The Federal Reserve has a communications problem. There is a critical disconnect between what the central bank is willing and able to communicate and what the bond market wants to hear.
The market wants quantification and certainty. But the Fed — particularly after its abandonment of the 6.5% unemployment threshold — now provides its “forward guidance” in terms of qualitative assessments and conditionality.
Caught in the mix is the “dots plot.” This chart, found in the Fed's Statement of Economic Projections, highlights individual Fed policymakers' viewpoints on the appropriate stance of Fed monetary policy at specific points of time.
WHAT THEY LOVE
Ah, certainty, and with quantitative measures — precisely the thing bond market types love.
That love explains the reaction to the March Federal Open Market Committee meeting. The average of the dots moved up — and by a lot. For 2014, the average level of the “appropriate target for the federal funds rate at year-end” moved up by 25 basis points, and for 2015, the average moved up by 50 points. The market reacted quickly by selling off these maturities and raising their yields.
Notably, Fed Chairman Janet Yellen, when asked about the surprising move in the dots during the news conference, said: “I think that one should not look to the dot plot, so to speak, as the primary way in which the committee wants to, or is, speaking about policy to the public at large.”
The trouble is, based on how closely the bond market prices according to the guidance implicitly provided in the dots plot, this is precisely what the bond market focuses on. Whether it continues remains to be seen. For tomorrow's FOMC meeting, at least, there is no update to the SEP, leaving the next debate over the dots to the June meeting.
What should we expect from monetary policy and the Fed's forward guidance? While the debate will continue around exactly what “a considerable period of time” means before the Fed begins tightening, if the economy stages a recovery from the first quarter's weather-induced disappointment, then tightening eventually will be upon us. Granted, that won't be until mid- to late 2015, based on current expectations, but that is no longer so far out in the future.
The risk for the Fed and for the market is the inability to rely on assurances of “low for longer” to restrain the increase in longer-maturity yields. These yields have been the prime target for the Fed's unconventional policies, as these influence most the outlook for asset values — and housing values foremost — that the Fed's policy hopes to reflate. Having achieved that success, policymakers now look to avoid its undoing from rapid increases in longer-maturity rates.
So how can the Fed control the pace of increase in longer-maturity rates even as it begins raising short-term rates? One idea recently being discussed involves the long-run “equilibrium” real rate. The notion is that structural changes in the economy now argue for a lower terminal funds rate than normal. The upshot is that even as the Fed starts tightening, it might start signaling a lower endpoint for that tightening than the 4% rate currently expected. That shift might lead to supporting longer-maturity yields (i.e., fewer increases in yields) even as the Fed begins tightening. And ironically, one of the most effective ways to communicate such a shift in expectation would be the very dots chart that Ms. Yellen just told us to ignore.
Whether the Fed goes down this path or not remains to be seen. But for investors, the key lesson from recent bond market performance is that if economic growth returns to the U.S. in the manner most expect — on the order of 3% real GDP — and if rising inflation rather than the falling inflation of the past few years accompanies such a rebound in growth as we would expect, then rising yields should be led by the front end of the yield curve. That challenges today's consensus positioning in the front end of the yield curve.
As an alternative, consider strategies at the very front and very back of the curve for finding a better way of shortening your duration. Combining a portfolio of mostly, say, bonds with maturities of two years or less, with a small portion of those with longer maturities — say, 30 years — can shorten a fixed-income portfolio's duration and maintain its income but yield a better performance outcome as the Fed moves closer to policy normalization.
Jeffrey Rosenberg is chief investment strategist for fixed income at BlackRock Inc.