nce I rose above the noise and confusion
Just to get a glimpse beyond this illusion
I was soaring ever higher, but I flew too high.”
‒ Kansas, “Carry on Wayward Son”
As we begin 2014, investors are realizing that they’re “not in Kansas anymore.” In fact, they may wonder where they are at all: More than five years of central bank activism, including rounds of quantitative easing (QE), leave them in uncharted territory. Investors are searching for alternatives that balance risk-taking and liquidity management and offer the potential for positive returns, as they contemplate the myriad issues facing the markets. Short-term bond strategies could very well provide this balance in today’s uncertain world.
While left tail risks – the likelihood of extreme negative events – have significantly diminished, individual and institutional investors alike are left to contemplate the new topography for investing in light of the Federal Reserve’s plan to taper its asset purchases throughout 2014. As central banks globally continue to weigh the benefits of continued QE stimulus in light of better, but not ideal, growth prospects, markets will likely be more volatile as they digest economic data to assess the strength of global growth. Risk-oriented investors can hope that they avoid any noise and confusion in the months ahead and don’t fly too high, like the “wayward son” of Kansas’ iconic rock anthem.
Remembering the dust bowl
Many investors are now expecting the trend toward higher interest rates to continue for some time and are shifting to short and low duration strategies or cash-equivalent ETF alternatives. While the ultimate timing of rate increases is certainly debatable, investors may feel as if they’ve moved from the magic of Oz – complete with the Wizard (the Fed) pulling the levers behind the curtains – to a barren Kansas landscape. Indeed, the landscape may seem like that of the dust bowl era when a combination of weather patterns in the Great Plains and the settlers’ lack of regard for their landscape combined to create severe living conditions. In the early 1930s, dust bowl settlers hoped year after year for better weather to change their luck. But hope didn’t provide them with relief from the dry, harsh conditions outside.
This is a great history lesson for current market participants. While fixed income investors hope for the best, they may find themselves at times in an investment dust bowl, looking for refuge from the howling winds of volatility and searching for the last remnants of easy capital appreciation before the sustaining rains of QE stimulus gradually fade away. While the economy appears to be on the mend, the rate and healing process toward optimal growth will be one of inconsistency and uncertainty.
Over the course of the next year, we believe all eyes should be on the short end of the yield curve. Central banks, including the Fed, will do their best to administer a soothing remedy for any unforeseen fluctuations in interest rates, in the form of more concrete forward guidance and possibly by using other tools at their disposal.
Importantly, the Federal Reserve’s recent “testing” proved that its fixed-rate repurchase agreement facility can be a successful tool in managing interest rates. Specifically, these tests have provided a viable floor for interest rates, something that the Fed will likely acknowledge at FOMC meetings during the first quarter of this year by eventually moving beyond the “testing phase” and increasing the size and scope of counterparties approved to utilize the facility.
While Fed officials have been discerning to point out that it is not being used to conduct monetary policy, the repo facility could be quickly recast as an effective tool should a tightening in credit be warranted. On the other hand, it could also be used to protect money market investors by providing a (zero) floor for short-term interest rates should the Fed foresee growth weakening to the point that additional stimulus, such as a cut in interest on excess reserves (IOER), is warranted. In either case, this tool could become the de facto new reference rate for short-term interest rate markets in the years to come.
As investors remain leery of a potential recalibration in interest rates upward, finding safety on the short end of the yield curve will become a definitive theme in 2014. Traditional money market funds have been viewed as the safe haven over the past 40 years, but ongoing concerns regarding their structural integrity have led to regulatory reforms for Rule 2a-7 money market funds; these will be detailed during 2014. While these proposed safeguards should help avoid runs on money market funds, as seen in 2008, there are two issues money market investors will continue to face over the next year: near 0% net returns and the possibility that the serious dearth of supply of investable assets could lead to fewer money market mutual fund options open to new money-fund clients.
Where to lay your weary head to rest
In our view, 2014 will be a year of gradual transformation. Although global liquidity remains ample, weary investors may have to deal with increased volatility: As central banks alter their stimulus arrangements, dealers and banks alike will continue to provide the market with less shock-absorption power due to their more stringent capital requirements.
Finding lower-risk assets that offer potential for positive returns would be an advantageous counterweight to any larger risk-oriented investment allocation strategy. But the challenge is not only finding those low-risk assets, but also managing them in a dynamically changing environment where credit preferences and liquidity conditions can change in the blink of an eye, as they have over the past five years. Interest rate expectations will likely continue to sway; currently, the market romances the idea of the Fed tightening as soon as late 2014. However, PIMCO believes that U.S. growth will improve but remain suboptimal, allowing the Federal Reserve’s forward guidance tactics to ultimately prevail.
While the road may not be as smooth as the one from Wichita to Topeka, in our view, front-end rates will remain on hold until early 2016. The key trend until then is that dust-bowl-like conditions should remain in the front end: Demand has markedly increased for low-risk, short-term assets while the dearth of supply continues. We believe even the upcoming issuance of the U.S. Treasury’s two-year floating-rate note will do little to alleviate the parched situation.
In this environment, active managers like PIMCO have a distinct advantage not only because they can seek to manage around interest rate volatility, but also because they can potentially source assets by identifying underappreciated sectors and utilizing their own analysts to review structure and relative value. While we might not be in Kansas anymore, by considering actively managed short-duration strategies, investors may find a way to rise above the noise and confusion that many “wayward sons” may find themselves in during the coming months.