Further For Longer

John Leiper – Chief Investment Officer – 12th October 2020

On Tuesday Fed Chairman, Jerome Powell, made a speech at the National Association for Business Economics, during which he implied the government should err on the side of caution and provide too much stimulus rather than too little. 

This followed rumours, the prior week, that Powell had spoken with Treasury Secretary Steven Mnuchin and House Speak Nancy Pelosi to provide assurances that the Fed stood behind whatever deal could be reached. That all fell apart when President Trump tweeted that he would not negotiate on a COVID stimulus package until after the election. The market took this tweet at face value and interpreted the lack of fiscal stimulus as deflationary. As a result, equities fell alongside precious metals whilst the US dollar rallied. Since then Trump has extended an olive branch, putting an extra $200 billion on the negotiating table, and markets have stabilized somewhat, allowing the Dow to post its best week since August. What is amazing is how quickly the narrative turned, on just one tweet. This is indicative of the kind of volatility we are likely to experience in the run-up to the US election.

Our goal is to look through the short-term noise and focus on the bigger picture. With that in mind, it is encouraging to note that the outlook for US inflation continues to improve, with easing financial conditions pointing to higher prices over the next few months. This is consistent with the Fed’s stated goal and recent shift to average inflation targeting (AIT) which means the Fed will now allow inflation to overshoot its official 2% target to compensate for prior years where inflation failed to reach that level.

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Unfortunately, there is a lack of detail on what AIT actually means other than to “achieve inflation moderately above 2 percent for some time”. Central bank language is often deliberately ambiguous to allow for some degree of policy flexibility so a specific definition is unlikely, although one suggestion put forward by Neel Kashkari, Minneapolis Fed president, would be ‘not raising rates for roughly a year after core inflation first crosses 2 percent’.

The Fed is also committed to reaching it’s maximum employment objective, previously estimated at around 4.1%. As shown by the bars below, in yellow, prior occasions where inflation (using the Fed’s preferred measure of PCE) runs above 2% and the unemployment rate falls below 4.1% are few and far between. So… a tall order, demonstrating no lack of ambition. But it goes further than the headline numbers as Powell is increasingly focused on some kind of social justice agenda. To quote from his speech on Tuesday:

“The burdens of the downturn have not been evenly shared. The initial job losses fell most heavily on lower-wage workers in service industries facing the public-job categories in which minorities and women are over-represented (…) Combined with the disproportionate effects of COVID on communities of colour and the overwhelming burden of childcare during quarantine and distance learning, which has fallen mainly on women, the pandemic is further widening divides in wealth and economic mobility.”

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Powell is absolutely right to consider the hardest hit in society. The problem is monetary policy is a relatively blunt tool for doing so. What is required is targeted fiscal policy. It also raises questions over the longevity of the stimulus measures used. If we assume that Powell will prioritise employment objectives over inflation, and the most disadvantaged workers over others, then we can expect a shift from ‘lower (interest rates) for longer’ to ‘further (stimulus) for longer’.  

That was also the conclusion of Michael Kiley, senior Fed economist and deputy director of the bank’s financial stability division. He estimates that to support the economy through COVID-19, and offset the inability of the Fed to provide stimulus by cutting interest rates (which are already close to zero), requires total bond purchases equal to 30% of US economic output, or $6.5 trillion. Thus far the Fed has purchased approximately $3 trillion meaning there could be another $3.5 trillion to go. That is astonishing when you consider the fact the money supply (M2) has already increased over 20% in just one-year.

‘Further for longer’ is consistent with our outlook for a pick-up in inflation and it is reassuring to see that inflation expectations, in red, have started to rise again after a slight pause in early September. If the Fed is truly committed to AIT, it will require further asset purchases and we think a large portion of that could go into inflation-linked Treasuries (TIPS). We have exposure to this theme across the ACUMEN portfolios via our allocation to US TIPS. This position has already performed well, outperforming the Bloomberg Barclays Global Aggregate (BBGA) index in GBP since the publication of our blog, The Return Of Inflation.

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Further quantitative easing is also consistent with our outlook, and current positioning, for a steeper yield curve. This was the case during prior rounds of QE, as detailed by the yellow bars in the chart below. However, higher long-dated yields could contribute to tighter financial conditions, putting the recovery at risk. Our view is the yield curve will continue to steepen albeit more modestly so as the Fed looks to implement a ‘light’ version of yield curve control, such as Operation Twist, which was suggested last week by Loretta Mester, Cleveland Fed President. This would see the Fed extend the duration of its asset purchase program by buying more longer dated bonds. By doing so, upward pressure in the 10-year Treasury yield will be more muted, allowing for lower real yields which will continue to support the economy whilst benefiting a number of core positions across the ACUMEN portfolios, including the Commodity Carve-Out.

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Meanwhile, in Europe the headline consumer price index fell to a 4 year low in September of -0.3% marking the first time the eurozone has seen two consecutive months of deflation since 2016.

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Whilst temporary factors such as lower oil prices, a stronger euro and a VAT cut in Germany have contributed to this weakness, the recent resurgence in coronavirus infections has hit growth expectations and will add pressure on the ECB to do more. Recent comments from ECB Chief Economist Philip Lane seem to imply as much and we expect a further boost to the Pandemic Emergency Purchase Program (PEPP) in December. However, we think the ECB has its work cut out and as such we continue to play this theme via long-dated EUR government bonds which have outperformed the BBGA index notably over the last few months.

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This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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