Mon, 15 Apr 2013
Although the Fed is likely to keep policy very loose through the end of the year, the unprecedented nature of the intervention means we can't tell what the disruption to financial markets will be when the Fed pulls back, says Western Asset's Steve Walsh.
Glaser: Let's take a closer look at the Fed; that seems to be a big driver of the market right now. Will they be able to gracefully exit from their extremely accommodative policy right now, or is this going to be a bumpy road?
Walsh: Jeremy, that's the $64 question. Again, you see what's going on around the world and the recent announcement in Japan. To a certain degree what's going on in the United States is an extraordinary monetary experiment, and experiments can end OK and they can end more troubling.
We can't, you and I, can't sit down and say, OK, Steve, let's analyze the four or five historical incidents when central banks did a similar thing. This is fairly unprecedented. Actually what is absolutely unprecedented is the Central Bank having to back away from this. It's really just the Bank of Japan that has ever, even pre this recent announcement, has had such extraordinarily aggressive monetary policy. They haven't had to back away yet, because they've been in the soup for almost two decades.
So I think you'd find Western Asset a little bit more in the "bumpy road" camp. Obviously, that's maybe a little bit of a higher probability outcome for us, and importantly, I think investors ought to try to think through what a bumpy road it might look like when we ultimately ever--and I think we all hope that one day the Fed has to back away from these policies. But they are such a big part of the marketplace, and I don't think anyone who follows financial markets, stocks, bonds or otherwise, can look at the last three or four years and say, wow, markets [haven't] been really impacted by the low interest rates, i.e., zero, and by the $3 trillion or $4 trillion Central Bank balance sheet, and the $85 billion a month that we're currently buying. Most people would probably say, well, gosh, that's probably kept rates a little lower than they would otherwise be, and it's probably--again, got investors to invest in other fixed income sectors, which has brought down spreads.
I think the Fed would believe that they have contributed to lowering spreads across risk assets within fixed income, have probably supported stocks, that's what they want to do. They want to support stocks, so we all feel a little wealthier and go spend money, and they've lowered Treasury rates.
Well, if that's right, if we all kind of embrace those outcomes or those conclusions to what Central Bank policy has brought markets over the last three or four years, what will the reverse do? What will happen when they stop?
If something facilitates lower interest rates when it's being done and then you stop doing it, does that mean interest rates need to go up? If the Fed ever slows down its purchase activity, suspends it or reverses it, is it likely to have the opposite impact on markets, that is, Treasury rates higher? Yes, that would seem to make some sense.
But what might it do for spreads and how will volatility play a role in this process when all of a sudden investors don't have the liquidity spigot being provided by the Central Bank? So a lot of uncertainty as to what the Fed backing away from this will do for market functioning and financial stability and economic activity.
But again, I didn't give you the answer there, except to say we favor a little bit more of the possibility that this is a little more troubling than the Fed thinks. The Fed has said, hey guys, we've got the tools; we can do this. And that's what you want them to say, and you want them to believe, and they do have models. But given the unprecedented nature of this, and given the size of the intervention that the Federal Reserve has undergone, I think one has to be concerned about the functioning of financial markets and potential disruptions to financial stability, and what that means for economies. And it could go OK, but we'd favor a little bit more of a bumpy road.
The other aspect here Jeremy is that it's not supposed to happen right now, right? I mean this is supposed to be--and the Fed has painstakingly said--we're going to stick with this for a while. They've really tried through their communication strategy to communicate that. You know what, this is going to be here a while. We're probably not going to move interest rates until the middle of '15, or we're not going to move interest rates until unemployment gets to 6.5%. And you've heard Bernanke recently say, you know what, maybe we won't need to sell securities; maybe we will raise rates, but hold onto our securities.
That is a Central Bank that again is trying to make the market feel a little bit better that we're not going to wake up one day with the Fed raising interest rates and selling lots and lots of securities into a marketplace that probably can't handle it. So great question. I didn't give you an answer, favor a little bit more the possibility of a bumpy road. Likely to be more and more discussed as we get through the end of '13 and into early next year, and again, bears watching by all investors.
Glaser: So how do you position your portfolio then if you're worried about this exit potentially being a fairly volatile event? Is that something you're worried about now or that you'll focus on in a few years when we get closer to that tightening?
Walsh: Well, one of the reasons in our portfolios generally that we have been dialing back risk, we have been reducing the amount of some of our spread sector overweights. We've reduced high-yield; we've reduced some of our senior financial bank overweight, … which we did toward … in the fourth quarter of last year--part of that is a growing belief that spreads in the marketplace today might not be paying you for the risks that exist in the marketplace.
Now there's a lot of risk. There is risk with Europe. There are risks with all these things. But specifically, certainly, one of the reasons to dial back risk is a recognition that at some point in time, the extraordinary monetary accommodation is likely to be pulled back, tapered is the good word to use today, and eventually released, and not believing that markets are as concerned as they probably should be about the possibility of volatility.
Now, you noticed I said we're dialing back risk. If it was a clear-and-present danger tomorrow, we'd get out of risk. But you factor in the concept, Jeremy, that we don't think this is likely to be a summer of 2013 issue, because the Fed has been pretty explicit that we're going to go with this for a while, that from our perspective, strategically, it's don't abandon these sectors, don't get every assets out of high-yield today, don't sell every senior bank debt you own or go to underweights to these risk categories, but begin to dial them back.
And [there are] a number of reasons that contribute to that conclusion. But one of them is believing the markets might not fully appreciate the sort of volatility that might come when this does get reversed. So that's how we respond.
On interest rates, we have tended to be under duration to our benchmarks. So if a traditional core mandate has a benchmark duration of five years, we've been running short of that to anywhere from 4.25 to 4.5. Rates haven't moved, so that obviously hasn't meaningfully added to performance to-date, because rates are still hanging out at pretty low levels, but our bias would be to favor having less interest rate exposure given the possibility for higher rates, and secondly to dial back the spread overweights that we've had since coming out of the crisis.