The Policy Unwinding
R. Scott Mildrum | February 21, 2022
Editor's Note: This is part 4 of a 4-part series published on Captive.com. Previous articles covered US economic activity and monetary policy. This part provides updates on recent developments in the United States as the Federal Reserve prepares to unwind years of policy accommodation.
The Federal Reserve tuned its monetary radio to the ultra-accommodative station at the outset of the COVID-19 pandemic. Its swift and aggressive action, paired with massive fiscal stimulus, helped offset a historic contraction in economic activity and paved the road to recovery. Now, 2 years later, the noise has drowned out the signal and that ultra-accommodative radio station is playing nothing more than static. With the highest inflation readings since the early 1980s, 4.0 percent unemployment, and a quickly fading Omicron wave, the Fed is ready to unwind emergency levels of monetary accommodation. This shift in policy has sent a jolt of volatility through financial markets in early 2022 and harkens back to 2013.
Back then, former Federal Reserve Chair Ben Bernanke mentioned the idea of tapering asset purchases in early May 2013 and 5-year Treasury yields jumped 1.20 percent in 5 short months. The spike in bond yields was dubbed the "taper tantrum." Today, the rise in Treasury market volatility so far is more akin to a fit, not a tantrum. Instead of reacting to asset purchase tapering (which started last year and is expected to end in March), market participants are responding to a wholesale hawkish shift in monetary policy and impending rate hikes.
Persistently high inflation, paired with historically tight labor markets, forced the Federal Reserve into a hawkish pivot late last year. Since then, inflation has continued to run hot, with ongoing supply chain issues and elevated input prices. The labor market continues to recover, faring far better than expected during the recent Omicron wave. These economic outcomes have prompted market participants to ramp up their expectations for rate hikes in 2022. Remember, in December the Fed was forecasting four interest rate hikes by year-end 2022. Recent market pricing suggests six or seven might be in the cards.
The Federal Reserve has stated that interest rates will be its main policy tool as it looks to remove accommodation. However, the calculus does not stop there for market participants. The nearly $9 trillion elephant in the room is the Fed's balance sheet. Throughout the pandemic, the Fed has been buying bonds at a feverish pace, absorbing a massive amount of Treasury and mortgage-backed securities supply. As a result, the Fed's balance sheet has ballooned to more than double its pre-pandemic size (see graph). Today, the Fed is in active discussions on how and when to reduce the size of its bond holdings, either through passive runoff and/or outright sales. So, while the Fed has stated that interest rates will remain its primary tool, in all reality, it has two levers to pull this tightening cycle and the balance sheet lever just may prove more disruptive.
Periods of policy transition are typically marked by increased volatility, and this cycle is proving no different. Given our outlook for higher interest rates in 2022, we maintain our short duration stance in fixed-income portfolios. While total returns for fixed-income portfolios are negative for the year, this defensive stance continues to protect client capital relative to various investment grade bond benchmarks in a rising rate environment. Without question, negative year-to-date returns are frustrating, but the silver lining is the opportunity to invest new capital and maturing proceeds at higher all-in yields, ultimately benefiting fixed-income investors in the long run.
We have been living in an income-starved world for almost a decade and a half since the end of the great financial crisis. With global interest rates pinned near the zero-lower-bound, the risk spectrum has been skewed and investors have chased returns in other, more risky asset classes. While the recent policy fit has resulted in higher yields, we have by no means exited the prevailing low-rate regime. As the Fed embarks down the path of policy normalization, rising rates will remain a headwind for fixed-income returns. As such, it will be important to listen to Fed communications as it formulates its exit plans. Continuing to manage interest rate risk will be paramount, while opportunistically investing capital at higher yields, working to generate meaningful investment income once again.
Performa has been managing assets on behalf of captive and other insurance clients for 30 years. Its capabilities include asset allocation, active fixed-income, and equity management through diversified mutual funds and separate account portfolios. With offices in the world's largest captive domiciles, including Bermuda, Vermont, and South Carolina, Performa is 100 percent employee-owned and has $5.47 billion in captive assets under management and advisement as of December 31, 2021.
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R. Scott Mildrum | February 21, 2022