Our investment outlook will shift as market conditions shift, and we will lean toward a more constructive stance when conditions support it. There are straightforward ways to do that while still remaining careful about larger cyclical risks. Present conditions simply don’t provide historical evidence that investors can expect to be rewarded by accepting market risk here.
Market conditions will change, not least because the belief in some “monetary put option” itself is superstition (see Following the Fed to 50% Flops), and not least because the Fed has announced – in what should be no uncertain terms – that it intends to taper this policy going forward. Moreover, despite the view that economic factors are the Fed's sole consideration and that small disappointments will cause the Fed to “flinch,” the members of the Federal Reserve Open Market Committee have become increasingly aware of the diminishing effectiveness and growing distortions resulting from QE. This is evident in recent speeches even by “dovish” members. The FOMC has also noted that “an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.”
Last week’s Federal Reserve monetary policy symposium at Jackson Hole certainly provided no support for the “flinch” expectation. Rather, the academic presentations emphasized the general futility of quantitative easing, while the presentations by policy-makers such as other central-bank heads focused largely on the mechanics of an exit:
“The United States and most other advanced countries are closing on five years of all-out expansionary monetary policy that has failed in all cases to restore normal conditions of employment and output. These countries have been in liquidity traps where monetary policies that normally expand the economy by enlarging the monetary base are ineffectual. Reserves have become near-perfect substitutes for government debt, so open-market policies of funding purchases of debt with reserves have essentially no effect.”
- Robert Hall, Stanford Economist & Chair of NBER Business Cycle Dating Committee, Federal Reserve Economic Policy Symposium (Jackson Hole)
“The portfolio balance channel of QE works largely through narrow channels that affect the prices of purchased assets, with spillovers depending on particulars of the assets and economic conditions. It does not, as the Fed proposes, work through broad channels such as affecting the term premium on all long-term bonds. The Fed’s purchases of long-term US Treasury bonds significantly raised Treasury bond prices, but has had limited spillover effects for private sector bond yields, and thus limited economic benefits. Moreover, since the safety premium on Treasury bonds stem from the economic benefits they provide to investors, by reducing the supply of Treasury bonds, the economy is deprived of extremely safe and liquid assets and welfare is reduced.”
- Arvind Krishnamurthy & Annette Vissing-Jorgenson, Northwestern University, Federal Reserve Economic Policy Symposium (Jackson Hole)
Note that even the benefit of "significantly raised Treasury bond prices" no longer exists, as 10-year Treasury yields and 30-year fixed mortgage yields are now higher than both their starting and average levels since QE2 was initiated in 2010. The interest cost of buying a home with a 30-year fixed mortgage has increased by 40% since last year. Moreover, while nobody evidently cares that the Fed is almost certainly insolvent on a mark-to-market basis here, to the extent that the Fed experiences net losses on its holdings, the overall impact on public finance is equivalent to the Treasury issuing debt at a higher interest cost than necessary.