I was recently asked, “What will be the impact if Bernanke is replaced? Could a new Fed Chairman increase rates sooner than expected and put major pressure on the fixed income market?” My response: I see three scenarios under which rates might rise significantly:
1. Fed tightening…highly unlikely in the next year
2. U.S. investor sentiment shift…most likely
3. Global loss of confidence…least likely, most damaging
Scenario 1: A Change in the Fed's Basic Approach
Bernanke may or may not continue as Chairman after his term expires. I think Obama is likely to ask him to stay. If Bernanke chooses to leave, Obama is very likely to replace him with another dove (few presidents would knowingly appoint a hawk)…with Vice-chairman Janet Yellen (a dove) probably the leading candidate. In any case the majority of the Fed Board of Governors are doves…so even an uber-hawk would have to build consensus to get a less accommodating policy voted in. But either way, the Fed has a mandate, and I think that mandate limits the risk of the Fed “stepping on the brakes” in the next 12 months regardless of who is chairman.
The Humphrey-Hawkins mandate (keep both inflation and unemployment low) still militates for low rates, and will probably do so until the unemployment rate falls far enough that “labor” becomes scarce enough that unit labor costs start to outpace inflation. I'd guess unemployment would have to get well below 7% before that happens… there's currently a very active debate within the Fed about what that “trigger” level of unemployment might be.
Bill Dudley, President of the New York Fed uses an analogy which I've used: If you're pushing a car stuck in the mud, you don't stop pushing the instant the car starts to move…you keep pushing until you're sure the car has enough momentum to get out of the mud. In Bernanke's more formal words in a speech last week: “…a highly accommodating stance of monetary policy will remain appropriate for a considerable time after the recovery strengthens.”
Bottom line: the risk of the Fed stepping on the brakes in 2013 appears small.
PS: I expect this scenario, if it plays out, to result in an inflationary boom: falling unemployment => rising wages => rising consumer spending => strong GDP => strong profits, etc. In that scenario, stocks should outperform bonds, and corporate spreads should tighten until the Fed steps on the brakes…which it has repeatedly said it won't do until the recovery (aka the inflationary boom) is well under way.
PPS: raising rates to 1% or so wouldn't be stepping on the brakes…it would simply be easing off the gas pedal. It's only when the Fed Funds rate is materially higher than the inflation rate (2%) that the Fed's foot touches the brake pedal.
Scenario 2: A Shift in Investor Sentiment
Retail flows into bond funds have been huge…and (in my mind at least) are based in part (but only in part) on the misconception that bonds are safe from loss (retail investors apparently thought they couldn't lose money in stocks in 1999…and that they couldn't lose money in real estate in 2005…and that now they can't lose money in bonds). Note: flows into bond funds are also driven by the need/desire for income, so the speculative/bubble risks aren't as high.
But if momentum turns sour and redemptions from loss-averse investors (who want income but hate losing principal) accelerate, who will bid on all the bonds money managers are trying to sell?….this is why markets overshoot on both the upside and downside.
Note: If the Fed tightens somewhat sooner than expected because the economy's OK (or beginning an inflationary boom), stocks will almost certainly be appreciating. Treasury rates may rise, but it's unlikely to be a quick bond market panic…advisers will preach diversification and adherence to asset allocation models. The real bond
bear market won't start until the Fed becomes more worried about inflation than unemployment and actively tightens (as opposed to simply normalizing rates).
Scenario 3: A Bond Market Panic
My biggest concern as a fiduciary/investor is a “tail risk”…a market panic…that the global bond market (or U.S. retail) loses confidence in the dollar and Treasuries' safe-haven status. (It hasn't happened to the U.S….or Japan…or France…yet…but other countries have ended up defaulting and/or hyperinflating when that happens). If a wave of “loss of confidence” selling starts, the Fed might be powerless to stop it, since further QE would further weaken confidence in the soundness of the dollar.
This is not a “black swan” in the sense of being unanticipated the fear of such an event seems pervasive among market professionals, if not among retail investors but it is a low probability-high payoff risk. The media is focusing on the Fiscal Cliff: in assessing the third scenario's risk, I'm more focused on whether Congress and the President address the deficit and Debt/GDP ratio…if they do, Scenario 3 becomes much less likely; if they don't….
Sam Wardell is the senior vice president and investment strategist for Pioneer Investments. This commentary originally appeared on the firm's website.
