Can’t hardly wAIT: the Fed’s new inflation target

Last week Jerome Powell was the headline presenter at the Fed’s annual Jackson Hole Economic Policy Symposium, and he unveiled the Fed’s new framework of Average Inflation Targeting (AIT). The Fed now “seeks to achieve inflation that averages 2% over time”, effectively the Fed will allow inflation to run above 2% (for how long and how high remains unclear) to make up for periods where inflation is below 2%. This change was anticipated by the markets and we are seeing a bear steepening move in the yield curve, as well as a rise in inflation breakevens given the move in longer maturity nominal yields over the last month. Higher long end rates is something most markets are not priced for but the odds of a further steepening of the yield curve due to a continued rise in long rates seems quite high.

We believe a combination of the following four factors may result in a structural steepening bias in the yield curve: 1) record Treasury issuance (that could be more skewed to the long end); 2) a demand gap between the supply coming and the investor base (the Fed can’t buy it all); 3) the Fed’s new policy of inflation targeting (which means they won’t raise rates in anticipation of inflation but will wait until it happens), and 4) the fact that the Fed will not implement yield curve control except as a last resort.

Whether we ultimately get above 2% inflation remains to be seen. But at the very least we think we are in the early stages of a new cycle and a rise in long-end rates is normal at the start of a new cycle. The 10-year Treasury has averaged a yield of about 2.2% over the past 10 years, therefore just getting back to average would be a massive move given where we are today (the 10-year is about 0.75%) and would wreak havoc on portfolios that are overweight long duration both on the fixed and equity side.

US Treasury Yield Curve Today versus 1-month ago

Source Bloomberg 8/31/2020

So how will this impact investors? Obviously rising rates would be a headwind for traditional fixed income, especially long duration, and we think benchmark hugging managers may also suffer. For example, we’re already seeing the impact. A popular 20+ Treasury Year ETF is down almost 6% in the last month, and AGG, a widely referenced Index BarCap ETF, is down more than 1%. Unlike other strategies, we seek to shift between sectors, depending on market conditions, and adjust duration to manage interest rate risk. When we see opportunities we will allocate to other sectors. This opportunistic approach allows us to be flexible in responding to changing market conditions and valuations across sectors. We manage interest rate risk through an approach that seeks to account for a rising rate environment using our 1- and 3-year “stress test” scenarios. In essence, we look for value opportunities across fixed income sectors (taxable and tax-exempt munis, credit, securitized, and Treasuries) which can offer yields that can help potentially offset any steady rise in rates (which would hurt bond prices). For months we have maintained sufficient “dry powder”, so we are comfortable with our positioning. Finally, short-duration (or select floating rate) strategies can also serve as a defensive bond allocation in such an environment.

Rising inflation would also impact equities as it could lead to a weaker dollar, and therefore we think International stocks may generally benefit from this trend. Rising rates could be a tailwind for bank and financial stocks. Also, we think high multiple growth stocks and defensive equities could be hurt the most.