The Fed’s Dual Mandate – Therein lies the Dilemma
Carret Asset Management
By Jason R. Graybill and Neil D. Klein
January 19, 2011
The Federal Reserve has dual, sometimes conflicting, mandates to promote price stability and to promote maximum employment. The Fed has averted a double dip recession, and the threat of deflation that hovered over us just a few months back has evaporated. If the Fed’s mandate was solely price stability, we believe the Fed would have already declared “mission accomplished”. However, unemployment remains at unacceptably high levels. The only way for the Fed to combat unemployment at this stage of the economic cycle is through further stimulative interventions that will be perceived as inflationary over the long term. Therein lies the Fed’s dilemma - stimulate the economy to create jobs at the risk of higher inflation.
Prior to 1977, the Fed had a single focus - price stability. An amendment in 1977 to the Federal Reserve Act of 1913, added the dual mandate of promoting full employment. During the quarter, this mandate caused a policy response in the form of Quantitative Easing (QE) II that sent interest rates higher, a move we have been anticipating and for which we are well positioned. The economy is growing again, but not quick enough to lower unemployment. Inflation, as measured by the core CPI, is currently close to record lows. While GDP growth will register almost 3% in 2010 and expectations for 2011 are north of 3%, this will be insufficient to meaningfully create further job growth. GDP expansion needs to exceed 4.5% to have a material impact on reducing unemployment.
The bond market flinched during the 4th quarter as investor’s concern about future inflation and the ability of the U.S. government to protect its AAA rating mounted. The Fed’s printing presses, which are now “computers” creating debits and credits with the major financial institutions, continue to run overtime with the announcement of QE II. QE II was designed to lower interest rates even further over the short term to
Key Interest Rates |
12.31.10 |
06.30.10 |
12.31.09 |
Prime Rate |
3.25% |
3.25% |
3.25% |
Fed Funds Rate |
0 – 0.25% |
0 – 0.25% |
0 – 0.25% |
3 Month U.S. T-Bill |
0.13% |
0.18% |
0.05% |
5 Yr U.S. Treasury Note |
2.01% |
1.77% |
2.68% |
10 Yr U.S. Treasury Bond |
3.30% |
2.94% |
3.83% |
10 Yr AAA Municipal Bond |
3.12% |
2.78% |
3.26% |
support real estate values, liquify the banks, stimulate the economy and create jobs. However, QE II was followed in short order by the November elections, and the resulting extension of the 2001 tax cuts, social security tax cut and extension of unemployment benefits had the opposite result. Interest rates increased during the 4th quarter on inflation and credit concerns. 10 Year U.S. Treasury bonds started the quarter at 2.53% and ended the year at 3.30%, an increase of 77 basis points. Many are using the phrase “too far, too fast” to describe interest rate moves over the past 90 days. We agree – while we do anticipate an upward trend in rates, long term U.S. Treasury rates have moved too quickly given our view that inflation through 2011 will remain at subdued levels. With lingering high levels of unemployment, low capacity utilization, and the Fed committed to the QE II bond buying program through mid year, it is difficult to make the argument that an outbreak of inflation is imminent. Accordingly, we anticipate the first quarter will bring a more stable rate environment.
Inflation Expectations
Source: Bloomberg
The Fed’s message is clear – improving economic data, alone, is not enough to change course. As long as inflation remains tame, job creation must strengthen before the Fed begins a tightening cycle. Therefore, we anticipate the Fed will remain accommodative through 2011 with short term interest rates remaining close to historic lows and the yield curve remaining steep. Additionally, with every passing day, the total debt of the U.S. mounts at an increasing rate. The recently passed “spend – spend” tax deal, will surely add to the deficit in 2011 and 2012. While we are in a much stronger fiscal position than the European Union, local, state and federal politicians must address our fiscal weaknesses to prevent a U.S. restructuring in the decades ahead. While we do not believe the U.S. credit rating is in jeopardy over the short term, it is time for Washington to rein in spending.
We feel obligated to make a quick comment on Europe as we believe it will continue to be in the headlines in 2011 and beyond, remaining a key focus for fixed-income investors. First it was Greece, then Portugal followed by Ireland – we would not be surprised to see Spain need dramatic government assistance/support in 2011. Spain’s maturity roll over schedule in 2011 through 2013, leaves no room for error or loss of investor confidence. Ongoing European problems could once again make the U.S. markets a safe haven, keeping a short term lid on rates.
Taxable Bonds
While unemployment remains elevated and will so for a few years, the economy is solid. Shoppers have returned; wages are growing, rising at a 3.4% annualized pace in October, the strongest growth in more than two and a half years; household net worth is on the rise; consumer confidence is well off its lows; and corporate profits will hit record levels early in 2011. Corporate cash balances for non-financial companies represented 7.4% of assets as of October 1st, the highest level since 1959. Corporate America has reduced leverage and increased liquidity resulting in stronger credit profiles for almost all of the companies we have invested in.
The previous factors contributed to above average taxable bond performance during 2010. Our exposure to the BBB sector of the investment-grade universe benefitted client portfolios as risk assets performed well. We continue to find the low end of the investment-grade universe attractive as corporate America is arguably in one of the strongest positions in decades and credit spreads remain at attractive levels (+169 5 Year Treasury to A rated Corporate).
10-Year Treasury Yield
Source: Bloomberg
We are maintaining our short duration focus of less than three years, as we believe we will see opportunities to extend portfolio duration in late 2011 and into 2012. We remain void of Treasuries and have continued to increase our small but growing exposure to Trust Preferreds in the financial sector. Portfolios remain well diversified across multiple industries and our average credit rating is solid at approximately A (Standard & Poor’s).
In prior letters, we have provided illustrations and examples of how duration can be a bond manager’s best or worst friend. We have had a short duration portfolio structure and have been void of Treasuries for several quarters, which benefited clients during 2010. We are compelled to provide a real life example of duration risk. The seemingly safe i-shares 20+ Year Treasury ETF (TLT) was down 10.8% in price during the 4th quarter as rising interest rates negatively impacted the prices of long duration U.S. Treasury bonds. This is a decline most Treasury investors wouldn’t have guessed possible.
On the supply front, investment grade debt issuance hit $861 billion through November 30th and will most likely surpass the record issuance of $918 billion in 2009. However, when maturities and tenders are factored in, net new supply was a lower than normal $200 billion. Since the corporate bond issuance cycle was so strong in 2009 and 2010, we anticipate a more modest level of supply coming to market in 2011. On the Treasury supply side, the stimulus and deficits must be paid for with an increasing future supply of Treasuries. The tight supply of corporate bonds versus Treasury bonds in 2011, is just one of the reasons we continue to favor corporate bonds.
Municipal Bonds
The municipal bond market remained in the unfamiliar position of headline maker in the 4th quarter. The market showed a degree of resilience in the face of an almost constant barrage of negative data points. These included continued concerns over state and local budgets, jaw boning politicians, the retiring of the Build America Bond (BAB) program, and under-funded pension commitments, to name a few.
As Investment Managers, it is our obligation to sift through fact and fiction to develop and maintain a prudent investment strategy. This is no easy task given the sheer magnitude of information, both good and bad, that is being generated. We are starting to see the early stages of bifurcation as the market differentiates between higher quality credits and marginal credits. Our diligent investment process, amid the uncertainties, should create many opportunities to add value over the coming quarters and years.
The municipal bond market is driven by three clear fundamental concepts: supply and demand, credit quality, and investor confidence. First, let’s breakdown the supply and demand dynamic. The municipal market has issued over $425 billion dollars worth of bonds in 2010, a huge increase over previous years. Much of that supply was driven by lower interest rates and the newer BAB program that was geared at the taxable bond segment. The steady stream of new issuance continued right up to December 31, 2010. The demand side of the equation was just as vibrant as supply for most of the year. The municipal market comfortably absorbed primary and second market supply without missing a beat. The key contributors to demand were flight to quality and expectations for tax increases. The market was in almost perfect balance for the first three quarters of 2010.
In the 4th quarter of 2010, the broader bond market changed course and experienced a rise in interest rates. The increase was driven primarily by the negative global reaction to QE II. U.S. Treasury bond yields increased in a meaningful way in the quarter. With all things being held equal, the U.S. Treasury bond market is often the backdrop to which other fixed-income investments are spread against. Fortunately, most of the investment-grade fixed-income universe built up quite the cushion and posted positive returns even with the “back up” in yields.
The rise in yields combined with ongoing municipal bond market worries, eroded investor confidence in the 4th quarter. State and local budget concerns remained in the forefront along with uncertainty regarding the municipal market’s ability to correct the mounting pension and healthcare cost shortfalls. Additionally, many media outlets have inaccurately connected the data points and have projected mass state and local municipality restructurings in the coming years. The media has also compared the municipal landscape to the growing contagion in Europe. It is extremely important to understand that interest rate risk is very different from credit risk. While the market will ebb and flow with interest rates, it is our contention that the market is not going to experience wide-scale failures in the investment-grade segment. Also, it should be noted that comparisons versus Europe are not accurate as state debt burdens, expressed as debt versus state gross product, are presently in the 2% to 5% range while Greece, for example, is over 112%. We are aware that these concerns, right or wrong, can erode investor confidence over time. Consequently, we do not ignore them or take them lightly. In fact, it is an ongoing part of our investment modeling approach.
Our vision for today and for the future is what we would call realistic optimism. The $2.8 trillion municipal market is comprised of over 60,000 different issuers that are diversified by location, maturity, interest rate, revenue sources, and credit support. Many of those issuers are serious about returning to a more solid fiscal position. The Rockefeller Institute of Government reported this summer that “state tax revenues are slowly rebounding”. Other sources identify the same trend which continued into year-end. We observe that most states, and many local municipalities, have continued to cut spending while building long-term plans to deal with their pension and healthcare commitments. The next, and most difficult step, is finding a way to raise taxes while reducing services. Politicians, at all levels, will be charged with balancing this difficult task. In the media they call this “The Day of Reckoning”. Instead, we see this as a positive, since many of the challenges will have been illuminated and only then can the appropriate forces start the work on reparations.
High-quality municipal bonds should continue to move in concert with U.S. Treasury bonds. We expect supply to decrease slightly to be more closely aligned with softer demand. The media will continue to cast a light on the challenges facing the market. As the overall economy improves, we envision states and local municipalities following suit. Downgrades may continue to occur but the most severe cuts should be limited to the marginal parts of the municipal landscape. In closing, we expect structural change to occur, in a positive way, over the next few years.
Carret Bond Strategies
Municipal Bond: An Investment-grade intermediate duration portfolio focused on preservation of capital and cash flow. Each portfolio is customized by state or with a national focus to meet individual client goals and objectives. Our strategy is designed to generate tax exempt returns with strong risk controls.
Taxable Bond: An investment-grade intermediate duration portfolio focused on corporate, government agency and U.S. Treasury bonds coupled with select opportunities in trust preferred securities. Utilizes top-down and bottom-up fundamental credit research with the goal of generating high current income with the preservation of capital.
Past performance may not be indicative of future results. Different types of investments and investment strategies involve varying degrees of risk, both short-term and long-term, including principal loss and fluctuation. No client or prospective client should assume that any material in this document serves as the receipt of or a substitute for, personalized advice from Carret Asset Managment, LLC or from any investment professional. Due to various factors, including the passage of time and changing market conditions, such content may be outdated and no longer reflective of current holdings or position(s).
(c) Carret Asset Management
