The Shift: Fed Makes U-Turn on Monetary Policy

For the Federal Reserve, it’s all about inflation right now.

After raising the federal funds rate nine times since December 2015, the Fed’s summary of economic projections now implies no rates hikes in 2019, down from previous expectations for two, and just one in 2020. In addition, Fed Chairman Jerome Powell has suggested the Fed will slow the shrinking or “unwinding” of its balance sheet, which grew dramatically in the years following the Great Recession, keeping it slightly above $3.5 trillion, or about $1 trillion higher than previously expected.

Kenneth Sommer, managing director and head of investment grade portfolio management for NYL Investors, part of New York Life Insurance Co., attributes the Fed’s more accommodative monetary stance not to concerns about the health of the U.S. economy but rather to trends in inflation. Like nearly every other central bank around the globe, Sommer said at the 2019 SVIA Spring Seminar, the Fed has failed to consistently reach its inflation target over the past several years, and it realizes it can’t continue to raise interest rates in that environment. It’s capitulated to that reality, and inflation is going to continue to dictate Fed policy over the near term.

“If the Fed is going to potentially raise rates at some point in the future, it’s going to be because inflation is running substantially above its symmetric 2% target for a sustained period of time,” Sommer said. “Conversely, if there’s likely to be a Fed rate cut, it’s because their inflation target is not being met and certainly is substantially below their 2% symmetric target.”

The Fed’s more dovish approach to monetary policy brings it more in line with central banks in Europe and Japan, whose economies have been lagging the U.S. economy.
Easy money policies around the world have had some unusual consequences, Sommer noted, like the debut of sovereign bonds, including German bonds, that trade with yields below 0%. The total amount of negative-yielding debt peaked in 2015 at just above $12 trillion, but remains at about $10 trillion today. Sommer said the Fed’s policy shift suggests that negative-yields will be with us for some time yet. He said some buyers of those bonds must believe rates could fall even further, which would increase the value of their holdings.

The U.S. economy itself remains healthy, Sommer said, as evidenced by the country’s strong employment levels, which have pushed up household net worth and are starting to drive wage inflation. The ISM Non-Manufacturing Index also remains well above 50, Sommer said, which is indicative of economic expansion.

Although the current expansion is on track to become the longest in the nation’s history this year, Sommer said he and his colleagues believe it to be sustainable, in part because of the Fed’s efforts to foster a climate fertile for steady growth rather than boom-and-bust cycles. “We are of the opinion that this (expansion) is likely to continue into 2020, in that 2% to 2.5% type of growth range we’ve seen,” he said.

To be sure, he said, there are a number of recession indicators that suggest the U.S. may be closer to a recession today than it was as recently as December, but he said he doesn’t expect a recession in the next 12 months and potentially not in the next 18 months.

In terms of what all this means for stable value portfolios, Sommer said that given the flatness of the yield curve right now his firm has positioned its portfolios to take advantage of the increased yields available at the front end of the curve. “We don’t believe it’s necessary to go out and get incremental yield by extending duration,” he said. The firm’s preferred asset classes in early April included asset-backed securities, particularly short-duration Triple A tranches; commercial mortgage-backed securities, where stable fundamentals and strong technical backdrops made for an attractive alternative to Single A industrials; and credit, where it continued to find attractive opportunities in the front-to-intermediate part of the curve.

Still, Sommer said his firm had reduced its credit exposure during the first quarter after investment-grade credit notched gains that eclipsed the losses registered in all of 2018. “We’ve come a fair amount in just a short amount of time, so we’re waiting for more data, we’re waiting for earnings,” he said. “We want to see where the next catalyst is.”