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Can’t Hardly W(AIT): The Fed’s New Inflation Target

September 2020 

The Federal Reserve now seeks to achieve inflation that “averages 2% over time,” effectively allowing inflation to run above 2% to make up for periods when it’s below 2%.

Insight from our sub-adviser, Schroders
Jonathan Mackay
Head of Sales, Wealth Management Solutions
Lisa Hornby
Portfolio Manager, Hartford Schroders Tax-Aware Bond Fund



Recently, Jerome Powell was the headline presenter at the US Federal Reserve’s (Fed) annual Jackson Hole Economic Policy Symposium. He unveiled the Fed’s new framework of Average Inflation Targeting (AIT). The Fed now “seeks to achieve inflation that averages 2% over time,” effectively allowing inflation to run above 2% (for how long and how high remains unclear) to make up for periods in which inflation is below 2%. This change was anticipated by the markets and we are seeing a bear steepening move in the yield curve, as well as a rise in inflation breakevens given the move in longer maturity nominal yields1 over the last month. Higher long-end rates is something that we believe most markets are not priced for, but the odds of a further steepening of the yield curve due to a continued rise in long rates seem quite high.

We believe a combination of the following four factors may result in a structural steepening bias in the yield curve: 1) record Treasury issuance (that could be more skewed to the long end); 2) a demand gap between the supply coming and the investor base (the Fed can’t buy it all); 3) the Fed’s new policy of inflation targeting (which means they won’t raise rates in anticipation of inflation but will wait until it happens), and 4) the fact that the Fed will not implement yield-curve2 control except as a last resort.

Whether we ultimately get above 2% inflation remains to be seen. But, at the very least, we think we are in the early stages of a new cycle, and a rise in long-end rates is normal at the start of a new cycle. The 10-year Treasury has averaged a yield of about 2.2% for the past 10 years. Therefore, just getting back to average would be a massive move given where we are today (the 10-year is about 0.75%) and could wreak havoc on portfolios that are overweight long duration3 both on the fixed-income and equity side.

So how will this impact investors? Obviously, rising rates could be a headwind for traditional fixed income, especially long duration, and we think benchmark-hugging managers may also suffer.

To manage changing environments, the Hartford Tax-Aware Bond Fund seeks to shift between sectors, depending on market conditions, and adjust duration to manage interest-rate risk. When we see opportunities, we will allocate to other sectors. This opportunistic approach allows us to be flexible in responding to changing market conditions and valuations across sectors. We manage interest-rate risk through an approach that seeks to account for a rising-rate environment using our 1- and 3-year “stress test” scenarios. In essence, we look for value opportunities across fixed-income sectors (taxable and tax-exempt munis, credit, securitized, and Treasuries) with yields that can help potentially offset any steady rise in rates (which would hurt bond prices). We have maintained sufficient “dry powder” for months, so we are comfortable with our positioning. Finally, short-duration (or select floating-rate) strategies can also serve as a defensive bond allocation in such an environment.

Rising inflation may also impact equities as it could lead to a weaker dollar, and, therefore, we think international stocks may generally benefit from this trend. Rising rates could also be a tailwind for bank and financial stocks. Also, we think high multiple growth stocks and defensive equities could be hurt the most.

 

Performance (%)
% (as of 9/30/2020)
Average Annual Total Returns % (as of 9/30/2020)
YTD 1YR 3YR 5YR 10YR SI
Hartford Schroders Tax-Aware Bond  I 4.68 5.16 4.42 4.20 --- 5.03
BENCHMARK 3.33 4.09 4.28 3.84 --- ---
Morningstar Intermediate Core Bond Category 6.50 6.66 4.88 3.94 --- ---
Performance (%)
% (as of 9/30/2020)
Average Annual Total Returns % (as of 9/30/2020)
YTD 1YR 3YR 5YR 10YR SI
Hartford Schroders Tax-Aware Bond  I 4.68 5.16 4.42 4.20 --- 5.03
BENCHMARK 3.33 4.09 4.28 3.84 --- ---
Morningstar Intermediate Core Bond Category 6.50 6.66 4.88 3.94 --- ---
SI = Since Inception. Fund Inception: 10/03/2011
Operating Expenses:   Net 0.49% |  Gross  0.61%
Performance prior to 10/24/16 for Class I-shares reflects the performance, fees, and expenses of the Investor Class of the predecessor fund Schroder Broad Tax-Aware Value Bond Fund. If Class I fees and expenses were reflected, performance would have differed. SI performance is calculated from 10/03/11.

Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted.

You can access additional fixed-income insights by visiting Market Perspectives



1 Nominal yields are the fixed interest rates (coupon) a bond issuer agrees to pay the bond purchaser.

2 The yield curve is a plotted line showing the interest rates (yields) of bonds of the same credit quality but different maturity dates. 

3 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement. 

Important Risks: Investing involves risk, including the possible loss of principal. Security prices fluctuate in value depending on general market and economic conditions and the prospects of individual companies. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Mortgage-related and asset-backed securities’ risks include credit, interest-rate, prepayment, and extension risk. • The purchase of securities in the To-Be-Announced (TBA) market can result in additional price and counterparty risk. • Obligations of U.S. Government agencies are supported by varying degrees of credit but are generally not backed by the full faith and credit of the U.S. Government. • Municipal securities may be adversely impacted by state/local, political, economic, or market conditions; these risks may be magnified if the Fund focuses its assets in municipal securities of issuers in a few select states. Investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable. • Derivatives are generally more volatile and sensitive to changes in market or economic conditions than other securities; their risks include currency, leverage, liquidity, index, pricing, and counterparty risk. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments. • The Fund may have high portfolio turnover, which could increase its transaction costs and an investor’s tax liability.

The views expressed herein are those of Schroders Investment Management (Schroders), are for informational purposes only, and are subject to change based on prevailing market, economic, and otherconditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Schroders or Hartford Funds.

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