Insights & Thoughts

Mixed Messages

Jun 19, 2019 | Quarterly Commentary

In normal times, which we haven’t seen in over a decade, the markets would look at unemployment solidly under 4%, GDP above 3% and inflation around 2% and think the Federal Reserve is surely leaning towards a neutral or maybe even tighter monetary policy. After all, Congress established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. The three data points above strongly point to those objectives being met.

So then why does the Fed seem to be leaning towards cutting interest rates (easing monetary policy) this year and what does that mean to me? The answer to the first question is that the world has become addicted to cheap money and after nine consecutive rate increases in the U.S., we began to see what the markets may be facing without the Fed’s support. These increases and the prospect of three or four more is what led to the huge sell-off we experienced in the fourth quarter last year. The subsequent recovery was driven by the Fed announcing that it was halting any increases in 2019. Thus, this matters to all investors because the value of their portfolio is directly and indirectly supported by these policies. It also matters to those needing the income to live on.

This addiction began in the years following the financial crisis. That crisis was brought on by a bubble in asset prices funded by too much debt. The government’s response was to buy up much of the outstanding loans (Quantitative Easing) and push down interest rates so that borrowers could better afford the debt payments until things turned around. In the end, the government pushed short-term rates to near zero and owned roughly four trillion dollars in mortgages.

These policies seemed to be so successful in the U.S. that the rest of the world took note and began their own QE programs. The European Central Bank, for example, began their own program which ran from 2015 through 2018. This was to support many of their member counties facing default. In those four years the ECB amassed 2.6 trillion euros (3.5 trillion U.S.) in corporate and sovereign debt and saw overnight lending rates drop to zero or even slightly negative.

An interesting consequence of these moves by foreign governments is that it has driven international capital into our markets. This flow has also been a big contributor to our lower rates as they’ve put significant upward pressure on our bond market and downward pressure on yields. In many ways, the Fed has lost control of longer-term domestic rates. Even if the Fed wanted to see longer-term rates head higher, it’s doubtful they could do much about it as long as the other major world economies pursued easy money policies at the scale we have seen.

The problem that this presents is that financial market valuations are being driven more and more by what the central banks do and less about the fundamentals. These policies have also been pounding income investors. Those are not just retirees but also insurance companies, pension funds and other entities who depend on the cash flow to finance their liabilities. A traditional bond portfolio just doesn’t cut it anymore. Conservative investors are now having to accept greater price volatility in their accounts in order to squeeze more cash flow from their portfolio. This includes a greater reliance on preferred stocks, junk bonds, private placement debt and the like. Those types of investments tend to be more correlated to stocks than bonds.

Stock investors have been loving the free ride. And they’ll continue to benefit form a world awash in liquidity. The big question mark is how long it can last. Everyone can agree that these policies won’t last forever. We also saw back at the end of last year what can happen when the Fed starts to close the tap. It was ugly.

Our strategy is to keep an eye on the news that matters and not get distracted by the headlines, take profits more frequently and rebalance often. We’re paying close attention to the news coming out of the Fed and the ECB. It helps that the Fed has been much more transparent in recent years as they want to give early signals to the markets as to what they’re thinking. We’re also hopeful that heading into an election year will provide a little downside protection for stocks.



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