Since the Global Financial Crisis (GFC), the Federal Reserve (Fed) has occasionally used its annual Jackson Hole symposium to preview changes in monetary policy. Over the last two months, financial markets began to anticipate Chair Jerome Powell would address the Fed’s dual mandate of full employment and price stability during his speech on August 27 (the meeting was held virtually this year due to COVID-19). In particular, the market appeared to expect a willingness by the Fed to allow inflation to overshoot its long-term 2% target, as we’ve witnessed a recent steepening in both the inflation breakeven and nominal yield curves (Charts 1, 2).
5-Year, 5-Year Forward Breakeven Inflation Rate
Data from 12/31/19 to 08/28/20. Source: Bloomberg L.P., PNC Capital Advisors
Spread Between 2-Year US Treasury Note and 30-Year US Treasury Bond
Data from 12/31/19 to 08/28/20. Source: Bloomberg L.P., PNC Capital Advisors
As expected, Chair Powell outlined several updates to the Fed’s framework, which was informed by both its internal research and a series of Fed Listens events around the country (the Fed Listens events were aimed at broadening the Fed’s perspective and engaging the public “as is appropriate in our democratic society”). This work led the Federal Open Market Committee (FOMC) to codify changes through unanimous approval of a revised “Statement on Longer-Run Goals and Monetary Policy Strategy.”1 Notable changes to the framework include the following:
- With respect to employment, the FOMC emphasized a broad-based and inclusive goal that assesses “shortfalls of employment from its maximum level.” Previously, the focus was on “deviations from its maximum level.”
- Regarding price stability, the FOMC moved towards a symmetric goal targeting longer-run inflation of 2% by seeking “to achieve inflation that averages 2% over time.”
This updated framework is a reflection of the low interest rate environment, both domestically and globally that has persisted since the GFC. By implementing these changes, we believe the FOMC is acknowledging that reliance on the traditional policy tool – the fed funds rate – will likely be constrained. While this suggests the fed funds target range will remain at or near the effective lower bound for an extended period, the announcement has helped alleviate market pressure that resulted from speculation about the possibility of negative rates in late 2021/early 2022 (Chart 3).
Fed Funds Futures Curve (Rate)
As of 08/28/20. Source: Bloomberg L.P., PNC Capital Advisors
It is clear the Fed stands ready to support the economy through both traditional and unconventional policy tools for the foreseeable future. Since the GFC, macro and structural issues have created persistent headwinds for the Fed’s efforts to achieve its inflation objective on a consistent basis. While these headwinds are unlikely to abate, we expect the announced policy changes should – all else equal – result in a steeper yield curve, higher inflation expectations (as measured by Treasury Inflation Protected Securities breakeven spreads), and a lower US dollar, supporting investor risk appetites. While well off its peaks, the global balance of negative yielding debt still approximates $14 trillion and likely limits the potential for US interest rates to rise materially despite a more dovish Federal Reserve – much to the dismay of the bond vigilantes of yore.
1 – “Statement on Longer-Run Goals and Monetary Policy Strategy.” Federal Reserve (August 27, 2020). https://www.federalreserve.gov/monetarypolicy/reviewof-monetary-policy-strategy-tools-and-communications-statement-on-longer-run-goals-monetary-policy-strategy.htm
2 – “Trends in U.S. Income and Wealth Inequality.” Pew Research Center, Washington D.C. (January 9, 2020). https://www.pewsocialtrends.org/2020/01/09/ trends-in-income-and-wealth-inequality/
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Next we examine each of these sectors in more detail.
We focused our analysis of the corporate credit sector on investment-grade securities, defined as BBB-rated and above. The profile of the corporate credit index can be deconstructed into two primary factors that describe risk and return: default risk and spread duration risk. We define default risk across three quality buckets: AAA-AA, A, and BBB. These ratings represent the average rating assigned between the primary credit rating agencies. Similar to modified duration, which measures a bond’s price sensitivity to changes in yields, spread duration measures price sensitivity to changes in credit spread. We believe it is a good proxy for duration risk of excessreturn, as opposed to duration risk of totalreturn (modified duration).
The table below shows excess return, volatility, and MIRs over various credit quality and bond maturity segments.
CORPORATE CREDIT Continued
Modified Information Ratio (MIR)
Between 1997 and 2019, AAA-rated ABS and agency MBS sectors exhibited significantly less volatility of excess return than nearly all credit sectors, resulting in compelling MIRs. Additionally, there was a low correlation of excess return between structured products and the corporate credit sector over the 22-year period, due in part to the high-quality and shorter-duration profile of structured products relative to the overall credit index.
We believe structured products provide an important source of diversification and can improve the risk-return characteristics of an overall portfolio. The diversification benefit provided by incorporating structured products in an asset-allocation strategy can be illustrated by comparing two portfolios, one consisting solely of government and credit sectors (Bloomberg Barclays Government Credit Index) and the other that includes structured products (Bloomberg Barclays Aggregate Index).
As shown in the following table, adding structured securities to a government-credit portfolio over the period 1997 to 2019 would have produced an enhanced average annual excess return, a reduction in return volatility, and a higher MIR.
When constructing a portfolio, there are additional aspects of the MBS and ABS sectors to consider.
STRUCTURED PRODUCTS Continued
OUR COMMITMENT TO OUR CLIENTS
We believe opportunistic sector allocation, coupled with an investment process focused on risk management and identifying relative value opportunities should result in consistent risk-adjusted returns over a full market cycle.
Over the last several years, we’ve experienced a wide variety of interest rate and risk regimes. We’ve adhered to the tenets of our risk-based philosophy throughout and used these opportunities to evaluate the findings of our historical analysis in practice.