The recent market rally that took place, after the minutes from the Fed’s last FOMC meeting were published, was kind of a relief rally because most participants had expected the hawks to get their message out, like it happened on earlier occasions, said Scott Mather, deputy chief investment officer at Pacific Investment Management Co.
What the markets saw instead was a more dovish tone from the FOMC members. The FOMC was so worried about the market’s possible interpretation of their stand and moves about the so-called “quantitative forward guidance” or “fuzzy/qualitative guidance” that they held a special pre-meeting ahead of the normal meeting so that they could talk about how they can make a nuanced change about this new world of fuzzy guidance, he added.
Asked if the Fed’s observation “rate-hike expectations were overstated” means re-calibration of timing in fixed-income investments, Scott said PIMCO believed the Fed is likely to wait longer before it starts to make moves on rates and once they do, they will go very slow. That’ what the leadership and the Fed has said for quite some time while the markets, at times, chose not to believe that.
However, what stands out from the minutes is that the Fed’s focus is on inflation, and they are very focused on wage inflation. In a modern developed economy like the US, the only way to get a very destructive round of inflation is when the economy starts to get high wage inflation.
Although the US market is improving, all the indicators the Fed looks at are not flashing any red signals. PIMCO believes wage inflation is the right indicator to monitor and doesn’t think there’s any upward pressure on wages in the near-term.
Markets are likely to remain volatile as they interpret the employment data, looking for lead indications of what might be a good indicator to lead to wage inflation. The Fed is probably trying to say that they really don’t know what the right indicator is and part of reason why they are trying to keep the so-called “quantitative guidance” behind because they tried it on numerous occasions in the last few years and each time they had to give up on it.
So, basically the Fed is going into a framework where they want to control expectations at the front-end of the curve, but realize they won’t be controlling the 10-year and 30-year rates as much as they were before. The direct portfolio expectations for investors are that they can anticipate the Fed to keep front-end rates well anchored; that’s the safe-place to invest.
But as they withdraw from quantitative easing and cut down the amount of bonds they are buying each month, the Fed will have less and less control over 30-year rates, which PIMCO thinks are probably at the lower end of the range, he explained.
Asked if that means higher volatility for fixed-income securities, which in turn could translate into better performance for fixed income markets, Scott said the fixed-income market is through a good-portion of the normalization process in interest rates. They probably have further to rise, but the markets have got some of them embedded in price going forward. So the big adjustment in rates is probably behind the markets.
From now forward, there won’t be many big movements that markets witnessed last year, and there’s going to be more volatility within a range. To navigate in such an environment, it’s important to realize that the markets are not going to break-out in a meaningful way and investors should size investment positions that relies on flexibility and allows moving around; sometimes be defensive and sometimes going back on the offensive, he observed.
Asked to comment on Greece’s recent success in selling five-year government bonds, Scott said PIMCO is cautious about Greek assets in general because the last time they issued 5-year bonds in 2010 things really went out of control. That doesn’t mean it will happen in the near-term, but investors need to ask themselves if they have more debt relative to GDP now or then, and the answer is now. So PIMCO is sort of suspicious about Greece’s ability to outgrow the debt problem. In the long-term, investors should be concerned about their ability to reduce the levels of debt, he concluded.
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