Fed QE to Shape Bond Market in 2013
The Federal Reserve’s aggressive quantitative easing will be a major factor in the fixed-income market but likely won’t help U.S. economic growth accelerate significantly.
By Cathy Roy, CFA, Chief Investment Officer, Fixed Income, Calvert Investment Management, Inc.and Steve Van Order, Fixed-Income Strategist, Calvert Investment Management, Inc.
|Steve Van Order|
After a 2012 dominated by accommodative monetary policy around the world, lingering concerns about the eurozone debt crisis, and worries about political gridlock in the United States, we expect 2013 to bring slow but positive economic growth in the United States and relatively low volatility in the fixed-income market.Corporate bonds in general had a good year in 2012, and we believe that technical conditions in the U.S.taxable bond market will allow both investment-grade and high-yield corporates to continue to rally in 2013.Based on this broad outlook, Calvert has conservatively positioned its taxable bond portfolios with respect to interest-rate duration1 while maintaining exposure to the corporate bonds that appear to offer more relative value.Calvert's strategic fixed-income investment committee will continue to monitor the economic and market environment to provide ongoing insights to our portfolio management team.
Fed Sets the Stage for 2013
In mid-December, the Federal Reserve (Fed) set the stage for 2013 by announcing that it will link future moves to tighten monetary policy to threshold levels of unemployment and inflation.Since the financial crisis of 2008 to 2009, the Fed had been providing approximate timeframes for its ultra-low interest rates and quantitative easing (QE), so the connection with specific levels of unemployment and inflation will likely remove some uncertainty for financial market participants.The Fed also stated that it will buy $45 billion in Treasury securities per month starting in January 2013.This new QE program will take the place of "operation twist," which ended in December and involved the Fed selling short-maturity Treasuries and using the proceeds to buy longer-term Treasuries.This new QE program is in addition to the $40 billion a month in mortgage-backed securities (MBS) that the Fed already buys.
Continued Slow U.S.GDP Growth
By committing to that very high level of Treasury and MBS purchases in 2013, the Fed obviously wants to keep the U.S.economy from slipping into a recession.We believe that the economy will avoid a recession, but we don't expect a rapid economic acceleration.We anticipate quarterly gross domestic product (GDP) growth in the area of a 2% to 2.5% annual pace in 2013, with the slower growth coming in the early part of the year and a pickup later in the year.This rate of GDP growth would be about in line with the pace set over the expansion cycle to date (2.5%, starting in the fourth quarter of 2011) and since the last cycle trough (2.2%, since the second quarter of 2009).
In an important transition from recent years, the residential housing sector will likely contribute to economic growth in 2013 rather than acting as a drag on growth.The downside risks to growth mainly come from the policymaker arena and include the risk of failure by Congress to increase the U.S.debt ceiling in time to avoid a temporary U.S.debt default in March, lack of clarity on business rules and regulations, and global financial market instability related to the euro crisis or a new crisis somewhere else (e.g.Japan or the United Kingdom).We expect U.S.federal fiscal tightening to clip at least one percentage point off of full-year 2013 growth compared to what it might have been, but a full fiscal cliff effect would have been well over 3.5 percentage points for the year.
The risk to the upside stems primarily from a potential boost in corporate spending.With much better clarity on tax policy and regulations, corporations could unleash economic stimulus through hiring and new investment.At the end of the third quarter of 2012, U.S.non-financial corporations held $250 billion more in liquid accounts than pre-crisis in 2007.These liquid assets are equal to 1.6% of nominal U.S.GDP—quite a source of potential energy.
With the unemployment rate high, the economy growing at significantly less than its full potential, and some households still struggling to deleverage, it is hard to envision a sustained rise in consumer inflation in 2013.Steady market expectations for low inflation in 2013 seem reasonable to us.We expect the Fed's target inflation measure—the headline personal consumption expenditures price deflator—to stay near an annual rate of about 2%.The risk that the headline consumer inflation rate could exceed the 2% benchmark would primarily come from an energy price shock or strong consumption-led economic growth.The former would likely wash out over time.The latter is more a phenomenon of the 1990s and 2000s.The risk that inflation would fall significantly would come from a cyclical recession.We believe that the risk of a recession is low (about one in five) but not trivial.
Although we expect positive U.S.economic growth and tame inflation this year, we don't see the unemployment rate falling below 7% in 2013.There's a chance that U.S.politicians could suddenly agree on fiscal issues such as tax policy and regulations, which could then motivate corporations with plenty of cash on hand to put that money to work through hiring and new investment.We don't think that scenario is likely, however.
Probabilities of Reaching Threshold Unemployment, Inflation
Along the same lines, we believe that it's possible—although quite unlikely—that the economy will reach the Fed's threshold rates of a 6.5% unemployment rate or 2.5% inflation that would prompt the central bank to consider tightening monetary policy.Based on past forecast error and the December unemployment forecast from the Federal Open Market Committee (FOMC), our calculations show that the probability of the unemployment rate reaching or falling through 6.5% in 2013 is about 14%.Using the same parameters, the probability of the unemployment rate reaching or falling below 7% in 2013 is approximately 26%.In terms of inflation, there is about a 17% probability of the PCE inflation rate hitting or exceeding 2.5% by the fourth quarter of 2013.
10-Year Treasury Yields
With this general economic backdrop and the Fed's very accommodative monetary policy in mind, in 2013 we expect the 10-year Treasury note's yield to fluctuate within the broad 1.4% to 2.4% range that has been in place since the fourth quarter of 2011.Within that broad range, we foresee the 10-year Treasury's yield spending much of 2013 in the 1.8% to 2% area.Although the Fed's new round of QE will take a large amount of Treasury supply out of the market, we think that it will act more as a soft cap on interest rates than a force that will drive Treasuries to new low yields.However, if the FOMC forecast for unemployment and inflation rates were changed so as to lower the probability of crossing those thresholds, it is possible that Treasury yields could move lower.
Supply Crunch Caused by QE
We do anticipate that the Fed's open-ended QE will take $1 trillion (not counting reinvestment of principal) in government-backed bonds out of the market by the end of 2013, split equally between long-maturity Treasuries and agency MBS, which will likely create a large negative net supply situation in taxable bonds denominated in U.S.dollars.This level of QE will also increase the central bank's balance sheet to about $4 trillion—nearly 25% of U.S.nominal GDP.
By removing such a large amount of Treasuries and MBS from the market, the QE initiatives will likely cause investors to continue to move into other types of taxable debt, such as corporate bonds, pushing yield spreads2 narrower in those other asset classes.We also anticipate that the Fed's QE buying should dampen interest rate volatility, although there could still be an occasional uptick in volatility.
Positioning of Calvert Portfolios
To help meet the challenges of fixed-income investing in 2013, which will include generating income in an environment of very low interest rates while still managing risk, we have conservatively positioned the duration of Calvert's taxable bond funds.Entering the new year, we are maintaining durations in our portfolios that are somewhat shorter than the durations of their respective benchmark indices, which will help mitigate losses if interest rates rise.Although we don't anticipate an increase in interest rates in 2013, it could happen and we believe that the short relative duration positioning is a prudent risk management measure.
Corporates Poised for Another Good Year
Despite the fact that both investment-grade and high-yield corporate bonds posted strong returns in 2012, we anticipate corporates having another good year in 2013 and are selectively adding corporates that seem to offer strong relative value to the portfolios.As mentioned above, the Fed's aggressive QE buying should create a supply crunch in the taxable fixed-income market, which would help continue to push investors seeking yield into sectors such as corporates.In addition, the fundamental financial condition of many corporations is still very strong, and we see corporate default rates staying low by historical standards in 2013.
Even after the BofA Merrill Lynch High Yield Master II Index, a common high-yield benchmark, returned 15.57% in 2012, we still see high-yield corporates as a particularly attractive asset class.The average yield of high-yield corporates relative to investment-grade corporates is quite high, so high-yield investors should continue to benefit from that incremental yield.
Security Selection to be Vital
However, with interest rates already so low and spreads having already tightened significantly in many sectors, security selection within corporates will be even more important than it has been in recent years.In that sense, the macro-factors that have largely determined performance over the last few years will likely give way to micro, issuer-specific factors in the search for good performance.With investor demand for corporates high and likely to stay robust, bond issuers are in the driver's seat and the level of investor protections in some new corporate deals has declined.Careful consideration and analysis of corporate sectors, fundamental credit, and relative valuation will be critical for success in 2013.We are confident that our dedicated team of experienced taxable credit analysts will continue to drive strong sector and security selection.
Volatility in "risk-off" assets such as Treasuries plunged in 2012, and we expect the Fed's QE policy to continue to dampen interest-rate volatility in 2013.However, short windows of volatility would provide attractive opportunities to capture incremental returns through successful rotation out of securities that appear rich (fully priced) and into those that our portfolio managers believe provide more attractive relative valuations.These periods of volatility could occur if there is a major change in fiscal policy or failed political negotiations in the United States, or around 2013 elections in Italy and Germany.
We have noticed that many analysts' market and economic forecasts for 2013 fall into a relatively narrow range.As a result of market participants being more uniform than usual in their expectations for the year, surprise developments will likely have more market-moving power.Calvert's strategic fixed-income investment committee has discussed some low-probability events which could significantly affect the bond market in 2013, including a surge in capital expenditures that would generate stronger-than-expected economic growth, a much quicker-than-expected move toward greater energy independence that would have global geopolitical ramifications, or a test of fixed-income exchange-traded fund (ETF) liquidity caused by rising interest rates.Although surprises are by definition unknown and impossible to accurately quantify, we believe that Calvert's team of taxable fixed-income portfolio managers and credit analysts has the expertise needed to navigate through any unforeseen events in 2013.
The Challenge of Thincome in 2013
In 2013, investors will continue to face a shortfall of desired investment income due to near-zero money-market rates and the thin fixed coupon payments on the most liquid, high-quality bonds.We call this the challenge of thincome for investors.Blends of high yield and short duration investment grade corporate bond investments can help meet the challenge of thincome.The high-yield allocation can provide a pick-up in yield and income, and the exposure to shorter-duration securities can reduce expected overall portfolio price volatility compared to an allocation to a typical intermediate duration, investment grade corporate bond product.The exact blend of high-yield and short-duration investments would be a function of each investor's particular need for income and risk tolerance level.
1.Duration measures a portfolio's sensitivity to changes in interest rates.Generally, the longer the duration, the greater the change in value in response to a given change in interest rates.
2.Yield spreads measure the difference in yield between a non-Treasury bond and a Treasury security with a comparable maturity.
This commentary represents the opinions of its authors as of 1/7/13 and may change based on market and other conditions.The authors' opinions are not intended to forecast future events, guarantee future results, or serve as investment advice.The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed.Neither Calvert Investment Management, Inc.nor its information providers are responsible for any damages or losses arising from any use of this information.
Investment in mutual funds involves risk, including possible loss of principal invested.
Mutual funds that invest in bonds are subject to certain risks including interest rate risk and credit risk.As interest rates rise, bond prices generally decrease.In addition, the credit quality of the securities may deteriorate, which could lead to default or bankruptcy of the issuer where the issuer becomes unable to pay its obligations when due.The prices of long-term bonds are more sensitive to changes in interest rates than the prices of short-term bonds.Therefore, in general, long-term bonds have more interest rate risk than short-term bonds.
High-yield, high risk bonds, which are rated below investment grade, can involve a substantial risk of loss because they have a greater risk of issuer default and are subject to greater price volatility than investment-grade bonds.An active trading style can result in higher turnover (exceeding 100%), may translate to higher transaction costs, may increase your tax liability, and may affect Fund performance.