Shifting from accommodative to neutral monetary policy (and perhaps eventually an even tighter policy) may prove a Herculean challenge. “After all, the Fed’s balance sheet sits north of $7 trillion,” noted Greg Bassuk, the chief executive officer of AXS Investments, in a recent blog post titled “How Federal Reserve Tapering Can Impact Portfolio Decisions.”
Based on the CME Group’s FedWatch tool, markets give it a two-thirds chance that the Fed’s interbank lending rate range will either remain at the current 0% to 0.25% or move up by a quarter point by the end of 2022. That gauge also projects a roughly one-third chance of the fed funds rate moving up to 0.75% to 1.25%.
Karen Schenone, head of fixed-income strategy at iShares, believes that “much of price inflation in areas such as energy, cars and trucks, grocery prices and other items is the result of the post-pandemic economic reopening.” She predicts “we’ll see higher inflation through the end of this year,” and more benign inflation readings in 2022.
Yet some strategists are on guard that inflation could still disrupt fixed-income (and by extension, equity) markets. Harley Bassman, a managing partner at Simplify Asset Management, says that beyond the near-term pressures on prices, there are demographic changes in the population that could also fuel inflation. “If you look out over the past 70 years, the only period of high inflation was when baby boomers entered the workforce and formed new households in large numbers,” he says. Millennials, he adds, are an equally significant demographic force, and their increased spending on houses and other items will pressure prices higher in the same way.
Housing is just one area where a demographic bulge will push up prices. Home prices are now roughly 20% above their levels a year ago, according to the S&P CoreLogic Case-Shiller Home Price Index, as demand clearly outstrips supply. Realtor.com notes that there were roughly 1.4 million homes for sale in the country in 2018. That figure has since fallen by more than half.
But this demographic influence on prices may not necessarily be a bad thing. “The Fed wants a steeper yield curve,” says Bassman, noting that higher long-term interest rates would “support our levered financial system,” as banking and insurance industry profit margins expand. (Net interest margins in the financial services sector expand and contract in tandem with the yield curve.)
Simplify offers a range of ETFs aimed at sideswiping the impact of rising long-term rates. One of these funds is the Simplify Interest Rate Hedge ETF (PFIX), which uses interest rate options to provide “convex exposure to large upward moves in interest rates and interest rate volatility.”
Bassman sees a “strong chance of significantly higher rates” in coming years, resulting from both an uptick in core inflation and a shift away from negative real interest rates toward neutral real rates. Over much of the past century, real rates, or the difference between nominal interest rates and the rate of inflation, had been modestly positive, but they have been mostly negative for much of the past decade.
“The Fed wants that to get back to a 2.0% real rate range,” says iShares’ Schenone, though she adds that it may take a few years for that shift to play out. If she’s right in her expectation that core inflation will move up to 2.5%, then the Fed may eventually hike rates to around 4.5%.
Lisa Hornby, head of U.S. multisector fixed income at Schroders, noted that the Fed used to adhere to the “Taylor rule,” which suggests that in a period of rising inflation, the real interest rate should also rise (acting, in effect, as a multiplier). While the Fed may not push real rates into positive territory anytime soon, Hornby, who spoke in late September, still sees a coming uptick in rates. “We are focused on short-duration bonds. The market has yet to reprice long-term interest rates,” she says.
In Search Of Yields
If and when the yield curve steepens, advisors will once again be offering clients an array of fixed-income ideas with more robust payouts. Until then, it has been a challenge to find decent yields without assuming a lot of risk.
Junk bonds are one area where the risk doesn’t seem to match up with the reward. In early 2019, the effective yield of the ICE BofA U.S. High Yield Index stood at 8%. These days, the yields are at only half that level.