- An aggressive new program of quantitative easing (QE) by the
Federal Reserve has validated our cornerstone belief that
central bank "money-printing" is far from over.
- It is our view that QE and the Fed's other easy-money policies are causing economic and market distortions in the here and now, but our real concern with these policies lies in the future. The economy and financial markets have become so dependent on QE and artificially low rates that it will be extremely difficult to reverse these policies without causing renewed recession or financial market dislocations.
- Additionally, the Fed has a well-established tendency not to recognize the effects of its loose monetary policy nor to tighten until it's far too late. They are especially skittish about tightening prematurely after the events of 2008 and 2009, having explicitly promised not to do so until well after the economy has strengthened.
- Between the extreme difficulty in reversing QE or raising rates without causing economic difficulties, and the Fed's tendency to act too late, we think there is very little chance that the Fed will unwind these policies in time. The likely consequences include higher inflation, a lower dollar, and potentially much higher interest rates. Any of those outcomes, to say nothing of all in combination, would have major implications for portfolio returns, so we feel it's crucial to be positioned for them.
- It's very difficult to predict when these consequences might come to pass, and it is downright impossible to know when the market will start to price them in. But considering our high confidence that they will happen, and the speed at which things can change in financial markets, we think it's wise to prepare for them even if their timing is unknown.
No Exit -- The Real Danger of the Fed's Easy-Money PoliciesLast month, the Federal Reserve announced a new program of "quantitative easing" (QE). The Fed will conjure up $40 billion each month and use that newly-created money to buy government debt securities. Unlike prior instances of QE, this one is open-ended -- the money creation will go on indefinitely until the labor market "improve[s] substantially." This move has validated our cornerstone belief that the Fed's money-printing was not over by a long shot.
We have a number of issues with QE and the Fed's easy-money policies in general. They distort market prices, encourage destabilizing financial speculation, and unfairly punish savers. But our far bigger concern lies in the future: the economy and financial markets have become so dependent on QE and artificially suppressed interest rates that it will be very difficult for the Fed to reverse these policies without major repercussions. So, they likely won't be reversed in time - resulting in a different but equally serious set of potential consequences.
Printed Into a Corner
There are various forces putting downward pressure on inflation -- the global economic slowdown, the Euro Area debt crisis, and the weak US labor market spring to mind. Those forces are being offset by the Fed's ultra-easy monetary policy, resulting in a positive but fairly low level of overall inflation.
But at least some of these disinflationary forces will subside eventually. At that point, the Fed's aggressively stimulative monetary policy will almost certainly begin to pressure inflation higher. The Fed has stated that should inflation start to rise, they will simply tighten policy by some combination of raising interest rates and reversing asset purchases.
For reasons we will outline below, we think there is very little chance that the Fed will tighten in a timely manner.
To raise the Fed Funds rate from its current level of roughly 0% to anywhere near historically normal levels would cause a huge increase in debt service payments -- obviously an issue in a heavily-indebted country like the US. Our federal debt provides a good example. As we are fond of pointing out, the US government is heavily indebted. But because the government pays an average of just 2.1% on its debt -- a result of the artificially low interest rates engineered by the Fed -- the interest payments are reasonable. However, if those rates were to rise, interest payments would become a serious problem. For instance, if the average rate the federal government paid on its debt rose to a more historically normal 5% (this was about the average rate paid over the past decade), interest payments would take up a full 22% of all tax revenues. 1 This fact alone could have a huge negative impact on economic confidence, to say nothing of the effects of rising debt service burdens throughout the economy. And that's just a return to an average rate - higher than normal rates could be catastrophic.
Reversing years of asset accumulation via QE is also quite a bit easier said than done. The Fed has become a major player in the market for government debt instruments (Treasuries and agency mortgage-backed securities), having accumulated vast sums of them since the financial crisis began. For example, the Fed now owns 37% of all Treasuries with a duration of 5 years or greater.2, 3 If the Fed were to start to reverse the years of QE, that would not only remove a huge source of artificial demand for government debt -- it would also substantially increase supply as the Fed tried to sell its enormous stockpile of bonds. This would likely push up rates, possibly by a lot, especially if we were already in a rising-inflation environment (as we would probably be if the Fed felt compelled to finally tighten). That kind of rate increase would exacerbate the debt service issue described in the prior paragraph as well as harming the housing market as the artificial downward pressure on mortgage rates was reversed. And such a dramatic change in the supply and demand for government debt could be very dangerous considering the extreme complacency and overvaluation in the Treasury market.
(For a discussion of how the relatively new Fed tool of paying Interest on Excess Reserves fits into an “Exit,” please see this followup article.)
By creating a situation in which the economy and markets are addicted to ultra-low rates and an artificially high demand for financial assets, the Fed appears to have trapped itself. There is "No Exit." A substantive reversal of current policies would have the potential to cause renewed recession or major market dislocations -- something the Fed desperately wants to avoid
Always a Step Behind
Even if the Fed could react as quickly as they maintain, it's unlikely that they would. The members of the Federal Reserve have demonstrated a strong tendency to act too late and to be oblivious to problems until they've already blown up. They appeared entirely ignorant of the biggest stock bubble in US history, a speculative mania that their own overly-permissive monetary policies in the late 1990s helped to spawn. As they slashed rates and flooded the economy with money in the aftermath of that bubble's crash, they were equally oblivious that they were helping to create the biggest housing bubble in US history. The Fed had its target rate at a then-all-time-low 1% as late as 2004, when the housing bubble was already raging here in San Diego. Fed Chairman Ben Bernanke denied that there was a housing bubble at all even as that absolutely unprecedented bubble was at its very peak in 2005.
The pattern is clear: the Fed doesn't recognize the effects of its ultra-easy monetary policy, nor does it tighten that policy, until it's far too late. We don't expect this time to be different.
If anything, they are even less likely to act in a timely manner. After the traumatic financial events of recent years, the Fed members are terrified to reverse policy too early (something they have strongly criticized other central banks for doing). In their most recent meeting minutes, they even came out and said that they would be in no hurry to tighten, saying, "a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens."4
Given the Fed's history of acting too late, and the fact that reversing current policy could cause major economic and financial problems, we think it's unlikely that they will do so in time to stem the consequences of their aggressive monetary policies.
No one knows exactly what those consequences will be, but the obvious candidates are some combination of higher inflation, a lower dollar, and higher (potentially much higher) bond yields. Any of those outcomes, to say nothing of all in combination, would have major implications for portfolio returns, so it's crucial to be positioned for them.
Even harder than the "what" is the "when." It is very difficult to know when these consequences will arise. But even to the extent that can be ascertained, it is impossible to know when the market will begin to price them in. (Given the strong recent performance in inflation-hedge investments, it's possible that this process has already begun -- but whether this is the case or not, we feel there is a long way to go before the effects of these policies are fully priced in).
Since we feel very strongly that these outcomes will take place, but we can't know when the market will come to price in that conclusion, we think it's important to be invested for the consequences of Federal Reserve policies. Considering how fast things can happen in financial markets, when something seems almost inevitable, it is wise to prepare for it even if its timing is unknown. That is exactly what we are doing.