Why ‘steepener’ play is wise approach for fixed-income investors

Portfolio manager explains why recent employment numbers mean the Fed will feel vindicated by lower-for-longer policy

Why ‘steepener’ play is wise approach for fixed-income investors

The U.S. Federal Reserve will not pivot from its interest rate path until it sees employment levels rising, which should ease investor fears of a dramatic U-turn and an earlier-than-expected hike.

That’s the view of Matt Brill, Invesco’s Senior Portfolio Manager and Head of North America Investment Grade, who told WP that advisors should view the Fed’s outlook through two separate entities – employment and inflation.

He said the central bank has put inflation to one side for now and will want to see a year’s worth of data before getting concerned. A more immediate priority is getting the eight and a half million out of work who had a job at the start of the pandemic back on the pay roll.

The path to a rate hike is a well-trodden one – and is not quick. From talking about tapering, to tapering and then hiking rates, there are boxes that need to be ticked in Brill’s mind. The Fed’s line is that they are still not even talking about talking about tapering!

Invesco believes that means tapering is highly unlikely until the first quarter of 2022. Then inflation comes back into the picture, with the Fed wanting to see it averaging above 2% before a hike becomes feasible.

“They need to see it average 2% for a sustainable period of time,” Brill said. “And we’ve heard some of the Fed members characterize sustainable as a year. From my calculations, you've got at least 10 months to go before the Fed is going to acknowledge that inflation has been running greater than 2%. A lot of people still predict that by the end of this year, things are going to start to really crash back lower in terms of inflation, which could cause the Fed to still be on pause in mid 2022.”

The Fed’s dot plots signify it won’t raise rates until the end of 2023 but Brill believes that’s unlikely. His outlook is that if we get into early 2022 and the economy is still going well, there will be some inflation and the bank will have to move its timeframe forward.

For investors and advisors, the job is to navigate this path, making sure their fixed-income allocation is positioned accordingly. If you believe the Fed will stand firm and stay on hold, the “steepener” play, being overweight the front end, is your best approach because that won’t change as inflation expectations pick up.

Brill explained: “We generally believe the Fed is going to keep telling you for the longest time that they're going to hold the line. It’s going to get a little more challenging as time goes by, but they're certainly not going to be changing course anytime soon.”

If you believe the Fed will pivot a little quicker, then he suggested “shorting the belly”, which means the 3-5-year interest rates. At the moment, there is minimal expectation of rate hikes being priced into those but that could change if people start to think the Fed is going to get more aggressive.

“The Fed is going to stay on hold for a while and be extremely accommodative because it’s really just focused on job creation,” Brill said. “The job numbers that came out last month [revealed] 230,000 had been created and everybody thought they were going to get on this pace of a million a month. That wasn't anywhere close - and that told the Fed that what they were doing is right.”