Ben Jones – Today we’re diving into the current events in the fixed income markets and what it means for your clients and their portfolios. You may have had a client or a friend recently ask you what is an inverted yield curve, and does mean that we’re about to go into a recession. Well today our guest is prepared to answer these questions and more. Scott Kimball is a senior portfolio manager with BMO’s Fixed Income team. If you’re a long time listener of this show you will recognize that this is his second appearance as a guest on the show. His first appearance was in episode seven.
Emily Larsen – For this episode we had our colleague Bret Solnoki visit Miami, sitting down face-to-face with Scott for a discussion the very week of the Fed’s FOMC meeting. They talked about the Fed’s interest rate cut and how we should be looking at fixed income right now. Take it away Bret.
Bret Solnoki – My name is Bret Solnoki. I’m a regional sales director with BMO’s Intermediary distribution team. Today I’m joined by Scott Kimball from BMO’s Fixed Income team based in Miami, Florida. Scott is a portfolio manager with this team. Scott, this is not your first time on the show. Welcome back. Since we last spoke you’ve been a busy person. You’ve been featured in Barron’s. You’re a frequent guest on Real You, Wall Street Journal’s podcast episodes. So thank you for returning to the show. It’s been an interesting year for the interest rate markets and there’s been a lot of noise around the Fed. Why do you feel it’s an important topic for advisors to pay attention to?
Scott Kimball – Certainly. I’ll sort of take a step back and just — the comment on what it is that we’re doing with the interest rate market, why is it that it’s getting so much of that attention. The first thing is the interest rate market in the U.S., particularly U.S. Treasury — when we say interest rates, we’re talking U.S. Treasuries — it’s been the most hated bull market in the history of the financial system. It’s been 30-year run of declining interest rates. The reason for that is the U.S. economy has gone from one of robust growth and high inflation risk to one of rather common growth, which is not to say bad, but retracing growth and seeing the U.S. economy grow at a rate consistent with the high single digits is very unlikely. So we’ve seen that we’ve arrived at more of a steady state on the U.S. Treasury curve, which reflects the fact that growth potential in the U.S. has declined. The second is inflation risk. Inflation risk, as we’ve seen, has not been a factor the Fed has really been able to exert much influence on, so we’re stuck sort of living below 2% despite a 2% inflation target. The longer we stay below the Fed’s stated target, the further the inflation premium comes out of the market. So that’s why interest rates have seen this path unfold and have arrived where they are, which is rather frustratingly and stubbornly low. So to the question on why someone should pay attention to something that is stubbornly low and seems rather uninteresting is because what rates are telling us, as they have over the past 30 years, is what is the likely future path of the U.S. economy. That’s what the Treasury curve is telling you. If we look at the difference between a two-year, a five-year, a ten-year, and a thirty-year, we construct that curve that is at the point in time we construct it what the market’s estimation is of the future path of the U.S. economy. Noting, however, that through globalization there is a little bit feedback from abroad, and we’ll probably talk about that a little bit more as we go through the podcast. The reason we need to be paying attention to that is yields are not just telling us what our opportunity is for investing in bonds. They’re telling us what the financial market outlook is for the economy and what we should be doing with asset allocation. So in many instances we ask the question — we get asked the question if the 10-year Treasury is at 1.75%, why would I even own bonds. The reality is that 1.75% is telling you that the growth potential from other parts of your portfolio in risk, whether that’s high-yield in the bond market or equity risk through various stocks, it’s telling you that the growth potential is not exceptionally high and the diversification benefit of bonds, which is where total return comes in, is actually quite strong. So for example, we started this year with the 10-year Treasury, we’ll call it 2.5%, just to keep it square. The ag is up in the neighborhood of around 11% as we talk now. What we’ve seen is that the decline in interest rates have driven the total return of bonds beyond what you would have thought based on their yield. So it’s an important conversation just to surmise on what the direction of the economy is that we can learn from interest rates and what we should be doing with our asset allocation to capture the diversification benefit of fixed income.
Bret Solnoki – So on September 18th the Fed cut rates for the second time in as many months another 25 basis points, so that’s two moves of 25 basis points over that time period. What are your general feelings on rates today?
Scott Kimball – The first thing that I’ll mention is the Fed. I’ll just start with that because it’s fresh, it’s a topic, they just cut rates by 25 basis points. As we sit here, the market — that’s what the market is grappling with today. It’s not thinking about Brexit, it’s not paying much attention to the ECB, although it should be. All eyes are on what is it that the Fed is doing with financial policy. What we saw yesterday was a vote in which the Fed agreed to cut rates by 25% but there was dissensions. What’s interesting about those dissensions is they came in two distinct categories. There was the old guard, which feels as though the inertia of the U.S. economy is isolated and that global factors are noise and we should be setting our policy based on the U.S. economic outlook wholly and in and of itself. Then there’s what we’ll call the new guard, the ones who are looking at the global growth conundrum. They’re looking at negative rates overseas, they’re looking at disinflation in Europe, they’re looking at Japan, who has not been able to get the economy above 1,000 RPMs, to borrow a bad car analogy. They’re saying this has to seep into the U.S. economy at some point. Those were the ones that were in favor of additional accommodation. So the Fed settled on 25 basis points. It was the second time they did that. So it’s a total of 50 basis points reduction. The question is what does that actually mean from a U.S. economic perspective? The reality is probably not much. Because the interest rate differential between the U.S. and abroad is still very significant. You’re seeing bond yields in Germany at negative half, negative 60 basis points against a U.S. Treasury of 1.75. That’s a 230 basis points pickup in interest rate differential between the two economies. That’s not going to weaken the dollar. It’s not going to offset the global trade flows caused by a trade war or tariff situations with China. So strong dollar policy is going to remain in effect despite the easing policy. It’s not going to do much to really jostle inflation expectations higher. What we think actually occurred is the Fed is afraid, and this goes to the old guard, new guard. The old guard had a reputation of keeping the things too tight for a little too long. Those are what we call the hawks. The doves are looking at that and saying you know, that’s the old way of doing business. In this globalized world we need to be a lot more responsive. So when we think we hit neutral, you can’t spend more than a couple quarters there, because the cycles are going to come faster than they have in the past. So they pull back on the reins and they let a little steam out and they reduce the friction the Fed may have caused. I don’t know want to say they have caused it, but maybe if they thought perhaps they caused friction, they pull it back a little bit. So what do you do with that from a rate outlook perspective? If the Fed is indecisive in that way and they’re starting to ease financial policy, they’re not expecting runaway growth, they’re not expecting runaway inflation, and they are probably expecting that interest rate differential between the U.S. and abroad remains pretty robust and pretty steep. I would not expect rates to rise materially anytime soon. That’s not our position here. We think you’re going to see some punches traded between the hawks and the doves. You’ll see the curve at times steepen, where you’ll see 30-year and 10-year rates go up a little bit more in the front end, you’ll see it flatten perhaps as long rates come down a little more than the front end. But the steady state of where we are on the curve is likely to remain. So the answer is from a rate outlook, we don’t expect the 10-year to breach 2% by much. We think that’s probably more of a fair value range, 2 to 2.25.
Bret Solnoki – Okay.
Scott Kimball – But the 3.75 we saw going into — around late 2017, 2018, was sort of an aberration. We think the market has reset its base interest rate expectation lower and we agree with that outlook.
Bret Solnoki – How do advisors, investors interpret the post-rate cut statement from the Fed? And from Powell, specifically. Because what I’m seeing is it’s hawkish, it’s dovish, there’s a lot of confusion maybe around what direction he really wants to see things.
Scott Kimball – Our opinion is what Powell has served up is a bit of a buffet. There’s a little bit of anything in there for whoever is looking for a particular story. If you wanted to be hawkish you would look at his comments about the U.S. economy remaining on firm footing and that the outlook remains strong, and that it’s navigating the global economy quite well. If you want to be dovish you’re hanging on to the side of the buffet line where he commented about the Fed remains prepared to act. If you’re looking to be completely confused, you can go to the middle of the buffet line where he uses this term mid cycle adjustment. The challenge that we have with that is that when you say an adjustment in policy, it means the outcome from the Fed’s adjustment economically speaking needs to be differentiated from whatever the economy was looking like before they did it. To us, adjust is 50 basis points. 50 basis points is a much strong market signal if it comes in one cut versus the two sort of escalator like retracements that they’ve done. Our perspective is a mid cycle adjustment means 50 basis points in one sitting, but the Fed served up two 25 basis point cuts. And as a result, — initially they tightened conditions, because credit markets got a little sloppy. We saw some high-yield deals that weren’t able to print. We saw a lot of withdrawals from loan funds. The market calmed down a little bit and a lot of that has washed out and returned a bit more normalcy. But now we saw the situation with the repo market earlier in the week and over the weekend where people were looking to sell short dated securities and there weren’t enough people standing around to buy it because the money was invested out the curve chasing longer dated yields for more money. So mid cycle adjustment did not have the intended effect, because the policy implementation of the adjustment in our view was mischaracterized. So when we think about Powell’s comments, that’s the one we think is most relevant, is the Fed has indicated a mid cycle adjustment in verbiage, but in action they’ve just sort of started an easing cycle like they have any other one. That’s probably the part that investors are going to have to grapple with the most.
Bret Solnoki – Let’s talk about some of the outside influences, then. You mentioned earlier the global indicators and factors, how much they’re looking at that in their decision making process. But also last week the President called for Fed officials to lower interest rates to zero or less. How much influence, how much rhetoric from the President is influencing the decisions today in your opinion?
Scott Kimball – That’s an interesting question and it’s a good one. There’s two different chapters to that. The first is this is an unprecedented amount of communication between the Executive Branch and the Federal Reserve. So markets are correctly trying to figure out, first of all, why they’re occurring. And secondly, what effect does is it having. Well, why are they occurring? Because a few factors. One is we are coming up on election cycle, and so goes economy, so goes elections. We also have a President who is used to borrowing money and is very familiar with interest rate markets. Given his background, easier policy is better for business. Higher asset prices, lower borrowing costs, more growth. There is certainly some mechanics to that that resonate with him. The second aspect of why this is getting a little complicated is – is your question — what effect is it having on the markets. What effect is it having on the Fed. The Fed truly — In our opinion, the Fed truly believes they are independent of the tweets. The Fed truly believes they are setting policy in and of its own data validity and that the market is taking a different perspective from that of what is happening daily in that sort of strange discourse. The reality is the market is interpreting or being influenced by this rhetoric from the Executive Branch at a pretty high level. So while the Fed may be independent in a direct way, in an indirect way there is no question the Fed is responding to market expectations. The Fed has responded to the forward interest rate path projected for the Fed funds rate. They’ve responded very strongly to credit markets. They’ve responded very strongly to interest rate volatility. So is the Fed being directly influenced by the President? Probably not in their mind. Are they being influenced indirectly by the market, which is in turn being influenced by the Executive Branch? No question.
Bret Solnoki – And then how about global indicators or factors? How much is that influencing what the Fed is doing?
Scott Kimball – That goes back to that old guard, new guard mentality that we think exists on the Fed. I also want to clarify, although I hammered them on this earlier, it’s a good thing to have differentiated schools of thought and approaches to the economy on the Federal Reserve.
Bret Solnoki – Sure.
Scott Kimball – The markets may not like it because the market likes — in this more transparent world we’re living in when it comes to the Fed. They may want an all-in opinion that everybody agrees with. But with the transparency factor we’re seeing some of inner workings of the Fed more than we have in the past. So in the old guard way they would tell you that the U.S. economy in and of itself has its own inertia and that’s what you set policy to because everything else is noise. The newer approach, we’ll call it, is going to look at things and say through globalization, through trade, through monetary systems, overseas growth expectations have a bigger influence on the U.S. growth outlook than we’ve seen in the past. So they believe that setting policy perhaps with a bit more nimble approach, a little more reactive to the global concerns, those are going to be things that we need to pay more attention to now. This is an area where we think the Fed is probably being more directly influenced in that most of the Fed regardless of what side of the fence they sit on on setting policy, are taking note of what’s going on overseas. A big factor to look at is the interest rate differentials. Even if the Fed wants to weaken the dollar, can they do it with negative yields throughout Europe? We even have — there’s even high yield securities in Europe that have negative yields. Is that one where the Fed can really exert much influence over the long end of the curve? Probably not. So those are global factors that are making the Fed’s job a lot more difficult. I think you’ll have to add in we think about global volatility. The U.S. markets have enjoyed a pretty nice run of low volatility. We certainly have had windows where it’s certainly spiked up. But on average volatility indicators are pretty low. The question then becomes what happens if overseas experiences a pattern of volatility. We have seen the correlation when those volatility spikes have occurred. The correlation between the U.S. and overseas is a lot stronger than in the past. So through rates, currencies, and volatility, and the Fed’s reaction to those factors, it’s a pretty heavy set of things the Fed has to weigh that perhaps they didn’t have to consider quite as much in the past.
Bret Solnoki – Over the summer the Fed made some comments and said they would work to support the continued expansion. Kind of caught me a little bit by surprise, is this their objective, really, or just kind of what are your thoughts on what is the Fed’s objective? And is supporting the continued expansion part of that objective?
Scott Kimball – The Fed’s objective has always been by charter a two-factor thing. Sustainable is really the word they want to use. They call it full. But sustainable employment and price stability. The Fed in our opinion has checked off the employment box and feels as though they can’t really press unemployment any lower, and we would agree with that. The overall unemployment rate is very low. Some people want to hammer things like the participant rate. That to us is a little bit of a slippery slope. It wasn’t really a factor most people paid attention to until the financial crisis when it finally went down a little. We think overall participation noted, the Fed is pretty happy with where the unemployment rate is. We believe there’s a number — and the data, particular if you look at the small business indices, there’s a number of job openings available relative to workers and it’s a pretty healthy amount. So that ratio of openings to job seekers is pretty healthy. So the Fed probably is going to check that box off as there’s nothing more we can do there. Price stability is an interesting one, because prices, all things considered, have been reasonably stable in the U.S. ex-energy. But now we’ve seen the U.S. becoming an exporter of energy, we’ve seen energy prices really roll over. We saw it in the middle of the oil crisis get down to 25, but we stabled in between $50 and $60 a barrel for oil. The input cost from energy and oil prices into final goods and services is certainly a lot quieter than it used to be. So you could argue that prices are reasonably stable in the U.S.. The reason it might not feel that way is probably the one that’s really bothering the Fed, is that for this amount of unemployment, this low level of unemployment, we haven’t seen wage growth. We’ve seen periods where it looks like it’s accelerating, but it’s not really consistent with what you would expect for this low level of unemployment. So the Fed’s mandate in terms of the U.S. domestic economy is probably to throw as much accommodation as reasonably they can into the economic stew to get the wage growth number to accelerate. So yes, I actually do believe the Fed wants to see a little more inflation, but they want to see it in conjunction with real wage growth, which means if inflation is 2% wages are going 2.5, 2.75, so the real growth rate for wages is felt by consumers. Transition that to your question on the expansion. For this expansion to continue, we believe that’s what the Fed believes, the unquestionable objective is, is going to be wage growth. Yeah, I think the Fed can tack on, you want to call it 2B or objective 3, either one. They do have an objective of continuing this expansion. The global situation is giving them probably a little bit of headache, in that it’s distracting them from the domestic economy perhaps a little more than they’d like.
Ben Jones – So the yield curve has inverted in the US a few times this year, and Bret asked Scott why inverted yield curves signify potential recession, and why this time it might be different.
Scott Kimball – The first thing I want to say about inverted yield curves is, yes, they have preceded all US recessions. But not all inverted yield curves have led to recessions. So it’s a little bit precarious, and it’s a little bit on how you want to view the data. There’s a great quote about statistics, which is that if you torture the data long enough it eventually gives in. And that’s kind of my feeling towards the inverted yield curve, but why they occur can be a multitude of things. But primarily getting back to the idea of what a yield curve is telling us. The yield curve is giving us the forward looking path, or the market’s forward looking path, the likely path for an economy. So if we look at the 2, the 5, the 10, the 30 year, we say to ourselves where are these rates today and we can construct a curve. That’s the likely growth path that investors think the economy is going to take. So if we see a yield curve inverted, as we do now between the twos, fives in particular, so the two year and the five year are inverted, the five year is below the two year yield. What that is telling us is the market’s expectation is that growth is going to struggle between years two and five, and that over the long-term it will probably recover but not really get to a remarkable level. That’s what the shape of the curve looks like with the inversion particularly towards the front-end and the rather flat tail between the 10s and the 30 year. So that’s what the curve is signaling. Does that mean there’s going to be a recession in between years two and five? According to the Fed’s probability that they publish, there’s about a 35% chance of a recession in the next 12 to 24 months. That would be consistent with what the yield curve is showing today. So what the curve is telling us is that is there a likelihood of a recession in the next two to five years? Absolutely. Any of us who could tell you that – the expansion is getting kind of long on the tooth to be realistic here. Again, it’s the most hated expansion in history. People wanted it to end for a long time. And we sort of agree with that. We don’t see a near-term recession risk in the next one to two years, but from a probabilistic standpoint, sure. Sometime between year three, four and five looking forward from today, yeah, there’s going to be some sort of recession. But the curve is telling you it’s not going to be that bad. If it was going to be a truly damaging recession or one that was a borderline depression state, like we saw in the credit crisis, you would have seen a true yield curve inversion where the 30 year gets below the two year. That’s telling you that the US economy, for lack of a better term, is going to be a hot mess for the foreseeable future, and it’s going to take extraordinary stimulus and extraordinary fiscal and monetary policy intervention to right the ship. This yield curve only being inverted towards the front-end, is probably signaling if there is a recession, the tools are in place to get you out of it in a pretty short lived and benign way. So that’s what our assessment of the current situation is. Yes, at some point some type of a recession. The question that you should be asking is not yes or no recession, but when it comes, what kind? The curve is signaling not horrific and we agree with that.
Emily Larsen – Now that we’ve broke down this year’s currents, let’s turn our attention to our clients’ portfolios. Scott discussed how advisors should make investing decisions given this knowledge.
Bret Solnoki – Are there places that advisors should be cautious of chasing yield right now?
Scott Kimball – Yeah, there’s a few that jump out. The first is we think that loans have been used as a surrogate for rising rates, but in reality it’s just additional high-yield exposure. Nothing wrong with looking at that market for yield enhancement, but we would encourage people to consider it in the context of their total high-yield allocation. If you put 10% or 15% of a portfolio in high-yield bonds for yield enhancement and you add another 10% or 15% in loans, you’re 20% to 30% in high-yield. That’s something else to consider. And the rising rate story, clearly at all the Fed talk we’ve done, is pretty much dead in the water. So it’s just high-yield risk. Emerging markets, you look cheaper than you might be because certain countries are pulling that average wider and making it look juicier than it is. If you back out the Argentinas and Venezuelas of the world, it doesn’t really look remarkably cheap. If you’re looking for yield enhancement, we would stay stick with US high-yield. We would caution on the global high-yield front. There are opportunities, but take a look at and see what’s in the portfolio. Again, there are bonds in Europe that are BB rated, which is high-yield, that are carrying a negative yield. If that doesn’t give us an indication a rich bond I don’t know what does.
Bret Solnoki – If you think about retirees today, the challenge has been finding income, being able to invest for retirement, generate that income. If you’re talking to an advisor today, how should that client around fixed income go with this retirees or clients or investors that are approaching retirement age?
Scott Kimball – If you’re looking at the yield on a bond fund as your proxy for return, the first thing is if you look historically both investment grade and high-yield, if you look at the past 20 years and you look at the yield to maturity and say how often does that even fall within 50 or 100 basis points of the realized total return? It’s almost never. I think it’s happened three times in 20 years in investment grade and once in high-yield. So yield as an approximator for return is not a great solution. If you’re going to be withdrawing money and taking the dividend payments from the fund for living expenses, you have to sort of put that aside and look at the yield component and say, well, that’s all well and good. Just make sure you understand the volatility inherent with bonds. But you’re going to land at blending investment grade and high-yield until you find an acceptable interest rate. That’s the challenge of the marketplace, because if you have a spending requirement of 4% or 5%, you’re not going to get there on investment grade. High-yield bond funds might be paying 5.25 or 5. You have to probably come up with a weighted blend of the two where someone can make peace with what that yield looks like. The only thing we would flat out encourage people to do is going entirely of all your assets into one asset class, like high-yield. It’s probably a little too late in the cycle to do that, but a blend of municipal investment grade and high-yield to create a reasonable interest rate is really the only strategy if you’re beholden to spending income.
Bret Solnoki – You mentioned this earlier, but kind of the view on 2020. How should we be looking at fixed income heading into 2020 and throughout the full year of 2020?
Scott Kimball – There’s two different roles fixed income can play – yield or cash flow or diversification. The first is where do you want to be on that scale? I’ll take diversification first. If you’re looking for diversification against what’s a pretty robust equity premium, stocks are pretty high and multiples look, again, pretty generous. Despite the fact the yield is low, look at the total return for the AGG this year. I think you’re up around 8% on the AGG, 11% on credit investment grade corporate. Relative to where yields were at the beginning of the year, again, the yield is not a good approximator for bond returns. The diversification benefit of core bonds or even just investment grade bonds is very strong. If we are looking to use a diversification approach, it may not seem like something that jumps off the page when we look at the yield, but having your strategic allocation in fixed income is going to be perhaps even more prudent in 2020 than it’s ever been. If you’re looking at it for a yield or a yield source, you’re going to be beholden to parts of the market that are providing the number that meets your requirement. You just have to look at the historical volatility to understand. Again, we would encourage people not to use high-yield alone as a bond strategy. Blend it with investment grade and come up with an acceptable yield number to make sure you have a reasonable amount of diversification, because the total return and bonds ends up mattering more to people than they realize. We have the conversation a lot. People say, we have a strategic income strategy. People say, okay, that’s great. The fund is paying 5.5%. Perfect. But if you look at the volatility of what’s in there, it’s pretty high. If there’s a rough quarter and your bond fund is down 5%, then what good was the 5% yield. The reality is most people — most investors when we talk to them, retail or institutional, advisor or plan sponsor, they talk bonds in yields, but their actual return expectations are total return. And that at the end of the year when they look at their returns, they don’t want to hear but you got 5% if the total return was down 2. What they care about is what was the total return, and in that type of an environment where high-yield is down 5, investment grade probably did pretty well. That’s something that we think going into 2020 is going to be the key driver, and try to avoid making little bets within your allocation that you’re not aware you’re making. If you look at a high-yield bond fund, look at investment grade bond fund, look at the sector but the sub-sector allocations, and just look for managers and look for investment strategies that seem to have a pretty good diversification within the diversification. The sectors and things are spread out. Because, again, we talked about valuations. Is investment grade cheap relative to high-yield? Sure. It is amazingly cheap relative to history? Are any sectors really jumping out as must buy sectors in the bond market? Not really.
Emily Larsen – Bret and Scott, thanks so much for your time and sharing a great conversation with us today. We’ll leave you with Scott’s final words of advice.
Scott Kimball – I think the first thing I, again, would implore people to do is look at fixed income through what lens you believe is most accurate and ask yourself is it total return or income that I really need? Because if you’re a diversification investor, total return is more likely your driver regardless of what the yield is. And the second sentence that I’ll throw out there is whatever you think happens with the Fed monetary policy, the global concern going forward, fixed income is going to have a role in any of those outcomes. We’re always available to answer questions and share our views, because it’s an important conversation and these podcasts are a tool to let you know what we’re thinking, but markets are dynamic.
Ben Jones – Thank you for listening to Better conversations. Better outcomes. This podcast is presented by BMO Global Asset Management. To access the resources discussed in today’s show, please visit us at www.bmogam.com/betterconversations.
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Disclosure – The views expressed here are those of the participants and not those of BMO Global Asset Management, its affiliates, or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy, or security. This presentation may contain forward looking statements. Investors are cautioned not to place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only and does not constitute investment, legal, or tax advice and is not intended as an endorsement of any specific investment product or service. Individual investors are to consult with an investment, legal, and/or tax professional about their personal situation. Past performance is not indicative of future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. Keep in mind that as interest rates rise, bond prices fall. This may have an adverse effect on bond investments. High yield bonds may have higher yields and are subject to greater credit, market, and interest rate risk than higher-rated fixed income securities. BMO Asset Management Corp. is the investment advisor to the BMO Funds. BMO Investment Distributors, LLC is the distributor. Member FINRA/SIPC. BMO Asset Management Corp. and BMO Investment Distributors are affiliated companies. Further information can be found at www.bmo.com.