Weekly Bond Bulletin

3 September 2020

A new Fed framework

Changes to the Federal Reserve’s (Fed’s) policy framework solidify its easy stance—with important implications for fixed income markets.

Fundamentals

As we shift into autumn, central bank policy continues to be the main fundamental driver of markets. While the ultra-accommodative monetary policy stance remains unchanged, Fed chairman Jerome Powell made some important announcements about the Fed’s overall framework at the annual Jackson Hole symposium. The shift to an average inflation targeting approach—under which the Fed will try to get inflation sustainably above 2%, to make up for the fact that it’s been below 2% for an extended period of time—was largely anticipated by the market, even if it was expected to come at a later date. The more noteworthy incremental change is in the approach to the unemployment rate, with the Fed in future only responding to “shortfalls” and not “deviations”. In other words, a low unemployment rate will no longer push the Fed to raise rates. These changes solidify the Fed’s easy policy and remove the tail risk of a taper tantrum-like scenario for fixed income markets.

Inflation has remained consistently below the Fed’s 2% target

Source: Bureau of Labor Statistics, J.P. Morgan Asset Management; data as September 2020.

Quantitative valuations

Ten-year US Treasury yields bucked the typical seasonal trend by selling off 17 basis points (bps) in August, but nevertheless remain in the tight 0.6% to 0.8% range of most of the past five months. With the Fed reiterating its dovish bias, and absent a firm catalyst such as a vaccine, we expect rates to remain rangebound. In credit markets, spreads continued to compress throughout the summer: global high yield spreads tightened 27 bps in August to 520 bps, while global investment grade credit spreads moved 7 bps lower to 130 bps over the month. Barring a severe second wave of infections or disruption from geopolitics (such as US-China trade tensions or the US presidential election), we expect credit spreads to grind tighter. (All data to 31 August.)

Technicals

The global grab for yield is not abating, as cash continues to search for a home. In the week ending 31 August, money market funds saw a further USD 11 billion of outflows, bringing the monthly total to USD 72 billion. This money is flowing into an array of fixed income strategies, with solid inflows into developed market credit, emerging market debt, aggregate and unconstrained bond funds. The monetary policy backdrop is only reinforcing this trend, with the powerful waterfall effect likely to compel investors to move further out on the credit spectrum in search of yield, from investment grade credit to hybrid securities, to high yield and emerging market debt.

What does this mean for fixed income investors?

The Fed’s framework shift has reinforced its dovish stance. It will be important to watch whether other central banks follow suit, given the prevalence of missed inflation targets around the world. The rally has been strong across fixed income spread sectors, with global high yield and investment grade credit markets having retraced approximately 80% of the spread widening from earlier this year. And yet, what is stopping spreads from fully retracing to pre-Covid levels? Credit fundamentals are unequivocally weak, although the forward-looking nature of markets (with the economy arguably through the worst of the shutdown repercussions), combined with the weight of cash in search of yield, suggests that a return to pre-Covid spread levels is very possible.

About the Bond Bulletin

Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

Click here to read more about our FQT capabilities


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3 September 2020
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