Quarterly Update

Gregory S. Kaplan, Director of Fixed Income, Managing Director | Oct. 2020

Fed’s Historic Policy Shift Provides Tailwind to Risk Assets

Fed has committed to supporting economy as long as necessary

Policy shift is welcome, a significant departure from past practices

Higher threshold for rate hikes provides tailwind to risk assets

The Federal Reserve, led by Jerome Powell, did a commendable job at the outbreak of COVID-19, backstopping the financial markets and the economy with rate cuts, asset purchases and nine emergency lending programs. As the pandemic drags on, however, the Fed’s focus has rightly shifted from stabilization to economic stimulus. During the past quarter, the Fed formally adopted a “flexible average inflation targeting program.” This is a significant and welcome departure from the Fed's prior practice of making policy decisions based on its inflation forecast (versus observed inflation). Prior policy often led to rate hikes in anticipation of hitting the elusive target, inadvertently slowing the economy (see chart).

The Fed has also tied this new policy to the other half of its dual mandate by conditioning rate hikes on “full employment” (think 4% unemployment). By setting these two coincident conditions as necessary for rate hikes, the bar is now significantly higher for tighter monetary policy. This and other tools (e.g., QE) indicates that the Fed has now thrown its full weight behind doing whatever it takes to support the recovery.

An extended period of low rates does not in itself cause inflation, as many fear. The real economy is a necessary participant in rising inflation, hence the repeated urging by Fed members for Congress to pass another fiscal stimulus package. The market has reacted accordingly, with five-year forward inflation expectations rising from the pandemic-induced low of 1.1% to 1.7%, still well below the 2% target as the recovery slows (see chart).

What does this mean for investors? The Fed has demonstrated the willingness, flexibility and firepower to support the recovery and is clearly committed to seeing it through. Risk assets (e.g., high yield corporate and municipal bonds) will continue to benefit from this support, hence our continued emphasis on opportunistic fixed income sectors at the expense of other fully valued or lower-yielding investments.

Key Points

Fed has committed to supporting economy as long as necessary

Policy shift is welcome, a significant departure from past practices

Higher threshold for rate hikes provides tailwind to risk assets

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Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

Alternative investments are speculative, entail substantial risks, offer limited or no liquidity and are not suitable for all investors. These investments have limited transparency to the funds’ investments and may involve leverage which magnifies both losses and gains, including the risk of loss of the entire investment. Alternative investments have varying, and lengthy lockup provisions.

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Index Definitions

The S&P 500 Growth Index measure growth stocks using three factors: sales growth, the ratio of earnings change to price, and momentum.

The Dow Jones U.S. High Dividend Yield Index serves as a benchmark for income seeking equity investors. The index is designed to measure the performance of 80 high yield companies within the S&P 500 and is equally weighted to best represent the performance of this group, regardless of constituent size.

Bloomberg Barclays Municipal Bond Index is a market-value-weighted index for the long-term tax-exempt bond market. To be included in the index, bonds must have a minimum credit rating of Baa. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least 1 year from their maturity date.

The Bloomberg Barclays Global High Yield Index is a multi-currency flagship measure of the global high yield debt market.

Indices are unmanaged and one cannot invest directly in an index.

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