Switching Drivers Mid-U-Turn

February 6, 2018

A leadership change at the Fed

  • An era of academic leadership has ended at the Federal Reserve with the recently concluded tenure of Janet Yellen as the chair of the Board of Governors.
  • Newly appointed Chair Jerome Powell is the first non-academic to hold the position since 2006 and the first non-economist since 1981 - but is expected to be a source of continuity and stability. 
  • We've anticipated the Fed's gradual police normalization, and our strategies have been positioned accordingly.

 

An era of academic leadership has ended at the Federal Reserve (Fed) with the recently concluded tenure of Janet Yellen as the central bank’s chair. In retrospect, the dawn of this period—with Ben Bernanke taking the helm in 2006—came just in time for the onset of the global financial crisis. Under Bernanke, the central bank implemented unprecedented monetary policy actions that helped the financial system and, by extension, the economy, recover from its damage. Under Yellen, Fed policy began to steer back toward normalization.

Today, as newly appointed Chair Jerome Powell settles into the driver’s seat, the central bank remains in the midst of policy-reversal. The first nonacademic to hold the position since in 2006 and the first non-economist since 1981, Powell is nevertheless expected to be a source of continuity and stability.

Looking in the Rearview Mirror

Yellen was elevated from vice chair to succeed Bernanke as chair in early 2014, the first woman to lead a major central bank. She was not only a distinguished academic (having taught economics at elite institutions around the world), she also had experience with driving monetary policy; Yellen served as a member of the Board of Directors for several years in the 1990s before assuming other leadership roles throughout the Fed.

We witnessed unquestionable continued improvement in the labor market on Yellen’s watch, as well as a firming economic expansion and generally hospitable conditions in financial markets. This means that, when it comes to setting monetary policy, at least part of the Fed’s dual mandate was achieved: maximum sustainable employment. However, it’s difficult to assert that the central bank under Yellen met its other mandate: achieving price stability. Exhibit 1  shows developments on the dual mandate going back to the early days of Bernanke’s tenure.

Exhibit 1: Mild Price Pressures Preclude Progress

graph of dual mandate

Sources: U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics, and Federal Reserve Bank of St. Louis

We can see the Fed’s progress toward achieving its dual mandate more clearly in Exhibit 2, which depicts each measure on its own axis of a scatter plot labelled by date and a mandate “bullseye.” A quick look indicates that Yellen’s tenure can be summarized as a circling of the bullseye, with a nearperfect plot in late 2016, but consistently undershooting the Fed’s inflation target.

Exhibit 2: Like Throwing Darts, But Harder

bullseye scattter plot

SOURCES: U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics, and Federal Reserve Banks of St. Louis and Chicago

At Yellen’s final press conference, when asked what was left undone under her watch, she agreed that the Fed missed its price target and expressed concern about the prospect of lasting, systemically low inflation. Restrained price pressures have been attributed to everything from the oil-price collapse that began in mid-2014, to several one-time transitory factors (like, for example, broad-based reductions in cell-phone bills), the effects of an aging population on labor-force participation, and the failure of wages to accelerate despite an improving labor market. This last point—that the labor market is recovering—may well hold the key to unchaining higher inflation, as a low unemployment rate is generally expected to eventually put upward pressure on prices.

While we expect Powell to continue on the normalization path set during the Yellen era, we recognize that the composition of the Board of Governors is expected to change and may present speed bumps in the plan.

Unemployment in December 2017 dropped to 4.1%—the lowest rate in seven years and far below the 5.8% average since 1948 (when such numbers were first recorded). This also marked the most improved unemployment rate ever documented—dropping by nearly 40% in the four years ending December 2017.

As these historically strong unemployment figures were being recorded, Yellen oversaw the inaugural steps toward removing monetary policy accommodation: the Fed began a rate-hiking cycle in late 2016 (notwithstanding a solo hike in late 2015). The near-perfect plot in December 2016 provides a good rationale for setting out on the path toward policy normalization, and the continued strength in the labor market, alongside sustained economic growth (both domestically and around the globe), may solve the conundrum of persistent low inflation.

The reaction of financial markets to Fed policy announcements generally serves as a strong indicator of the central bank’s forbearance and communicative ability. By this measure, Yellen improved on her predecessor’s shift toward greater openness. Under her leadership, there were no taper-style tantrums like those witnessed in 2013—even with the Fed’s five rate hikes following nine years of near-zero interest-rate policy and the first steps toward reducing its $4.5 trillion balance sheet of Treasurys and mortgage-backed securities (MBS), which had been accumulated through bond-buying programs implemented to help boost economic growth amid the global financial crisis.

Yellen’s peers generally agreed with the markets, with 60% of economists surveyed by The Wall Street Journal giving her an A grade versus only 34% for Bernanke.1

Turning the Corner

The Fed, in the middle of navigating its monetary-policy U-turn, switched drivers in early 2017 with the confirmation of Jerome “Jay” Powell as the sixteenth Fed chair. While Powell is the first non-economist chair since 1981, he—like Yellen—faces a chairmanship with no precedent, including balance-sheet reduction and a new normalized fed funds rate.

Powell’s background departs from the academic-government sphere of his two immediate predecessors; however, he shared more than five years of cooperation with Yellen on the Federal Reserve Board of Governors, for which he began this tenure under Bernanke in 2012. He is widely expected to be a source of continuity and, therefore, stability for the economic policymaking body.

Powell’s career began in private-practice law and investment banking, followed by senior roles at the Department of the Treasury during the George H.W. Bush administration, after which he returned to banking and private equity with a focus on the industrials sector. His private-sector experience is evident in the transcripts chronicling the debate and decision making of the Federal Open Market Committee, which depict his role as a conduit for the private-sector and investor perspective.2

The transcripts also reveal Powell’s acute sensitivity to the communication and perception challenges that face the Fed; this should ease concerns about whether he is likely to trigger negative unintended consequences in financial markets.

Destination Normalization

While we expect Powell to continue on the normalization path set during the Yellen era, we recognize that the composition of the Board of Governors is expected to change and may present speed bumps in the plan.

We have been anticipating the Fed’s gradual policy normalization, given the clarity with which the central bank has pursued this course, and we suspect it will continue to move cautiously in that direction. The fed funds rate is expected to move steadily higher, and the Fed’s balance sheet is expected to shrink (barring any unforeseen near-term recessions).

This policy path has pushed short-term rates higher at a time when middling economic growth has kept long-term rates low. We have capitalized on this dynamic over the last several years, positioning our fixed-income strategies to favor a flatter yield curve (that is, a shrinking difference between short and long-term rates). Exhibit 3 sets the fed funds rate against the spread between 2- and 30-year

U.S. Treasury rates. A declining spread means the difference between the two rates has fallen, and therefore indicates a flatter yield curve.

Exhibit 3: Term Spread Falls as Fed Funds Rate Rises

Term spread falls as fed funds rate rises

Within our short-term fixed-income strategies, we shortened duration in those strategies by (in part) increasing allocations to floating-rate notes. Elsewhere, we positioned for a balance-sheet unwind by underweighting mortgage-backed securities (MBS). When the Fed accumulated 29% of outstanding MBS as a non-economic, price-insensitive buyer (through its bond-buying program), this had the effect of narrowing spreads in the MBS market. Now that Fed is stepping back slowly from this market, we expect gradual spread-widening—and have therefore positioned our strategies in an effort to take advantage of relative value opportunities within MBS.

1 “Economists Give High Marks to Departing Fed Chairwoman Janet Yellen.” The Wall Street Journal, December 12, 2017.

2 Federal Open Market Committee Meeting Transcript, pages 119-120. September 12, 2012.

Legal Note

Glossary
Duration: Duration is a measure of a security’s price sensitivity to changes in interest rates. Specifically, duration
measures the potential change in value of a bond that would result from a 1% change in interest rates. The shorter the
duration of a bond, the less its price will potentially change as interest rates go up or down; conversely, the longer the
duration of a bond, the more its price will potentially change.

Floating-Rate Note: A floating-rate note is a debt instrument with a variable interest rate. Interest adjustments are made
periodically and are tied to a money-market index such as Treasury bill rates.

Mortgage-Backed Securities (MBS): Mortgage-backed securities are pools of mortgage loans packaged together and
sold to the public. They are usually structured in tranches that vary by risk and expected return.

Important Information
This material represents an assessment of the market environment at a specific point in time and is not intended to be
a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as
research or investment advice and is intended for educational purposes only.

There are risks involved with investing, including loss of principal. Bonds and bond funds will decrease in value as
interest rates rise. Mortgage-backed securities are affected by, among other things, interest rate changes and the
possibility of prepayment of the underlying mortgage loans. Mortgage backed securities are also subject to the risk that
underlying borrowers will be unable to meet their obligations.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments
Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor.