With the release of the minutes of the December Federal Open Market Committee (FOMC) meeting on Tuesday, December 13, the Federal Reserve announced that it would be making changes in how it communicates the Committee’s collective thinking. Brown Advisory believes that this is a significant development, with serious long-term and short-term implications.
Currently, all Fed governors and regional presidents submit a series of quarterly economic projections for the current year, each of the next three years and the “longer run.” The range and central tendency of each is released but without attribution. Going forward, the Fed will also provide each member’s forecast of the Fed Funds rate for those same time periods. In addition, members will also publish narratives that help frame how they are thinking, such as explaining any major assumptions underlying their forecasts. They will articulate their expectations for the Fed’s balance sheet. Putting the Fed Funds forecast and the narratives together will give investors a much better sense of how the FOMC is thinking about monetary policy beyond just the current meeting. For example, the Fed Funds forecast tells you exactly when members, as a group, think the first rate hike will be coming. The balance-sheet narrative will indicate whether the Fed is thinking about either expanding or contracting its balance sheet.
Would this help implementation of monetary policy? The preponderance of recent academic research around monetary economics says yes. The theory is that transparency allows the market to “correctly” react to the Fed’s policy measures. As it is now, the Fed’s thinking is left up to interpretation. Take, for example, the period right around the end of the Fed’s first asset purchase program (the so-called QE1). At the time there were some Fed governors talking about exit plans and policy normalization. It was not clear, however, what exactly all of the planning for policy normalization meant. How soon and how aggressively would policy be normalized? And by what means? All this uncertainty probably caused interest rates and mortgage spreads to be higher than they would have otherwise been, particularly given that (with hindsight) it now appears that a majority of FOMC members favored a much more gradual approach to tightening policy. Effectively, the market misreading of the situation caused some degree of unintentional monetary tightening.
By eliminating a great deal of the uncertainty around the Fed’s policy stance, the hope is that the market will more precisely price in the Fed’s intended path for interest rates. This is another potential advantage of greater communication. A standard theory of the yield curve is that longer-term interest rates reflect a discounted series of expected short-term rates over the course of the term; e.g., the two-year Treasury reflects 720 days worth of expected overnight rates over the next two years. In reality, however, longer-term rates also include some yield premium for the uncertainty of that path of overnight rates. Investors need to be paid more to own long bonds because the longer the maturity, the less certain the path of short-term rates is.
While it would seem that increased certainty over the path of interest rates will decrease bond market volatility, there is a risk that this could cause more volatility, at least at times. Even if the FOMC itself is projecting its own actions, there is still uncertainty, if for no other reason than that circumstances are always shifting. If risk premia decline, rates will have less room for error. Big surprises could cause interest rates to be more volatile. For instance, there are some economists who believe that the level of certainty the Fed put around its most recent tightening cycle in 2004-2005 encouraged too much leverage among certain investors. These investors felt like they knew with certainty their cost of funds and therefore were comfortable increasing their leverage. We know the ultimate result.
More immediately, we believe that the release of this new communications strategy increases the odds that the Fed engages in another round of long-term asset purchases, or quantitative easing (QE). This time, we expect the purchases will be focused on mortgage-backed securities (MBS). Still, we continue to believe that another round of QE isn’t needed and may not have any significant positive economic effect. But the reality is that there is a cadre of FOMC members who have favored additional monetary easing for some time yet believed that reforming how the Fed communicated with the public would greatly enhance the impact of more QE. It isn’t totally clear that Fed Chairman Ben Bernanke is yet in this camp, so QE is not yet a foregone conclusion. But the odds have definitely increased, in our view.
In terms of how Brown Advisory is investing fixed income portfolios, the increased chance of QE does not have a major impact on our thinking. As discussed above, Fed purchases will be primarily concentrated in MBS, but they will particularly focus on newly issued MBS, which will not necessarily help performance of existing bonds available for purchase. If the Fed is successful in bringing down MBS yields significantly, it will touch off a refinancing wave, which will eliminate any benefit investors realize from reduced MBS supply. We have been investing with this possibility in mind for some time now and therefore we believe we are well positioned. We have been buying MBS structures where the borrower faces a particularly low rate, thereby allowing some cushion before these borrowers can refinance.
Additionally, the enhanced communication is likely to cause a compression of yields between shorter-term (0-2 years to maturity) and intermediate-term bonds (5-10 years to maturity). That makes the current time as good as any to invest cash and near-cash holdings in intermediate-term bond strategies. Even if the Fed does not conduct another QE program, we expect short-term rates to remain near zero for the next two years, and perhaps even longer. Extending maturities slightly should be a low-risk strategy.
Thomas D.D. Graff, CFA
Fixed Income Portfolio Manager
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