Review bond portfolios and consider alternatives in light of Fed's announcement, says Picton Mahoney
After watching reaction to last week’s Federal Reserve announcement, Phil Mesman, Partner and Head of Fixed Income at Picton Mahoney Asset Management, noted “the dovish pushback that we saw from central banks”.
“It was a big week for the central bank,” he told Wealth Professional. “The Royal Bank of Australia said it wasn’t going to hike rates in 2022. The Bank of England didn’t hike them. It’s really hanging onto its hat on inflation being transitory versus permanent. The FOMC (Board of Governors of the Federal Reserve System) reiterated its well-telegraphed tapering plan, which begins in December and finish next summer. That was expected.”
What caught the market’s attention was the Fed emphasizing transitory inflation, whereas the Bank of Canada considered inflation more concerning. The Fed language – that inflation had persistently run below its 2% goal, so it will aim to achieve it moderately above 2% for a while – supported the market, which kept rallying.
“The difference is,” said Mesman, “in Canada, we’re a more commodity-driven country, so the growth in inflation is more prevalent here than it is in the U.S. So, the output gap is starting to tighten and that’s what concerns the Bank of Canada. It raised rates, whereas the U.S. is really holding off on that.”
Up until the Fed announcement, he would have said the banks were leaning a bit more towards inflation being permanent than transient, so he saw a big shift on the margin. But he also thought it was important because inflation is one of three factors that drives government bond yields – the others being central bank policy and bond supply. While tapering may slow things, he said the government bond yields will be pushed higher because of tapering.
“What we’ve seen is the market is looking to see what the central banks believe ... whether inflation is transient or permanent,” he said. “What we saw was a shift toward a more transient view from the key central banks.”
Now, Mesman is watching whether the central bank will be right or wrong. He said the strong job numbers that appeared across the board late last week is a data point that “could see some challenges down the road”.
Since inflation causes bond yields to climb, he thought the Bank of Canada move was prudent. Despite the Feds’ language tilting toward more transitory inflation, its tapering is still slowing.
The Fed’s announcement said that, beginning later in November, it would increase its holdings of Treasury securities by at least $70 billion a month and of agency mortgage-backed securities by at least $35 billion a month. Starting in December, it would also increase its holdings of Treasury securities by at least $60 billion a month and agency mortgage-backed securities by at least $30 billion a month. While it anticipated making similar reductions each month, it said it was “prepared to adjust the pace of purchases if warranted by changes in the economic outlook”.
Mesman recommended that advisors review their bond portfolio as they continue to watch inflation and growth.
“Our numbers have proved we can add value in tough bond markets,” he said. “So, there’s a strong business case for alternative income, and traditional bonds are going to have a tough time delivering because yields are very low.”