Death of a Salesman

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In the current market construct, there are some questions often on top of mind for fixed income investors:

How far can interest rates and consequently bond yields go?
Is this the right time to invest, given the meaningful correction in the last six months, or should one wait for better opportunities?

Answering these questions would likely involve evaluating the follow-up near-term drivers of rates: 1) Are we looking at a soft landing or an outright recession, which would make central banks reverse course or at least slowdown in their paths? 2) How serious are central banks about quelling inflationary expectations even at the cost of growth? While the concerns are well founded, sometimes quibbling over near-term drivers, in other words, trying to catch the bottom can lead to suboptimal investment outcomes.

To put it mildly, the last six months have been turbulent for fixed income investors. Bond yields across geographies have moved up substantially. The Bloomberg US treasury index has delivered its worst half-yearly return since its inception in 1973. The world, beset by the pandemic and supply chain disruptions since 2020, was further impacted by the escalation of geopolitical conflict between Russia and Ukraine this year.

This led to heightened volatility in financial markets and surges in commodities prices across energy, metals, food and fertilizers, thereby increasing risks to global growth, inflation and macro stability. One of the reasons for the bond market’s turbulence has been the rapidly shifting interpretation on the nature of inflation by various central banks.

Like the four stages of grief in the world of psychology, interpretation of inflation by global central banks has also happened largely in the form of the following four stages:

Denial: Inflation is transitory
Anxiety: Inflation is due to exogenous shocks and likely to dissipate after supply chain normalization
Bargaining: Exogenous supply side shocks are outside central banking scope
Acceptance: Inflation is here to stay longer and is probably driven by supply side shocks. However, one needs to act decisively to anchor inflationary expectations

The table below illustrates some of the policy shifts undertaken by the advanced economy central banks in the last 12 months:

Date	Central bank commentary

	US Federal Reserve (Fed)
28/Apr/2021	Inflation has risen, largely reflecting transitory factors¹
30/Nov/2021	“it’s probably a good time to retire” the word “transitory” to describe inflation”²
16/Mar/2022	The probability of a recession within the next year is not particularly elevated”³
22/Jun/2022	"It's certainly a possibility, "…"It's not our intended outcome at all but it's certainly a possibility.": Jerome Powell, Chair of the Federal Reserve of the United States, on recession⁴

	European Central Bank (ECB)
03/Nov/2021	ECB “very unlikely” to raise rates in 2022: Christine Lagarde, President of the European Central Bank⁵
09/Jun/2022	European Central Bank confirms July rate hike plans, raises inflation projections significantly⁶

	Reserve Bank of Australia (RBA)
16/Nov/2021	It’s ‘still plausible’ first rate rise won’t be before 2024: RBA Governor Philip Lowe⁷
07/Jun/2022	RBA announced the biggest single hike in the cash rate in 22 years by 50bps. “The resilience of the economy and the higher inflation mean that this extraordinary support is no longer needed,” RBA Governor Philip Lowe⁸

The rapidly changing policy stance of various central banks have led a large section of market participants to declare “the death of forward guidance” or the loss of credibility of central bank communication. However, the objective of the above table is not to critique the monetary authorities in these extraordinary times, but to highlight the challenges facing the investment world. It’s understandable that investors would want to reduce at least one source of unpredictability, i.e., the path of interest rates, with a certain amount of clarity and transparency.

Nevertheless, it will be helpful to understand that extensive central bank communication is a recent phenomenon. including post-rate decision news conferences, and the most potent tool used by central banks in recent history – “forward guidance” or the communication about the likely future course of monetary policy. Post the global financial crisis, when many of the advanced economies were plagued by policy rates close to their effective lower bounds, central banks have often turned to forward guidance — as an alternative means to stimulate financial conditions.

In theory, there can be two types of guidance. The first, often described by economists as “Delphic (predictive)” or “state contingent”, is a form of guidance that seeks to convey the probable state of monetary policy in the future, based on fulfilment of certain conditions.

For example, post the global financial crisis in 2008, the Federal Reserve signalled the likelihood of a long period of low interest: "Weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time” (Source: Federal Reserve, https://bit.ly/3R71R4Q ). Hence, the forward guidance was contingent on “weak economic conditions” and were subject to reversal if there was a significant change in economic conditions.

The other form of guidance, called “Odyssean”, promises a certain path irrespective of how things turn out.

For example, in its December 2020 monetary policy, the RBI reinforced its forward guidance by supplementing state-contingent forward guidance with time-contingent guidance by stating its intent to continue “with the accommodative stance of monetary policy as long as necessary – at least during the current financial year and into the next year …”(Source: RBI, https://bit.ly/3yeQWO3 )This can be construed as an Odyssean promise as it was not largely conditional on any economic outcome.

Although sometimes a conditional guidance can be construed as a commitment based “Odyssean” guidance, central banks tend to use it rarely. This may be because, in practice, it’s quite difficult to make credible commitments of this sort, as central banks sometimes have no choice but to change their policy paths if economic conditions change.

The central banks and bond investors had a successful run for a large period post the GFC till the Pandemic as inflation remained largely stable and central banks’ state-based guidance was largely maintained.

While some commentary in the recent past, as highlighted in the tables above, might almost fall into the Odyssean category, as they had the element of time involved, they were indeed “Delphic”, as the monetary policy stance was conditional upon a certain growth/inflation dynamic, which turned upside down due to the geopolitical conflict between Russia and Ukraine.

Conclusion

“Sometimes it's easier to understand things than it is to figure them out”.

- Casey Stengel, American Major League Baseball Player and Manager

Forward guidance by central banks is largely aimed at providing greater clarity on the reaction function and the assessment of future economic conditions. It is crucial to distinguish between an intended pledge by the central bank and a perceived commitment by the market. Neither does the commitment preclude the policymakers from being oblivious to the economy. A central bank is likely to be “data-dependent” in its objective of macro stability. Hence, it doesn’t mean that forward guidance is dead. Just like central banks had to reverse course in the last six months due to inflationary pressures, they are very much within their realm to forge a different path today, based upon evolving growth/inflation trade-offs, which are currently in favour of anchoring inflation expectations.

As always, there could be data surprises in the pipeline on either side. Also, the ensuing volatility that lies before market participants and central banks may conclude the nature of the economic cycle that we are in.

As investors, we have the luxury of ignoring all the noise and leave the nuances to central banks and economists. We can stick to an asset allocation framework and assess the risk-reward on the balance of probability framework by evaluating the depth of policy normalization already priced in on the yield curve. We can choose to follow a staggered approach towards our fixed income allocation, based on our risk appetite.

A systematic approach towards dividing our allocation between our liquidity needs, goals and time objectives, which may include moderate duration/roll down/actively managed long-duration strategies, can help in broadly achieving our financial goals without us having to worry about the next change of stance.

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