An evolving monetary policy
May 14, 2013
Coming out of the Great Recession, the U.S. economic recovery has been among the slowest recoveries on record. As the economy has continued muddling along, highly unusual — indeed, unprecedented — monetary policy has been among the most newsworthy developments. The Federal Reserve has been intent on promoting growth, employing actions that have never occurred in the entirety of the central bank’s 100 years of operation.
Looking at the details
Here is where the Fed’s stated policy measures stand today, as first announced in December 2012:
- An open-ended commitment to buying up to $40 billion in mortgage-backed securities per month
- An open-ended commitment to buying up to $45 billion in long-term Treasury bonds per month
- A commitment to holding down interest rates until unemployment reaches 6.5%, so long as inflation isn’t projected to go above 2.5% looking ahead two years
All three of the above tools are important, but the last one represents a notable break with the past. By putting forth quantifiable thresholds for unemployment and inflation, central bankers have essentially declared a willingness to communicate with more clarity and directness than is customary.
It’s all in the timing
Despite the Fed’s communicative stance, investors remain uncertain about the Fed's ability to adjust quickly enough when it comes time for tighter policy. Fed officials have often expressed confidence in their abilities to shift monetary policy at the right time, avoiding the pitfalls that could ensue if rates stay low for too long (as has happened in the past).
One cannot to predict whether that Fed will get the timing right. In the meantime, we lay out below a few of the commonly perceived benefits — along with some potentially negative ramifications — of the Fed’s current monetary policy, along with a few thoughts on each.
On the Delaware Investments Fixed Income team, we sympathize with investors who put more emphasis on the drawbacks than they do on possible benefits (which are quite thin by comparison). On the whole, we agree that fixed income assets have become distorted in the wake of monetary policy, and that many bond investors are facing a condition in which more risk is not necessarily being met with more compensation.
However, we believe the Fed policy will influence asset prices across the fixed income landscape. And whatever trajectory those prices might take, we aim to continue following our long-held tradition of investing broadly across bond markets, putting a premium on managing risk, and conducting rigorous research. In our view, there will be little margin for error, considering today’s low-yield environment and the appreciation that is already reflected in bond prices.
As we move into the coming quarters, we believe investors will be well served by keeping a close watch on the monetary policy environment and the related side effects that could influence the risk/reward relationships within investors' fixed income allocations.
|Capital has become too cheap
||Prolonged levels of low interest rates may spur consumption such that it reaches highly speculative levels.
Within such an environment, we believe that imprudent decisions can be made, as shown in the banking and housing bubbles that preceded the financial crisis of 2007–2009.
|Bonds have become mispriced
||The Fed’s asset purchases have supported bond prices, pushing yields in certain areas of the market to historical lows. This may create a situation in which bonds become valuable as an income instrument only, with little potential for price appreciation.
|The likelihood of inflation is intensified
||Despite heightened worries about inflation, price levels have remained relatively tame, reflecting factors that include: (1) stubbornly high unemployment, (2) slack in the manufacturing sector, and (3) weakness in the velocity of money, the rate at which money in circulation is used to purchase goods and services.
|The possibility that the explicit thresholds are misinterpreted as actual policy goals
||One line of thinking is that the quantitative thresholds for unemployment and inflation could be interpreted as triggers for an immediate increase in short-term rates. The Fed has taken precautions to help prevent such misconceptions, insisting that future policy actions will follow a balanced approach that is consistent with its long-run goals of price stability and sustained output.
Furthermore, policymakers have stressed the difference between a policy threshold and a reflexive trigger, pointing out that thresholds will not be employed robotically but rather alongside a broad analysis of market indicators and financial developments.
|The likelihood of inflation is intensified
||While the likelihood of inflation is listed above as a potential danger, it may have positive implications as well. One of those considerations is from the viewpoint of a person or an organization that is paying down a loan. Inflation allows debtors to repay loans in dollars that are less valuable than those they originally borrowed.
|The perception of the Fed as being more communicative
||For the most part, the Fed speaks in general terms when discussing its expectations. As such, the central bank rarely gives precise, numerical thresholds when discussing its views on the future path of interest rates. By including such specifics in its December 2012 statement, the Fed has engaged in a higher degree of openness than it has ever pursued.
Will the Fed make a graceful exit? We believe ending the asset-buying programs will be among the first steps the Fed takes when it comes time to normalize monetary policy. Presumably, the next step will involve raising the fed funds rate – interest rates charged by banks to each other for overnight loans to meet reserve requirements. How quickly will this step be taken?
It’s an important question, because a too-sudden increase in rates could spur bond markets to “trade ahead” of the Fed. By way of example, here’s what happened to Treasury yields in early 2004, as financial markets recovered from the prolonged softness that set in between 2001 and 2003.
March 2004 | Yield on 10-year Treasury bonds: 3.7%
April 2004 | Yield on 10-year Treasury bonds: 4.5%
Performance does not guarantee future results.
The views expressed represent the investment Manager’s assessment of the market environment as of May 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s current views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Fixed income securities can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder a issuer’s ability to make interest and principal payments on its debt.