Co-Head of Investments Jeff Klingelhofer dives into the Fed’s role in today’s inflationary environment and the pockets of value within fixed income that could interest investors moving forward.
Observations in Fixed Income Q4: Inflation Remains the Top Story
I’m Jeff Klingelhofer, co-Head of investments at Thornburg Investment Management. As I’ve pointed out most of the year, the top story has been—and will continue to be—central bank actions around the world and the removal of accommodative monetary policy. On one hand, the Fed is aggressively raising rates and continuing the paradigm shift from a free cost of money at the start of 2022, to a very significant and real cost of money as the year draws to a close and likely into 2023. And on the other hand, we’ve witnessed scores of interest rate increases around the globe, with global central banks having raised rates well over 100 times. This paradigm shift and the exit from the great monetary experiment has rippling effects around the world. From pain in emerging markets, to stocks down significantly in most regions around the world, to potentially destabilizing effects of extreme dollar strength, which caused the Bank of England and the Ministry of Finance in Japan to intervene in currency markets, it’s left many investors feeling like they’ve been clocked by a two by four.
For the Fed, there is only one story: inflation. That’s all that matters. The Fed must see evidence that the inflation print is declining rapidly towards its 2% target. A lot of inflation will be less sticky in nature, so I expect it will come down fairly quickly to around five or six percent. Whether that’s good enough for the Fed, however, will depend on the sources of inflation: good versus bad inflation. If it stems from good inflation, aka services inflation, and particularly from low wage earners’ rise in pay, that will be enough for the Fed to pause. But if it’s still coming from bad inflation, i.e. goods inflation, then the Fed will power us into a recession.
Unlike in past instances of Fed action, when the Fed has been typically proactive in its approach to monetary policy, a shift at Jackson Hole 2020 brought about a new Fed regime. And markets are putting it to the test. This new Fed has been reactive in the current tightening cycle, meaning they only tighten when inflation is already high and when they thought it would stay high. Given the Fed’s current thinking, I believe it’s going be the same reactive approach on the way down. Only when inflation starts to fall will they start talking about ending their rate hiking cycle.
But what might lead to that? Well, that’s where the Fed’s third mandate enters the picture.
The Fed’s third mandate used to be financial stability. That’s how they interpreted moderate long-term interest rates and the reason why is that it was complementary to their first two goals. If the Fed stepped in when asset prices fell, does that cause unemployment? I would argue it doesn’t. But does it spawn below trend inflation to rise UP toward trend? Or does it at least support inflationary pressures? I would argue it does because if our asset portfolios are going up, we’re more confident to go out and spend money, pulling forward demand. But now the world has changed and so has the third mandate. The story is now about inclusive employment.
The Fed no longer cares about financial stability per se. They only care if financial stability becomes a concern around price stability. This is no different than it was in the past. It’s just that the definition of price stability has shifted from targeting below trend inflation and trying to push it up, to now targeting above trend inflation and trying to push it down. The Fed only worries that if they’ve tightened so much that they force us into a recession and trigger a global financial crisis. Then yes, that would be deflationary, and financial stability would again reenter the equation due to a shift in the Fed’s primary mandate of price stability.
Today, the Fed is trying to push down inflation. And as a result, I think their third mandate changed as well. The Fed talks a whole heck of a lot about inclusive employment and compressing the wage gap. In light of that, I think as we watch inflation roll over and begin to come down, we have to desegregate the idea of good inflation and bad inflation. Where bad inflation is goods inflation, but potentially good inflation is services inflation. Why services inflation? Because low wage workers are exerting their upward force on the labor market.
Given these lenses and the changing interpretation of the Fed’s third mandate, I don’t think we need to see inflation come all the way back 2 to 3%. I think we just need to see it declining and I think we need to see the composition of inflation continue to shift. But I think there’s a real risk, or perhaps opportunity, that central banks around the world might say, “maybe 2% isn’t the right target. Actually, we’re trying to increase wages of low wage income earners and therefore we need to tolerate potentially even 4-5% inflation.” Or some level that’s not disruptive to markets, but that’s workable in the broad economy.
Since my argument is that the Fed’s third mandate is currently focused on inclusive employment. We are watching the composition of inflation more than the headline inflation itself. In other words, the Fed does not care anymore about market stability. They only care if market instability bleeds over into price instability. As such, our base case looking forward remains in place, but the left and right risk tails are getting fatter. As the Fed tightens aggressively, that may become an increasingly left tail risk should a financial crisis develop.
With our base case in mind, we continue to like the consumer. Although the consumer is beginning to show some signs of deterioration, they remain steadfast through financial market volatility and rising costs. Excess savings is coming down and at some point, consumption will have to soften, perhaps notably. While the overall consumer is strong, we are avoiding the subprime or lower credit score bands because we realize that these consumers are under the most pressure in terms of their ability to service their debt. We’ll be watching jobs numbers very closely as any increase in unemployment tends to disproportionately hit this lower quality borrower. But we very much like the top of the stack prime consumers who are less vulnerable to default.
In the corporate bond space, yields are starting to look interesting again. In some pockets, investors are beginning to be compensated for the risks in the market. I would expect us to continue to be selective given downside risks, preferring to take more risk only when the risk/reward tradeoff is more apparent. But this is something we will continue to watch closely.
We are also monitoring liquidity, which in the fixed income market, is less robust. Markets are still functioning, which was not the case in when the situation turned dire, as in March 2020. We’re able to buy and sell every single day.
Looking ahead, we remain humble and admit that nobody knows the direction that we’re ultimately heading. Few investors have experienced inflation like this, so it’s new for the markets. And the inflationary roots are very different from previous varieties. We’ve played a giant monetary and fiscal game, and we don’t know the outcome. Nevertheless, we do believe that we are positioned well in this environment.