Fed’s path unclear

Navigational aids are hazy

It would seem that Federal Reserve Chairman Jerome Powell, whose life has been an odyssey through America’s most rarefied institutions, has taken a keen interest in, of all things, astronomy. In a speech last summer at the annual Jackson Hole symposium, Mr. Powell expressed frustration with the unusual variability of the metrics he refers to as “celestial stars.” To be sure, the Fed’s astronomical objects of interest reside within the macroeconomic firmament: the natural rate of unemployment; potential output growth; the neutral interest rate; and so on. All riveting stuff for diehard economists. But the Fed has found navigation increasingly difficult of late.

“Navigating by the stars can sound straightforward,” said Powell. “Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly.” These are candid words for a central banker (heaven forbid they ever communicate in plain English).

But Powell was very clear here: The stars are inexplicably shifting. For example, estimates of the natural rate of unemployment have fallen sharply as unemployment has tumbled, while estimates of the potential growth rate have also plunged. He goes on: “The FOMC has been navigating between the shoals of overheating and premature tightening with only a hazy view of what seem to be shifting navigational guides.” Translation? My day job is tough. Those bloody stars won’t stop moving. The usual economic indicators we track are no longer reliable.

All of this makes monetary policy more mystifying – and, in part, responsible for the Fed’s constellation of misjudgments in the post-crisis period (their forecasts have consistently missed the mark since 2008). But the more important question is why are the stars not stable, as they have been in the past? For us, the answer is simple: A range of forces since the GFC has conspired to broadly bring down global growth – deleveraging, a downshift in labor productivity growth, aging populations, a slowdown in technological advances, and maturing urbanization in China have all played a role.

The world is suffering from a demand problem. A general rise in savings around the globe and more risk aversion has marked the post-2008 world. Investment demand has fallen sharply relative to the level of available savings around the world. The last investment boom in the U.S. took place in the 1990s during the internet and technology revolution. Since then, capex has tumbled. And even though the U.S. is nearly a decade into its current expansion, the total output gain is only about 85% of what it was during the 1990s. This is a crucial reason our investment team believes the current cycle could last longer than many anticipate.

All of the above creates more stress and uncertainty for the Fed (not to mention a pestering president insulting your golf game and trying to influence monetary policy from his smartphone). But where to next? In Powell’s speech, he reviewed other historical episodes when gauging the level of key variables was difficult – notably the 1960s and 1970s when monetary policy mistakes contributed to an inflation blowout.

How can the Fed prevent another misstep? Powell gave some clear signals here too. Arguing in favor of caution on policy rates, he cited the work of William Brainard, recommending that “when you are uncertain about the effects of your actions, you should move conservatively.” In other words, be extremely wary of over-tightening as policy gets near neutral levels. The fact of the matter is that the Fed, or any other central bank on planet earth, is in no rush to normalize policy. Structural forces will keep them cautious for years.

Investment implications

How does the above translate into the outlook for bonds and other fixed-income securities? After nearly 10 years of generally falling interest rates, many investors have come to believe in lower-for-longer interest rates. It wasn’t always this way. In the aftermath of 2008, many were convinced that monetary largesse would translate into a combination of high inflation, a plummeting U.S. dollar, and gold at stratospheric levels. It didn’t.

But now many assets have been bid up on a “lower forever” view. It was a long ride down in yields, boosting the values of a wide variety of interest rate sensitive investments in the West. Through financial alchemy and a masterstroke of marketing genius, REITs, dividend payers, and a vast assemblage of ETF product provided a higher and more tantalizing yield. To be sure, our clients relished in this yield bonanza (with our Global Income strategy posting attractive calendar year gains every year since its inception in June 2008).

But no party lasts forever, and 2018 was particularly cruel to fixed-income investors. But the bond market will regularly run ahead of itself. Large and steady spikes in yields, even if they glacially drift higher over the coming years, are not likely to be sustained.

The world, facing a deficiency of demand, will continue to require lower rates than in the past. The key point is that the bond market will be volatile and hostage to high debt levels and other structural headwinds around the world. Expect big bond selloffs and regular rallies. Most will continue to panic each time. The fault will not be in the Fed’s stars, dear investors, but in the market’s reaction to them.

Tyler Mordy, CFA, is President and CIO for Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article first appeared in Forstrong’s publication Super Trends and Tactical Views, available on the Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.

Notes and Disclaimers

The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.