Could the Fed further fuel a rally in risk assets?*



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      By Eric Stein, CFA, Co-Director of Global Income, Eaton Vance Management and Andrew Szczurowski, CFA, Portfolio Manager, Global Income Group, Eaton Vance Management

      Second in a three-part series

      Boston - At the Group of 20 (G20) summit in Japan, the U.S. and China agreed to resume trade talks, with both sides offering concessions. While this temporary cease-fire may cause the Federal Reserve to reverse recent signals that rate cuts could come soon, other factors, such as weakening economic data, could cause the Fed to follow through on cutting the fed funds rate later this month. The Advisory Blog recently sat down with Eaton Vance portfolio managers Eric Stein and Andrew Szczurowski to get their take on where Fed policy stands today - and what it means for markets and investors.

      In the previous post, you discussed the likelihood of the Fed cutting the fed funds rate later his month. How are markets likely to react?

      Andrew: Markets are where things get a lot trickier. You have to look at what the market is pricing in, to get an idea of how it might react. The market is pricing almost four cuts over the next year and 3 of those cuts to come by year end. While that's possible, I don't think it's likely with the economy not nearly as weak as the market's expectation would imply. Treasury yields have had a tremendous rally this year already in anticipation of multiple rate cuts from the Fed. They've come a long way, and that's where my biggest hesitation lies: what the market's already pricing in versus what we might get. We could have a scenario where the Fed cuts rates 25 basis points in July and Treasury yields rise, because the market is currently pricing in 30 basis points of cuts to come in July. If the market was expecting no cuts and the Fed cut rates, there would be a huge benefit to financial markets from that surprise. Risk markets would likely get a large rally in the surprise scenario and Treasury yields would likely fall as well. But that is not the scenario we are currently in, the market has very high expectations for the Fed.

      What does this mean for investors?

      Eric: In the short-term, it's a very good time to be an investor — particularly in emerging markets debt, but in other credit markets as well — because as the whole rate structure comes lower, investors search for yield. You just see yields across the whole developed world — in Europe they're negative, in the US, Canada, Australia, New Zealand are sub 2% in all of those markets. Investors have to look elsewhere.

      I think that central banks globally are going to oscillate between missing their inflation targets and allowing normal market functioning or really having easy monetary policy, getting close to their inflation targets, and potentially worrying about financial stability and frothy asset markets. At the beginning of 2018, you had frothiness in asset markets; that was one of the reasons the Fed got hawkish and ultimately hiked four times in 2018. Markets were dramatically selling off in December 2018; that was one of the main reasons to turn dovish. The Q1 Fed dovishness was mostly because of what happened in December. The recent dovishness has been about the trade war, structural inflation concerns, and cyclical slowdown in data.

      If the Fed is as dovish as the markets are expecting, to some extent they can be a slave to the markets where they feel forced to do what the markets tell them. That keeps asset markets high, and maybe even going higher. At some point they'll be concerned about markets being too high. I don't think we're there yet; there's a lot more room to run.

      But I think central banks are going to operate between two uncomfortable equilibriums: one where we have frothy asset markets and at-target inflation where they raise rates to keep markets from getting too frothy, then inflation falls and that's arguably what we've had recently. It'll be tough for central banks to both hit their inflation target and have financial markets in general equilibrium.

      How should inflation factor into an investor's allocations?

      Eric: Despite the fact that inflation is lower, I like breakevens in the US and inflation-linked bonds in other countries — New Zealand and Thailand, for example. Partially because I think central banks will be somewhat successful in raising inflation expectations at least a bit, even though I think it generating a lot of inflation would be challenging.

      If you have a strategy that's long-risk assets, particularly in the fixed-income space — so emerging markets, credit assets — a significant pickup in inflation can hurt that narrative. In fact it likely would hurt a lot of credit markets. I don't think we're anywhere near there, but from a portfolio construction standpoint I think it makes sense to have inflation breakevens, partially because the Fed and other central banks are concerned and want inflation expectations to widen. They also hedge other positions that I like predicated on a more dovish Fed. The only thing that knocks the Fed and other central banks less dovish is a pickup in inflation and inflation expectations.

      Andrew: I also think now is a good time for inflation breakevens for a number of reasons. For one, breakeven rates are hovering near their lows for the year, which seems odd given the dovish pivot from the Fed. Commodity prices are also quite a bit above where they began the year, but that hasn't filtered through to higher breakevens yet. Oil is up 26% from where it began the year, which would normally have led to higher breakevens, but not this year. Asset prices have risen substantially across the board as well. We also are in the midst of a trade war with China and many companies haven't passed the full extent of those tariffs onto U.S. consumers yet, but have said they would at some point. Last but not least, we also have a president who has been very vocal about wanting a weaker dollar, which would like to higher import costs and higher inflation.

      That, plus unemployment being low and wages rising — maybe not at some kind of exponential pace but still 3%+ — and it's going to be tough for inflation to go much lower. The Fed could be walking into a trap on the inflation front. We could finally see inflation expectations rise in the coming months.