Pivot to Patience
Financial markets started 2019 reversing almost all the dismal performance that risky assets experienced in 4Q18. Equity markets gained 13%, oil prices increased 34%, corporate investment grade spreads tightened 30 basis points1, and corporate high yield spreads tightened 120 basis points. The resurgent appetite for risk came along with a shift in the tone of monetary policy known as the Powell pivot. The more accommodative stance taken by the Federal Reserve (Fed) was in part a response to the risk sell-off, but as we discuss below, it is also rooted on deeper concerns about slowing economic activity and low inflation expectations.
For the quarter, the U.S. Treasury real yield curve at the 5-, 10-, and 30-year maturities rallied 55, 45, and 30 basis points, respectively. Overall, TIPS returned 3.4% in the first quarter, outperforming nominal Treasuries by 0.7% on a duration-adjusted basis. Breakeven inflation rates at the 5-, 10-, and 30-year tenors increased 30, 15, and 10 basis points, respectively. The breakeven curve, with rates between 1.8% and 1.9%, remains about 20 basis points below last year’s peak.
The recovery of energy prices helped push March’s headline Consumer Price Index (CPI) to 1.9%, after weaker prints earlier in the year (1.5% for February and 1.6% for January). Core CPI slid to 2% in March, following weaker apparel prices caused by a change in the methodology of data collection.2 Soft inflation prints and low inflation expectations reinforce the Fed’s more patient stance.
In terms of performance, our accounts finished the quarter in line with benchmarks. Early in the quarter our portfolios benefitted from higher breakevens and a steeper real yield curve, in line with seasonal patterns. As we shortened duration, rates declined further, and we gave back some of January’s gains. Although the supply of long-maturity TIPS increased, no meaningful auction concessions materialized. As we enter the second quarter, our portfolios emphasize 5- to 15-year maturities to capture strong inflation carry; currency-hedged tactical exposure to French inflation-linked debt in accounts eligible for non-USD allocations; and a long breakeven position in accounts with futures authority.
The risk-off episode of 4Q18 was attributed in part to the fear that the Fed might tighten rates too much. Recall that on October 3, Chairman Powell stated that rates were “a long way” from neutral. Then, after equity markets dropped 6%, on November 28 he stated that rates were “just below” estimates of the neutral rate. Although the Fed increased the federal funds rate (FFR) at the December 19 meeting, the seeds of the Powell pivot had been sown. By the end of 2018, the market priced zero rate hikes for 2019 and in both meetings of 1Q19 (January 30 and March 20), the Federal Open Market Committee (FOMC) left rates unchanged. Moreover, the FOMC statement following the January meeting noted that the Fed will be “patient as it determines what future adjustments to the target range of the federal funds rate may be appropriate to support these outcomes.”
One cannot know with certainty what led the Fed to signal a more accommodative monetary policy, but we believe that to varying degrees, three factors played a role: (1) sluggish economic performance overseas, (2) expectations of slowing domestic growth, and (3) below-target inflation and low inflation expectations.
Regarding global economic performance, starting in the second half of 2018, a confluence of factors caused global economic activity to slow down. China’s growth declined and the euro area lost momentum as consumer and business confidence weakened and demand from Asia decreased. Furthermore, trade tensions affected business confidence and financial conditions for some emerging markets as well.
In the U.S., on March 22 the yield on 10-year Treasury bonds dropped below the yield on 3-month Treasury bills (10Y-3M), inverting that segment of the yield curve. An inverted yield curve reflects investors’ expectations of an economic downturn, and in the past, an inverted yield curve preceded every recession since 1970. (See our recently published Strategy Insight “An Inverted Yield Curve: What Does It All Mean?” for more on this topic.) When investors expect a downturn, they anticipate that the Fed will ease short rates in the future. Since the path of short rates, in part, determines longer-term rates, investors increase demand for long-term debt today, lowering longer rates. Although the 10Y-3M slope is no longer inverted, a version of this dynamic seems to be taking place. The probability of a recession beginning in 12 months, implied by some economic models (that combine yield curve and economic activity data) is close to 30%, and the market-implied probability of a rate cut in 2019 is above 50%.
Our preferred gauge of U. S. economic activity, the 3-month moving average of the Chicago Fed National Activity Index (CFNAIMA3), finished 2018 in positive territory, signaling above-trend economic growth. This index fell to -0.18 in February, suggesting below-trend economic growth. Nevertheless, it stands above levels seen in 2015 and 2016, and above -0.7, the threshold that in the past has indicated the beginning of a recession. At current levels, economic fundamentals suggest slower growth, but not an imminent contraction.
One consequence of inflation undershooting its target is the risk of inflation expectations getting anchored at levels also below target. In the U. S., the Fed’s preferred measure of underlying inflation, the year-over-year change in Core Personal Consumption Expenditures (Core PCE) is at 1.8%, below the Fed’s 2% target. Since 2012, Core PCE exceeded this target only once, reinforcing the Fed’s patient approach to monetary policy normalization. Moreover, in late 2018 the Fed embarked on a review of its long-run monetary policy framework following its failure to meaningfully lift inflation expectations. The alternatives to the current environment are average-inflation targeting and price-level targeting. Both would let inflation run above target to offset periods when inflation undershoots its target. With price-level targeting, the Fed commits to keep the price level near a growing target; therefore, to bring the price level back to target following times of low inflation, the Fed would let inflation accelerate.
Financial markets recovered from the risk sell-off at the end of 2018. Early signals of a more accommodative monetary policy stance materialized following slower economic activity and low inflation expectations. In our view, a supportive Fed and an environment where risks of an economic downturn are minimal favor TIPS, making them attractive relative to nominal Treasuries. Furthermore, with breakeven rates still below 2%, there is room to find value as inflation expectations align with the Fed’s policy objectives. As always, we will capitalize on the opportunities we find with our time-tested investment strategies.
James J. Evans, CFA
Jorge G. Aseff, PhD
Head of Quantitative Research
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be, interpreted as recommendations.
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IM-06313-2019-04-18 Exp. Date 07/31/2019
1 Basis point is a unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of a financial instrument.
2 The Bureau of Labor Statistics started incorporating data reported directly by a department store, replacing about 5% of quotes collected using traditional surveys