The Fed’s great monetary policy experiment is being pushed into new frontiers, but may more likely create more inflation in asset prices than the real economy.

Monetary policy was already heading into uncharted territory before the pandemic—but Covid-19 has sent it into overdrive. The current round of quantitative easing (QE) is theoretically unlimited, fulfilling the “QE Infinity” moniker. Since March, the Fed has often purchased more assets in mere weeks than it did for entire past QE programs (Federal Reserve, October 2020).

With the Fed additionally dipping its toe into credit and high yield assets for the first time (as well as the usual Treasury and Mortgage Back Securities (MBS) purchases), it may even be more accurately referred to as “QE infinity and beyond.” 

Lower For Ever Longer
The Fed has additionally forecast that it will keep rates at the “zero bound” for multiple years as it implements its new policy targeting an “average” rather than an absolute inflation level of 2%.

This implies that it will let inflation run “slightly hot” before turning down the stimulus tap and reversing any of its current easing policies.

On the flip side, if financial conditions take a turn for the worse, the Fed has made clear that it will up its asset purchases from the current monthly run-rate of at least $40bn in mortgage-backed securities (MBS) and $80bn in Treasuries. 

The bottom line is that financial assets live in a world in which Fed’s current actions are bigger, broader and faster than they’ve ever been.

Inflation Still Missing For Now
Considering this unlimited ammunition, and a Fed willing to tolerate a temporary inflation overshoot, should this have us worrying about the inflation genie finally bursting out of the bottle?

We don’t think so. Monetary policy has already pushed against its limits in Europe and Japan but still failed to generate any meaningful inflation. Monetary policy both at home and abroad has only really stimulated inflation in asset prices, and that will potentially continue to be the case.

The greater risk of inflation will likely come from fiscal policy stimulus. As monetary policy approaches the limits of its efficacy, Fed Chair Powell himself has been one of the many voices calling for the Treasury to step in to keep stimulus flowing to support the economy, above and beyond the Covid relief bills.

This has been part of a wider sea change in the economic system. We are potentially shifting from the post-1970s central bank-dominated “neoliberal consensus” to what we are tentatively calling “neofiscalism.” It casts the role of QE as more of a vehicle for financing (or “monetizing” to use the correct economic phrase) the Treasury’s debt issuance in a manner that can keep a lid on yields.

But at best, this only implies that inflation, if anything, is a long-term concern (perhaps several years away) and not a near-term phenomenon.

Today—although the labor market has rebounded better than most anyone expected—unemployment remains elevated and we think it will struggle to return to its pre-Covid levels. It leaves significant slack in the system. Ultimately, Covid was a disinflationary shock. Until the economy rebalances, in our view only then can inflation begin to materially accelerate. Furthermore, we think secular disinflationary factors, such as aging demographics, technological disruption and global trade also need to be overwhelmed.

But What If We Are Wrong And Inflation Returns?
There are a number of ways core or core plus strategies could aim to benefit from rising inflation.  An example would be floating rate instruments, which upwardly adjust their coupons when rates rise.

Higher exposure to spread assets would also be worth considering. Inflation would erode the real value of existing corporate debt loads. It would potentially be easier for companies to grow Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) relative to their debt burdens and delever, which would potentially mean lower default probabilities and stronger credit metrics.

Don’t Fight The Fed
Absent an inflation threat in the short term, we feel the Fed’s stimulus will remain a fixture in markets for years to come. Even when the time comes to unwind its balance sheet, it will likely be a slow, protracted process—weaning the market off QE may not be easy.

The Fed’s buying and selling could have a significant impact on market technicals and investors need to consider the central bank’s activity carefully.

The Treasury additionally faces a $2.8trn deficit, likely necessitating more Treasury issuance—we expect this to increase the Barclays “Agg” weighting to Treasuries by 3-5%.

This of course also depends on non-government issuance patterns. Indeed, corporate issuance since the Covid crisis in March has been record shattering. 2020 issuance year-to-date exceeds the total in most calendar years, at ~$1.5trn (Barclays, October 2020). This has largely been a result of companies taking the opportunity to raise liquidity and term out maturities to ride out the uncertainty.

But importantly, most of this activity has now been done, and so corporate bond investors are starting to enjoy a tailwind from falling supply. 

QE Doesn’t Mean There Will Be No Losers
Although QE will continue to support the functioning and performance of financial assets, the current crisis is still widening the divide between the winners and losers.

Default rates are projected to rise in sectors directly impacted by Covid-19 such as leisure and is accelerating the decline of already-struggling sectors such as brick-and-mortar retail and related commercial real estate.

We believe investors need to emphasize balance sheet strength and staying power of potential investments. As bond investors, we need to assess the credit worthiness of every credit, including the sustainability of its capital structure, the stability of its underlying ratings and ultimately the probability of a worst-case default outcome.

Of course, these factors are always important for fixed income investors, but they are crucial in periods such as these, amid high macro uncertainty and elevated corporate leverage ratios with an underlying economy that is still in the recovery phase.

Gautam Khanna is a senior portfolio manager at Insight Investment.