposure.
Edward Goard is managing director and chief investment officer, fixed income at Munder Capital. He can be contacted at: firstname.lastname@example.org