Here's How We Can Get a Secret Window Into the Fed

Investors take years off their lives trying to interpret central bankers' statements...

Folks will come up with any method to figure out what policy makers are really thinking.

Just consider when Alan Greenspan was chairman of the U.S. Federal Reserve... Investors read so much into his "irrational exuberance" statement in December 1996 that they considered it a warning that assets might be overvalued, and it caused markets across the globe to drop dramatically.

They also used to look at Greenspan's briefcase before he walked into a Federal Open Market Committee ("FOMC") meeting. The theory was if the committee was going to change rates, then the briefcase would be full... because Greenspan would need documentation to convince the other members of the shift. 

Unique methods like these continue to be popular because central bankers play such vital roles in the market. In some ways, they're the most influential asset managers in the world. As such, it would be invaluable if someone could see inside and really know what central bankers are thinking.

Here at Altimetry, we attempt to decipher what central bankers truly believe using the same earnings call analysis we use on corporate quarterly earnings. We aim to identify where management is showing real signs of "confidence" or "stress."

At Valens Research – the firm that powers Altimetry – the hedge-fund clients love these earnings call analyses because they provide so much information. As I like to put it, it's "the closest thing to insider trading without actually having insider information." This is because our Earnings Call Forensics framework helps these clients understand what management teams are actually thinking. 

We use the technique when the Fed chairman gives a press conference after FOMC meetings. These conferences just started in the last decade... and only in the past two years has current Fed Chairman Jerome Powell spoken at a press conference at the end of each meeting.

The last meeting was from July 28 to July 29, and captured our attention because it was relatively constructive...

Unsurprisingly, Powell appeared to be exaggerating when discussing how differentiated the Fed's current programs are from quantitative easing ("QE"). 

The central bank's massive injection of money directly into the system to bolster the economy may be more similar to QE than Powell wants to let on. The chairman also avoided the use of the phrase "quantitative easing" because of the negative connotation associated with it.

In addition, Powell overstated how much the committee really discloses its diversity of opinions. Many votes are unanimous or close to unanimous in the FOMC... But the committee may not be as unified as it portrays itself to be.

On the other hand, Powell was highly confident when talking about the Fed's commitment to greater transparency. This confidence is in terms of the central bank's public review of monetary policy strategy, tools, and communication practices. 

Powell was also confident in the Fed's commitment to doing everything it can to reach full employment and a tight labor market. The chairman also mentioned he wants to achieve economic recovery the correct way, ensuring the Fed's stimulus efforts don't only end up in the pockets of the wealthy. 

Furthermore, Powell was confident about how asset purchases have been particularly beneficial in this pandemic-driven crisis – specifically in reducing the cost to borrow for corporations and resolving issues in the credit markets.

Finally, Altimetry Daily Authority readers with concerns about hard currency will be relieved... Powell was confident when talking about the Fed's commitment to resolving shortage issues with coin volumes in circulation.

Looking at the whole press conference, Powell's confidence in the Fed's commitment to reach full employment was encouraging. It shows the Fed has its priorities on the issues that can help the economy sustain itself, as opposed to just asset bubbles growing.

On top of that, Powell's confidence in how the FOMC's efforts have already scaled back risk in the economy should be able to keep investors bullish. The Fed is seeing that its efforts to de-risk are having great success, and that these are taking the mass-default scenario off the table.

Finally, the commitment to sustainable borrowing costs for operations points to sustainability in the current credit environment.

Powell's confidence in such key areas of the endurance of this rally, reducing risk of defaults, and providing broad-based economic growth signal continued positives in the current market. In turn, this should provide assurance to investors to stay bullish.

Bonds have been a great investment over the past decade, for all the wrong reasons...

For most individual investors, bonds have traditionally been a way to invest with lower risk and a more guaranteed income – diversifying against the volatility of an equity portfolio. They yield a set interest rate for a predetermined length of time, before the principal is returned to the investor.

In the U.S., the bond market currently stands at roughly $40 trillion in value, slightly more than the market cap of U.S.-listed firms of around $35 trillion. Over the past 10 years, the yields on bonds have remained relatively low, due to the Fed slashing rates after the Great Recession. Income has been limited.

Low and declining interest rates have led to an oddity for bond investors in the form of investment income usually reserved for equity investors: capital appreciation.

As rates have continued to fall, bonds have gone up in price. This is because bonds that pay out a fixed rate are worth more as investors looking for an investment at the same risk must now accept a lower interest rate.

However, some investors are worried about how secure the future of bonds really is. Bob Prince, a chief investment officer at asset-management firm Bridgewater Associates, is concerned about the typical investment strategy for individual investors. Earlier this month, in a Bloomberg interview, Prince explained how the low interest rate environment has created bond market risk that can even spill out into equity markets. 

Prince detailed how with rates near zero, the economy has little room to enact further policy to control rates. That means limited room for bond yields to fall further... And that means limited room for further capital appreciation for bonds just because overall yields are falling. 

Additionally, if we see any resurgence in inflation due to monetary policy actions in 2020 after the pandemic recedes, bond prices will fall dramatically. This is because to slow inflation, the Fed will raise rates – ending the 10-year sprint (in a 40-year marathon) of capital appreciation for bonds.

Prince spoke directly to the risk for investors with a typical "60-40" portfolio, or a portfolio with a 60% allocation to stocks and 40% to bonds. This is why bond selection will become more important in the next year as investors look to properly hedge risk. 

Prince's discussion with Bloomberg was top of mind to us considering the level of interest we heard from Daily Authority readers requesting more topics about bonds going forward. We'll be covering bonds a few times a month, starting this week... stay tuned.

Regards,

Rob Spivey
August 24, 2020