As expected, the Federal Open Market Committee removed the word ‘patient’ from their statement on monetary policy, thus signaling the beginning of the end for a near zero percent federal funds rate.
The Committee’s statement:
- Removed the word ‘patient’, but left intact the language on ‘data dependency’ (“measures of labor market conditions, indicators of inflation pressures and inflation expectations, and reading on financial and international developments”) as a determinant for future fed funds rates. The reference to “international developments” is a veiled reference to ECB activity and the strengthening dollar (which has hurt exports).
- Moderated its economic outlook – “economic growth has moderated somewhat”, given recent economic releases
- Continued to state that inflation remains below target, noting that inflation has declined further below longer term targets. The Committee added language stating that it wants to be fairly “confident” that inflation is moving back toward its 2% target.
- Reiterated its view that below-normal rates may be needed for some time
- Specifically said that an April fed funds rate hike is “unlikely” and that the timing of the initial hike remains undetermined
As a result, over the near term, we expect:
- Consistent with the Fed’s guidance, we expect two rate hikes in 2015 – in September and December – with a year-end fed funds rate of 0.75% (the top end of the range, which is currently 25bps). We expect an additional 4 rate hikes in 2016 to 1.75% by year end.
- Today’s actions are supported of the front end of the yield curve, as the Fed emphasized the low and gradual nature of future rate hikes.
- Investors should expect continued moderate volatility
Over the medium/longer term, we expect:
- The front end of the yield curve will be repriced to higher rates as we approach the initial rate hike. Meanwhile, technical support for the long end of the curve will continue, resulting in a bear flattener (long term rates move up, but short term rates move up more).
- Increased volatility as the market adjusts away from forward rate guidance, but that volatility will eventually be dampened by liquidity from central banks
- A higher probability for trend or above trend growth to be supportive of risk assets
- Growth and higher rates in the U.S. should contribute to a stronger dollar
What does this mean for investors?
- Investors should be on alert for the risks of navigating a shifting US rate environment, underscoring the need for global unconstrained fixed income investment strategies. Managers who take a best ideas-driven approach can focus on generating total return, irrespective of benchmark, with the freedom to seek out the best sources of yield. That flexibility is important given the distortions of today’s bond markets, particularly when it comes to actively managing both curve positioning and duration, as well as taking advantage of an environment that supports risk assets by seeking out beneficiaries of the strong dollar and of central bank accommodation outside the US.
- Gartside is currently positioning his fund with a curve flattening bias and has an allocation to floating rate paper. He’s maintaining adjusted empirical duration (a measure of interest rate sensitivity) of just 0.09 years, in order to mitigate actual duration risk. He prefers credit, where he holds nearly 60% of his fund, with more than 1/3 of the total fund in high yield debt. He’s also slightly overweight selected currencies, including the US dollar, funded primarily with short positions in the Euro and Yen.
- One of his highest conviction current investment ideas is European high yield debt.
- The sector may no longer offer particularly ‘high yield,’ but Gartside points out that everything is relative. In other words, compare the modest yields in European HY to those on offer in other parts of the bond market. More than a quarter (26%) of European government bonds are trading on a negative yield, more than half (54%) of Germany Bunds are trading on a negative yield – with some 23% yielding less than the -20 basis points that marks the threshold for ECB bond buying eligibility. In effect, this means the ECB will have to buy longer dated government bonds, further flattening the yield curve at the longer end.
- Citing another reason to like European high yield, Gartside highlights the solid fundamentals underpinning the sector, outlining the tailwinds bolstering Europe, including falling oil prices, the weaker currency boosting exporters and the stimulative effective of the ECB’s ambitious QE bond buying programme. He notes the sector’s average credit quality is slowly improving, even surpassing the average creditworthiness of US high yield. The ability to pick amongst the best ideas in this sector is key, as Stealey and his team look opportunistically for companies falling into and out of the high yield space, based on in-depth credit research.
- Gartside also likes idiosyncratic plays in emerging market debt, where he has about 15% of the portfolio. Having the flexibility to account for volatile currency impacts is important here; as evidence Stealey cites the example of Turkey, where he’s traded in and out of the position in response to changing dynamics. He invested last year to capitalise on Turkey’s benefit from falling oil prices (they are a huge energy importer), but has since taken profits head of election year pressures that are likely to signal central bank cuts and a negative market reaction.
Nick Gartside is chief investment officer, Fixed Income, JP Morgan Asset Management and fund manager of the JPM Global Bond Opportunities Fund.