“The Trimmed Mean PCE inflation rate over the 12 months ending in October was 1.7 percent. According to the BEA, the overall PCE inflation rate was 1.2 percent on a 12-month basis, and the inflation rate for PCE excluding food and energy was 1.4 percent on a 12-month basis. The tables below present data on the Trimmed Mean PCE inflation rate and, for comparison, overall PCE inflation and the inflation rate for PCE excluding food and energy. The tables give annualized one-month, six-month and 12-month inflation rates.” (Dallas Fed monthly release, October - https://www.dallasfed.org/research/pce )
The Federal Reserve has grunted out small noises about maybe some future peeling back on the QE. We see that in FOMC members’ comments and, more importantly, in references in the minutes of meetings. Many analysts have dissected the Fed’s words and offered opinions. We’re not going to take the time to repeat all of that here.
But we will add a warning for investors: “Watch what they do and not what they say.” Admittedly, this is a paraphrase of the famous line that John Mitchell uttered shortly after the election of President Richard Nixon in 1968. Mitchell had run the Nixon campaign. He was asked what the Justice Department would be doing with regard to rolling back civil rights or not enforcing relevant laws. He replied, “Watch what we do, not what we say.”
Since the COVID crisis exploded, the Fed has tried to consistently articulate the pathway that they are following for interest rates, while confirming that they will continue on that path for a period of time. In a September Bloomberg interview, Fed Vice-Chair Richard Clarida defined this path in very precise terms (“Fed’s Clarida Says Months of 2% Inflation Needed for Liftoff,” https://www.bloomberg.com/news/articles/2020-09-23/clarida-says-fed-won-t-consider-rate-hike-until-2-inflation-met?sref=q88SDHkB). I will paraphrase. He suggested that the Fed will maintain the current course until the inflation rate in the United states is above 2% and is averaging above 2%. He also said that the Fed will use the year-over-year rate of change in the PCE to guide this policy. So, there it is. All you have to do is track the monthly rate of change in the year-over-year PCE. Then project a trend for it. Pencil out a time when you think the average will be above 2% for a reasonably consistent period (say six months or a year); and, bingo, you have the timing of the Fed’s first quarter-point hike in the short-term policy-setting interest rate. Right now, that rate range is 0.0% to 0.25%. So pick your date and add 0.25% and become a Fed rate forecaster along with all the others in that professed club of experts who really don’t know any more than you do.
Richard Clarida doubled down on a message previously sent by Fed Chair Jay Powell. Powell has noted more than once the importance of the PCE as the preferred inflation measure. He has specifically mentioned the trimmed mean PCE computed by the Dallas Fed. Readers, please note that the Dallas Fed offers a free notification service, available here: https://www.federalreserve.gov/newsevents/subscribe.htm. You’ll find easy-to-read descriptions, and the numbers are calculated for you. All you have to do is read the directional tea leaves and then make your own decisions about where you think the PCE is heading.
For separate-account bond managers like Cumberland, this exercise becomes a much more intensive labor. The process drives some decisions about how to handle total-return bond accounts. Here’s a simplified example.
We know the Fed has the power to eventually get the inflation rate up to their target. To do that, they have to ignore other factors like the value of US dollar as a world currency or the impact their policy will have on asset prices or what their money creation will do to the capital charges imposed on banks that have to hold the excess reserves they create. It is when the Fed tries to do more than one thing at a time that this exercise becomes complex and the pressures build within a system now competing internally, with forces that are not fully understood.
Given multiple Fed measures at work, we don’t know how long it will take the Fed to get to 2% averaging of the PCE, and we don’t know what intervening shocks will either accelerate the timing or delay it. We have to guess and develop alternate scenarios and strategies. But we do know that the Fed has the unlimited power to create electronic money out of thin air. And we do know the mechanisms that the Fed uses to inject that newly formed money into the banking system and, through derivatives used by those banks, into the financial system of the world.
We also know that financial markets will respond to whatever the Fed does. Market agents will listen to what the Fed says, but they will follow the advice I offered above and look at what the Fed does, not what it says.
So if the Fed starts to “taper,” markets will begin to adjust, as they have in previous tapering episodes. Taper means to alter the trajectory by slowing the rate of quantitative easing or the purchases of securities that expand the size of the Fed’s balance sheet.
Market agents will also closely watch the composition of that balance sheet. The operative acronym is WAM, (weighted average maturity). This is a mechanism by which the Fed can influence the various interest rates in the market as it selects which securities to buy. We expect WAM to become more and more important. Reason: The Fed can use this method to buffer interest rate rises in the middle and longer maturities while still holding to the promised short-term interest rate forecast.
In other words, Clarida can never be seen as misleading the financial world now that he has declared a clear reference path and rate policy. Powell can never be seen as straying from his repeated policy path. The Fed is committed to the precise path they articulated whether they like it or not. If they change that path, they risk a market shock of unknown proportions. We saw that in the past with a “taper tantrum” under Fed Chair Bernanke. We believe the Fed does not wish to repeat that error. The Fed learned the hard way, but we have confidence that they did learn and don’t want to repeat that mistake.
So what is a bond manager to do?
Use a barbell and avoid a ladder. The ladder is a trap. It positions a portfolio over a series of maturities and does so mechanically. Thus, the ladder exposes the holdings in the portfolios to every twist and turn of a market gyration. Consider any interest rate and how it changed in the last year. Then look at any ladder during the period you review. You probably won’t like what you see.
The barbell, on the other hand, lets the investor alter the weight of the ends of the barbell. For example, if you project that the Fed will be responding to a rise in the PCE in the year 2023, you can start to position a barbell right now to capture your expected or forecasted direction of interest rates. You do not have to believe and rely on what they say. And you can calculate your risk (using two technical approaches called duration and convexity) at any given moment and change the risk profile promptly based on what they do. That is where we find ourselves today in the bond market of the United States.
In the discussion of ladders and barbells it is important to have articulated scenarios clearly, along with the rationale for them. Here’s a discussion from November 2015 on what was visualized then: “Low Short-Term Rates for a Long Time?” https://www.cumber.com/low-short-term-rates-for-a-long-time/. Note that this was written before the presidential primaries of 2016, before any Trump tariffs or trade wars, and long before COVID.
Let me add that a great deal about this Fed decision pathway is not clear to the Fed’s own decision makers on the Federal Open Market Committee. If it isn’t clear to them, how can it possibly be clear to those who have to respond to what they do? What is clear is the risk measures. Those measures can be derived from the market-based prices of bonds. That is what Cumberland’s team does every single day.
We look to the market to give us guidance. We don’t say the market is “right.” We do say that the market price reveals the consensus pricing of all the market agents at the moment that a transaction occurs. The market is where bond investors vote with real money and not mere opinions. That is why we “watch what they do.” We listen to what they say but take their messaging with many grains of salt.
Anyone interested in taking a deeper look at using a barbell as opposed to a ladder can email me, and I will ask one of our folks to send you some research work we have done on this issue. We will be happy to discuss duration and convexity and how we use these applications.
Right now, we have a barbell, and the duration targets vary depending on which bond market (tax-free or taxable and highest credit grades or mid-grades). We are very leery of lower-rated paper, as the spreads have become very tight, and therefore investors are not getting paid well for the added risk of default or delayed payments that can be associated with junk or lower grade credits.
David R. Kotok
Chairman of the Board & Chief Investment Officer
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