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Loomis Sayles' Matt Eagan on the Macro and Fixed Income Outlook

December 11, 2012

by David Schawel, CFA

I’m glad you bring up the central banks. As a portfolio manager myself, I have seen firsthand how much the Fed has affected asset prices through its quantitative easing (QE) programs.

We are in the late stages of a “risk-on” rally. The effectiveness of Fed policy diminishes over time.  The Fed has flooded the economy with money, and as risky asset valuations have gone up we have started to layer in hedges. We’ll go toward neutral in credit and take our beta down to zero. We won’t go short, because of the risk of getting hit by the Fed.

I’ll present a counterargument to that. Although many areas of the credit markets have rallied substantially, as measured by inflows, investors have not been pushed substantially into stocks yet, which is arguably one of Bernanke’s main goals with QE.

That’s a fair statement. The risk premium can come down in equities and multiples can go up. The thing that people may misunderstand is that QE-infinity does not have a shelf life with a date. I wouldn’t be surprised to see, at its next meeting, the Fed buying more U.S. Treasury bonds as Operation Twist ends. You’ll probably see $40 billion of Treasuries in addition to the $40 billion of MBS from QE3.

What’s interesting about another Treasury-bond buying program is that it would be balance sheet expansion. Operation Twist was “sterilized,” as they were selling one maturity and buying another. They were adding duration, but it was still sterilized.

Exactly. It’s pure balance sheet expansion.

Real yields have continued to go lower, and I’m waiting for the 30-year real yield to turn negative as well. What is the catalyst for those yields to become less negative and eventually positive? And does the fact that they are negative here (except for the 30-year) imply that Fed policy is working?

The Fed will move toward a targeting mechanism. They might currently use inflation and employment as dual mandates, but really what they are targeting is nominal GDP. They are distorting the yield curve very successfully. The idea is that they will keep long-term yields low until they hit their targets closing the trillion-dollar nominal GDP output gap, which we think could take a few years.

The first impact would be that the yield curve will start to rise and steepen. It will steepen initially as the numbers get better. People won’t be looking for a certain date; they’ll be looking for economic forecasts. Rates will rise on a secular basis from here. The first cycle will be relatively benign on an inflation basis. It will be more painful from a real-rate basis as real rates move from negative to positive, and inflation will pick up more steadily after that.

In my view, a large percentage of market participants confuse base money supply and broad money supply. Bank loan demand has picked up, but it’s still extremely challenging here. Consumer and real estate loans are largely flat. Commercial and industrial (C&I) has picked up.

This is a key point. The money multiplier is not working right now. The money that is pumped into the banking system from QE is being stuck as excess reserves at the Fed and not lent out.

Lacy Hunt likes to say that the money multiplier is negative at the margin here. Would you agree?

Yes, I would. If they pump a trillion dollars into the monetary base, even if the money multiplier is negative, it will still expand nominal GDP at some level. Eventually, the deleveraging will turn around, and the private sector will start to borrow. You need to watch when lending starts to pick up again. That will be when those excess reserves start to leak out. The Fed is saying it will be able to rein that in by draining the reserves or raising interest on excess reserves (IOER).

I am not a big believer that IOER will be a very effective tool if things started to overheat. For instance, at the margin, I don’t believe lending decisions are being made over whether IOER is at 25 bps or 225 bps.

It’s some hubris that the Fed thinks it can do that. I agree; those reserves will leak into the economy at some point, although I can’t tell you when.

That’s all the questions I have. Thanks for your time.

Thank you.

David’s conclusion

Going forward, fixed income investors should be aware of the risks they are taking in their bond funds. Coming off of the heels of substantial gains in both government and credit bonds, investors need to understand the risk-reward tradeoffs that various fixed-income classes have going forward. Investors who are willing to look at alternative bond funds should consider the Loomis Sayles Strategic Alpha Fund (LABAX). In addition to having a great grasp of the macroeconomic issues, I like that Mr. Eagan has a strong credit background, which shouldn’t be underestimated in a time when yields are at all-time lows and competition for spread assets is so high. While this type of fund is not for everyone, it could be a suitable part of a portfolio for a fixed-income investor seeking attractive absolute total returns with low volatility.

Copyright 2012, CFA Institute, Reproduced from the Inside Investing Blog with permission from the CFA Institute.  All rights reserved.

David Schawel, CFA, is based in Raleigh Durham NC and works as a fixed-income portfolio manager. His blog is Economic Musings and you can follow him on twitter at @davidschawel.