Should We Worry About Consumer Credit?
Our forecasts for longer dated government bonds were for yields to gradually rise during 2018, but not in an uncontrolled manner. At 2017 year end, we had 10 year Treasuries at 2.75%, bunds at 0.75% and gilts at 1.50%. These moves are small, but severe enough for us to position much shorter down the curve and avoid the potential mark-to-market losses that such a move would generate.
However, it is important to note that our forecasts were based on a continuation of the policy goals by central banks, namely a nominal inflation target of 2%. In recent days and weeks there has been an escalation of discussions concerning how the Fed may amend its mandate for the future. Everyone knows that there will be significant personnel changes at the Fed this year and this may well pave the way for a discussion on a change of mandate, or at least the half of the mandate that controls inflation. By way of example, last week the New York Fed’s president, Bill Dudley, was calling for a review of the nominal target and instead proposed targeting a range of 1.5% to 2.5%. He is not alone, San Francisco Fed’s chief, John Williams, advocates a price level target in which the Fed would aim for an inflation goal on average over a given time. Given that the Fed has been under its 2% target for the last 5 years, that form of regime would imply a higher inflation tolerance in the future.
In addition, former Fed Chair Ben Bernanke predicted two weeks ago that under the incoming new chair, Jerome Powell, the Fed would appoint a sub-committee to study the subject of the Fed’s inflation target. We also know that the new Fed Vice Chair is likely to be a candidate with a strong economics background, and we know that San Francisco Fed President Williams has that pedigree and is interested in the job. While there is a long list of candidates that are being considered for this important post, it is hard to argue with the quality of Williams CV.
What does all this mean from a markets perspective? Well for fixed income investors, especially those exposed to rates markets, a review of the Fed target is clearly bad news. Allowing inflation to run hot for a while to catch up lost ground would reverse the flattening yield curve, causing it to steepen, resulting in higher long end yields. How much higher it will go is hard to predict, but we think it prudent to add 50bps to yield targets, should it become apparent that the Fed is reviewing its inflation objective.
Its impossible at this stage to forecast accurately the likelihood of such a move, but public talk by people in key positions means it is not low risk.
You can debate whether a change to the Fed mandate would be positive for the economy, but it would almost certainly be bad news for bonds, and investors should consider adjusting risk accordingly.