The passing of the reins at the U.S. Federal Reserve is the economic equivalent of white smoke rising from the Vatican. Every word from the new monetary "pontiff" will, no doubt, be parsed and analyzed for signs of change, however subtle. But when it comes to Janet Yellen, who will take over on February 1 as the first female Fed chair, the word on the street is continuity.
The change takes place amid high stakes for Fed policy. Yellen will attempt to wind down the Fed’s unprecedented bond-buying program while trying to strike a delicate balance between reviving a still sluggish economy with high unemployment, and managing the risks of inflation or recession down the road. To avoid investor anxiety, she will need a very deft touch.
“Ben Bernanke has said Janet Yellen was closely consulted on policy, long before her nomination, and that she fully supports recent decisions,” says Bill Irving, portfolio manager of Fidelity Government Income Fund (FGOVX), Fidelity Inflation Protected Bond Fund (FINPX), and Fidelity GNMA Fund (FGMNX). “So I expect we will see consistency after the transition. What’s less certain is the path of the economy, and how that could impact policy.”
For investors, this means the Fed will likely continue to be accommodative, holding short rates at zero and continuing its massive bond buying, albeit at a slower pace as the economy strengthens. Expect the Yellen Fed to increasingly experiment with forward guidance on short-term rates as a way of keeping both short- and long-term rates low. Such an accommodative stance should continue to support riskier investments such as stocks.
Of course, any rapid acceleration or slowdown in the economy would force the central bank to change the script. But at this stage there are reasons to believe that modest growth is the most likely scenario.
More pragmatic than dovish
Yellen comes to the job with a long line of credentials that make her among the most experienced chairs in recent memory. Highlights include four years as a member of the Board of Governors, six years as president of the San Francisco Federal Reserve, and three years as the vice chair of the Federal Reserve System.
Yellen is often described as dovish, and market reaction to her nomination seemed to confirm that investors expect her to keep rates low. But that doesn’t mean she will never raise rates, just that she doesn’t see the case for it now.
“I would say her ‘dovishness’ is a bit of a caricature,” says Irving. “Many of her colleagues are more concerned about the costs and the risks associated with the large size of the Fed’s balance than she is. But she advocated for interest rate increases under Greenspan, even while others wanted lower rates. Her current position seems pragmatic in that she views unemployment as a greater risk than inflation—a position that has been vindicated in recent years. I don’t think she would tolerate above-target inflation.”
Yellen's top target: jobs
At the most recent meeting, Bernanke announced that Yellen fully supported the Fed’s statement that it expected to keep the Fed funds rate near zero long after the unemployment rate reaches 6.5%, as long as inflation stays below their target of 2%, but will begin reducing bond purchases from $85 billion per month to $75 billion per month beginning in January. Last March, Yellen explained that with employment so far below its maximum level and inflation running below the Fed’s 2% objective, she believed it was appropriate for the Fed to prioritize fighting unemployment versus the risk of higher future inflation.
“Unemployment has been falling, but so has labor force participation, meaning people have given up looking for work and aren’t counted in that unemployment number,” according to Irving. “Some argue those jobs and people are never coming back to the workforce—that we have seen a structural change. But Yellen believes that the lack of demand is the main cause of low participation, and given an economic uptick more people may return to the workforce. That means that the unemployment number could actually go higher as more people look for work—and, in my view, that suggests a Yellen Fed would keep rates lower for longer, even if it risks inflation.”
Yellen's new tool: forward guidance
The forward rate guidance that Bernanke introduced and Yellen is expected to continue is meant to help keep rates low, even as the Fed tapers the pace of bond buying, by altering investors’ expectation of future rates. However, the jury is out on its effectiveness. It is possible that even if forward guidance keeps short-term rates low, long-term rates could rise, and that could slow the housing recovery—one of the pillars of the economic resurgence—and rattle investors. That might force the Fed to change the path of the taper.
“Being supportive of continued risk-taking among investors and entrepreneurs has been one of the Fed’s primary goals,” according to Richard Carter, vice president of fixed income products at Fidelity. “The last thing it would want to do is upset the apple cart by removing the stimulus too quickly or unexpectedly, slow the recovery, and cause investors to retreat to cash. If they were to reduce bond buying by $10 billion each month, the QE program would run until the fall. During that time, they can see what happens to inflation and the economy and adjust as needed. If the economy accelerates faster than expected, then they would have the grounds to wind down QE sooner—and I believe markets would view it as a positive.”
What to expect
Whether or not the Yellen Fed can successfully unwind its bond-buying program will have far-reaching implications for investors.
The Fed has clearly offered guidance that they expect rates to stay low in the coming months. But if the economy is stronger than expected, rates could rise faster. Since October, the market has generally been sending rates on longer bonds up, as it anticipates a stronger economy will cause the Fed to accelerate the schedule. For investors the pace of rising rates is key.
“The yield curve is steep, which is to say you get paid a lot to move into longer-maturity bonds compared to cash,” says Irving. “To be bearish on bonds is to say rates will rise enough to eat through the yield advantage. That would happen if the economy surprises to the strong side—and in that case, riskier assets such as stocks should do well. On the other hand, if the economy disappoints again, it is plausible that riskier assets will be under pressure, and bonds would outperform.”
According to Carter, we are at the time in the economic cycle where bonds continue to have their role in terms of delivering income and the potential for tax exemption with municipal bonds. He says that rates seem unlikely to fall significantly from here, so the price gains seen in recent years may be less likely. What we saw in 2013 was the relatively strong performance of the high yield category relative to more conservative grades of credit. Even as the yields on Treasuries rose, the spread or—incremental additional yield—between junk bonds and Treasuries contracted and, when added to their higher coupon payouts, provided positive returns for the year—albeit not as strong as in 2012. The question is: How long can this credit spread contraction persist and act as a counter-weight to increasing Treasury rates? ”The incremental yield offered in exchange for the additional risk may not be particularly compelling from this point on," according to Carter. “At some point in the credit cycle these spreads begin to widen again as monetary conditions are tightened or default rates begin to rise.”
If you are more concerned about principal preservation, then he suggests considering shorter duration bonds and bond funds, or bond ladders. These strategies may be particularly relevant in the context of a yield curve that is still fairly steep and the potential for investors to hold these bonds to maturity, or close to maturity, before the Federal Reserve is likely to begin raising short-term rates.
For investors who are likely to be increasing their allocation to equities, don’t forget the diversification properties of Treasuries and CDs, which have historically shown the strongest inverse correlation to stocks. As the cycle matures, equities may reassume the mantle as the chief way for investors to participate in economic growth. But in that scenario, you may want to consider holding high-quality bonds, since these typically move inversely to stocks. This offsetting performance may be the most beneficial from the perspective of protecting your overall portfolio should growth disappoint and stocks struggle.
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