U.S. Fixed Income

Did the Fed just go Minority Report?

We believe the Federal Reserve is taking a risk — one we hope works — in shifting from reactive to preemptive monetary policy.
August 2019

On July 31, 2019, the Federal Reserve (Fed) cut the Fed Funds rate by 25 basis points (bps). This action marked not only a shift in monetary policy in today’s environment, but also a paradigm shift in the Fed’s approach. The Fed has explained their goal as being to “extend the expansion” and recently described their approach as an “ounce of prevention is worth a pound of cure.”

The view expressed by the Fed is that in an already low rate environment, the need to act early becomes more acute. In this approach, easing policy in advance of negative data is executed as an “insurance cut.”

The desire to preempt negative outcomes is logical from those in positions of power, but we are reminded of the dangers of such an approach by the 2002 dystopian drama, Minority Report. In that film, the PreCrime police unit eliminates all murders by anticipating these crimes and arresting individuals before they commit them. Of course, even in the future, the ability to predict is imperfect and the movie centers on the limits of such predictions and the Pandora’s box opened by attempting to foresee and change the future.

Examining how the oracles communicate

Recent Fed chairs have prided themselves on increasing the transparency of the Fed’s policy and decision making. As forward guidance from the Fed has increased, the natural reaction from market participants is to anticipate not only changes in policy, but changes in guidance. Indeed, guidance, as opposed to actions alone, effectively becomes part of policy.

This high level of transparency led to some odd outcomes in the immediate aftermath of the first rate cut in a decade. Typically, a currency would decline and the curve steepen with a rate cut, but with the market seemingly certain of the Fed’s forthcoming cut, the exact opposite occurred as markets front-ran the Fed’s move.

The Fed was transparent in talking the market into expecting 3+ rate hikes in 2019 and equally transparent in talking the market into multiple cuts this year. Transparency that led the markets astray did no service, but a quieter Fed that pivots less may create less volatility for the participants in the real economy.

Similarly, the Fed has emphasized data dependency as part of its campaign for transparency. This would seem to be a reasonable anchor for policy, but the Fed has made this equation more complicated by citing an additional factor, trade tensions, among its rationales for the July rate cut.

In our view, consistency rather than transparency should be the goal.

Paradigm shift

The Fed’s dual mandate from Congress since 1977 obliges the Fed to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” This focus on unemployment and inflation has largely manifested itself in counter-cyclical monetary policy as the Fed has used policy to respond to strengthening or weakening data in those spheres.

However, if this Fed has shifted to a policy of extending expansions rather than combating recessions, this would appear to signify a meaningful shift in strategy from a de facto counter-cyclical policy to a pro-cyclical policy. The challenge of pro-cyclical policy is then in pondering Fed actions in the event a recession were to occur and counter-cyclical policy were needed.

While the Fed’s actions are felt instantly in the financial markets, there is a delay between when the Fed acts and when the impact is experienced by the real economy. This delay risks the possibility that the real economy deteriorates after a cut, economic data (which itself can lag the real economy) suggests additional rate cuts. In that case, markets and politicians would likely clamor for additional monetary stimulus, but the Fed would be left to encourage patience for its stimulus to kick in and left with a diminished toolkit to respond.

In this way, the risk of a policy shift goes beyond just the proximate downturn and to the core of the Fed’s efficacy. In large part, a central bank’s ability to effect outcomes is driven by moral suasion. Notably, European Central Bank (ECB) president Mario Draghi’s statement that the ECB “is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough” was more effective in ending a crisis than any monetary policy tool the ECB has deployed since. If the Fed’s gambit of preemption were perceived to fail, even if only because of the delay between action and flow-through, would they be putting a century of acquired institutional credibility at risk?

To illustrate this point, if the Fed were to cut rates three times this year in line with Fed Fund Futures expectations, but the economy were still to fall into recession in 2020 (acknowledging that any rate cut has a lagged beneficial effect on the economy) the Fed would be facing a recessionary environment but a Fed Funds rate that is 75 bps lower than when they began to cut i.e. a range of 1.50 — 1.75%. If the Fed were to believe further stimulus were warranted, there is then a relatively high probability we would again witness a zero lower bound on Fed Funds rate, despite a high likelihood that any recession is likely to be far more mild than 2008.

 

History may help predict the future

The Fed has referred to the July 2019 cut as a “mid-cycle adjustment” and not necessarily a full cut cycle. However, since 1989, each Fed cut has been followed by at least two more, suggesting there is reason to believe the same will be true here as well.

Progression of rate cut cycles since 1989

Did the Fed just go Minority Report - Progression of rate cut cycles since 1989

Source: Federal Reserve, BMO Global Asset Management

The history of these rate cycles is asymmetric to cuts, which is to say that cuts have exceeded the hikes both in number and the magnitude. As a result, over time, the Fed Funds rate has demonstrated a downward trajectory.

Fed rate actions since 1989 (prior to July 2019 cut)
Size of move (bps) Hikes Cuts

25

32

31

50

4

16

75

1

2

100

-

1

Total

37

50

Total (bps)

1,075

1,825

Source: Federal Reserve, BMO Global Asset Management

Interestingly, while most associate a Fed accommodation period with strong performance of risk assets, this is not uniformly accurate. Of the two previous cycles (those for which the excess return calculation is available), in one, Fed accommodation was consistent with this assumed convention. However, in the 2007 cycle, this was notably not the case as fundamental economic deterioration and accelerating market fear far outpaced the benefit from Fed action.

Credit excess returns in basis points (excess return data was not available for prior periods)
Cycle 12 months leading up to first cut 6 months leading up to first cut 3 months leading up to first cut 3 months following first cut 6 months following first cut 12 months following first cut

2001

-433

-129

-155

107

271

291

2007

-218

-272

-303

-185

-677

-1300

Source: Federal Reserve, BMO Global Asset Management

There are limited patterns to extract in terms of the direction of rates, with some cut cycles leading to lower 10-year Treasury yields and others leading to higher yields. Total returns for fixed income (as measured by the Bloomberg Barclays U.S. Aggregate Bond Index) have been generally, but not universally, positive for the year following the first cut of a cycle. The only consistent market pattern is that yield curves have steepened historically in the year following the first rate cut, but even this pattern exhibits a good bit of variance in the degree of steepening. For what it is worth, the initial reaction to the recent cut has been a flattening rather than a steepening of the yield curve.

The recently renewed tariff tensions and corresponding market impact immediately after the Fed rate cuts are a healthy reminder that each Fed cycle has unique circumstances. While the Fed’s actions are meaningful, they have historically come at a time of negative data or events such that market results are more likely a balance of multiple factors rather than the Fed alone.

10-year Treasury yield (%)
Cut date Date of cut 1 year forward Difference

6/5/1989

8.37

8.46

+0.09

7/6/1995

6.03

7.02

+0.98

9/29/1998

4.57

5.96

+1.39

1/3/2001

5.16

5.11

-0.05

9/18/2007

4.47

3.54

-0.93

7/31/2019

2.02

?

-

2s10s (bps)
Cut date Date of cut 1 year forward Difference

6/5/1989

-3.15

13.85

+17.00

7/6/1995

48.55

58.65

+10.10

9/29/1998

29.25

36.10

+6.85

1/3/2001

37.10

207.90

+170.80

9/18/2007

49.90

185.06

+135.17

7/31/2019

21.11

?

-

FI total return (%)
Cut date 1 year forward

6/5/1989

1.82

7/6/1995

2.56

9/29/1998

-0.19

1/3/2001

7.87

9/18/2007

5.43

7/31/2019

?

Source: Federal Reserve, BMO Global Asset Management

Permanent stimulus

The use of fiscal stimulus has a long history in the U.S., but one challenge with that policy tool is that while easy to increase fiscal stimulus, politicians rarely find it to be the right time to remove stimulus under their watch. To wit, the last president to leave office with a lower outstanding national debt than when they came into office was Calvin Coolidge in 1929. Further, as we now find ourselves in the longest economic expansions in American history, the U.S. is expected to run a trillion dollar deficit this year. The risk of such pro-cyclical stimulus is that it both reduces the reserves for future stimulus and risks the possibility that the economy grows accustomed to the current spending as a baseline and future counter-cyclical stimulus will need to be that much larger to achieve the desired effect.

With the Fed’s move to preemptive monetary policy, a similar question emerges in the monetary policy forum as to when and how the Fed exits stimulus mode. If the Fed’s experiment in pro-cyclical policy does not create the Fed’s desired results, tightening policy would be extremely difficult. But similarly, if current conditions call for monetary stimulus in the Fed’s new formulation, it raises the question of when the Fed could remove accommodation. Growth in 2018 was reasonably strong by most measures, supported by significant tax reform. But with that level of fiscal stimulus unlikely to be available again soon, is the Fed content to remain in accommodation unless fiscal stimulus is meaningfully increasing?

With the Fed’s stated goal of extending the expansion, if the Fed insurance cut works, at what point then will the Fed be willing to remove accommodation, knowing that could be the moment that ends the expansion?

 

What the oracles might not see

While much focus of the decline in the 10-year Treasury yields since their October 2018 peak has been placed on expectations of slowing growth and the concomitant increased expectations of a Fed policy reversal, one of the underappreciated aspects of the decline in rates has been the pull lower by other sovereign debt. In particular, the German bund’s move lower in yield has been closely tracked by the U.S 10-year and the bund has demonstrated strong correlation with the U.S. term structure premium for the past five years.

U.S. term structure versus German 10-year bund since 2014

Did the Fed just go Minority Report - US term structure versus German 10-year bund since 2014

Source: Federal Reserve Bank of New York, Bloomberg, BMO Global Asset Management

A significant portion of the gap between the two bellwether yields can be accounted for by the cost to hedge between the currencies. As this measure is largely driven by the short-term yield differentials, when the Fed lowers rates, in addition to typically facilitating a steepening of the curve, it would also lower hedging costs between the dollar and the Euro. By lowering this hedging cost, the differential between the U.S. and German yields could converge as yield hungry European investors find U.S. yields more attractive.

While the ECB is expected to cut rates further in September, unless it does so by the same degree or greater than the Fed, hedging cost would be expected to fall. With more than $15 trillion of global debt trading with negative yields (as of August 15), the substitution effect of foreign investors purchasing U.S. fixed income for its yield is unlikely to abate soon.

Global negative yielding debt has reached record highs

Did the Fed just go Minority Report - Global negative yielding debt has reached record highs

Source: BMO Global Asset Management and Bloomberg. Represents the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index. Investments cannot be made in an index.

If this is the case, the argument made of behalf of the Fed that rate cuts could un-invert the yield curve (as it pertains to the Fed Funds and the 10-year Treasury) could be for naught. Given the history of inverted yield curves, there could be utility in counteracting the negative market signaling they contain. However, if new buyers appear as hedge costs decline, it would take multiple rate cuts to un-invert the curve.

 

Conclusions

Minority Report ends well, but only after the limits of the oracles’ prescience is revealed. The tainted PreCrime unit is closed and the protagonist is exonerated. Embedded in this “happy ending” is that the murder rate presumably climbs above zero. Left unstated, there will be victims either way and there are no easy answers. Both preemptive and reactive programs entail risks.

We believe the Fed is taking a risk — one we hope works — in shifting from reactive to preemptive monetary policy. It was not that long ago that the Fed was more forthright about the uncertainty inherent in economic forecasting as Chairman Powell used the analogy of walking into a dark room and slowing down to avoid furniture as an analogy for the Fed’s situation. Today, they seem more certain that they know the future and aim to alter it. We hope this approach works as the consequences for failure seem more pronounced than the end of a single economic expansion.

The beauty of counter-cyclical policy (monetary or fiscal) is that the economy generally experiences cycles and a downturn is likely to be followed by an upturn, which the policy actor can demonstrate as success of their policy. Even if the policy is misguided, the result may be favorable. By contrast, pro-cyclical policy creates the risk that a cycle that was already ending is attributed to the policy, even if that policy was correctly decided and enacted.

The Fed’s actions contain risks for down the road, but we see their actions as constructive near term for the economy. Fixed income as an asset class should benefit in this environment and in particular non-governmental sectors stand to benefit from renewed accommodation, enhanced liquidity and global demand.

Though U.S. corporate bond yields may not appear too generous to domestic investors, it is important to put them in a global context. For Euro-denominated bonds, BBB rated securities also exhibit negative yields through approximately five-year maturities. Accordingly, with many investors throughout Europe already exposed to lower-quality investment grade credit risk, it is likely that U.S. corporate debt yields appear relatively attractive, both in absolute terms and in terms of relative credit risk. If these dynamics persist, they will likely lend further support for the dollar-denominated bonds across the credit market spectrum.

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U.S. dollar versus Euro BBB yields

Did the Fed just go Minority Report - US dollar versus Euro BBB yields

Source: Bloomberg Barclays

The limits of the Fed’s actions may be tested again due to the albatross around the neck of Treasury yields that is negative yielding debt globally. Importantly, while Fed accommodation is no doubt impactful, it is far from the only factor steering investment results and investors would be well served to remain judicious in their risk budgeting.

This report contains our opinion as of the date the report was generated. It is for general information purposes only and is not intended to predict or guarantee the future performance of any investment, investment manager, market sector, or the markets generally. We will not update this report or advise you if there is any change in this report or our opinion. The information, ratings, and opinions in this report are based on numerous sources believed to be reliable, such as investment managers, custodians, mutual fund companies, and third-party data and service providers. We do not represent or warrant that the report is accurate or complete.

This presentation may contain targeted returns and forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such returns and statements, as actual returns and results could differ materially due to various risks and uncertainties. This material does not constitute investment advice. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

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