#QE

By:  Thomas Steffanci, PhD, Senior Portfolio Manager

The Federal Reserve’s latest policy meeting last week finally put some meat on the bone by concluding they would start the tapering of their $120 billion monthly purchases of government securities. Though they were inexact as to the precise timing, it appears the program will begin in November and finish up by mid-2022.

But there were a couple of things in the Fed’s statement that took the market by surprise. The Fed issues a detailed quarterly summary of what members of the Federal Open Market Committee (FOMC) individually forecast about the next 3-year movements in inflation, economic growth, and the Federal funds rate. Those estimates are summarized in a Summary of Economic Projections (“dot plot”) where each of the 18 members (including Chairman Jerome Powell) map their projections on a three-year ahead calendar. It’s there where the changes since the June summary had market impact.

In their last “dot plot” in June, seven of the 18 members thought that the Fed should start raising interest rates by the end of next year, rather than in 2023. In the latest one, half of the committee determined that 2022 was more likely (when the tapering was finished). They also pushed their longer-term interest rate estimates higher. One reason appears to be that during the interval between June and September, annual inflation (CPI basis) rose to 5% as supply bottlenecks and rising wages continued to increase business and consumer costs. Elevated risks to their estimate of “transitory” inflation appear to have prompted Fed officials to begin their tapering and to revise their interest rate timing and to increase their interest rate projections. Market watchers dubbed this as a hawkish turn in Fed policy.

At the same time, however, employment gains slowed and high frequency economic data on retail sales and manufacturing and service activity weakened.  The specter of stagflation has begun creeping into economist’s lexicon, a legacy of the 1970’s. In previous meetings the Fed had emphasized that “substantial further progress” on employment would be needed for them to move to raise interest rates. In this meeting, the Chairman stated he is looking for “accumulating progress”, appearing to back off from his earlier statement.  With eight million people still unemployed and the slowing in employment gains, the Fed’s message seems to be that inflation is now a more pressing policy issue, especially if the gargantuan $3.5 Trillion spending bill is passed.

So, what has the market impact of all this been? Bond yields declined initially as some investors believed that the start of a less accommodative policy and a possible rise in interest rates in 2022 would forestall more rapid increases required later to confront inflation. But that sentiment didn’t last long. The Fed’s preparing to end its ultra-easy monetary policy has also signaled that the economy would continue to strengthen in the short term, putting upward pressure on interest rates, a view that shortly began to dominate bond market sentiment. Bond yields quickly turned higher. In fact, they have touched multi-month highs. And it didn’t help that several European Central Banks have either ended their bond purchase program (QE) or have begun raising rates.

Stocks were a different story. They reacted bullishly and interpreted the Fed moves as affirmation that the economy was on a solid growth path, giving confidence to expectations of healthy gains in corporate earnings. In fact, the S&P 500 registered its largest 2-day gain since mid-July at 2.2%. Small cap stocks (Russell 2000) rose 4.2% and banks have surged by 6 1/4%, indicative of investor confidence in the ongoing cyclical upswing. The long-term equity uptrend continues despite a changing Fed policy and an eventual rise in interest rates.

1. The S&P 500 is designed to be a leading indicator of U.S. equities and is commonly used as a proxy for the U.S. stock market. Price return quoted.
2. The Russell 2000 Index is a small-cap stock market index of the smallest 2,000 stocks in the Russell 3000 Index.

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By:  Steven L. Yamshon, Ph.D., Managing Principal

James Carville, President Clinton’s political consultant said at the time when Clinton was President, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” 

Back in the early 1980’s, bond investors were a force to be reckoned with and these “bond vigilantes” took matters into their own hands when the government was fiscally irresponsible, selling bonds en masse, pushing up interest rates sharply higher and forcing the government to get serious. What is a bond vigilante and why does it matter? The truth is any bond investor is a potential member of this esteemed group. Investors who purchase fixed income products such as bonds want a positive real return on their investment. The real return is the return after inflation, and this is what counts, because it is what your money buys. Inflation erodes your purchasing power.

When the Great Financial Crisis occurred in 2008, the Federal Reserve (the “Fed”) had to use all the tools at their disposal to keep the economy from sliding into a depression. Lowering interest rates is just one tool at their disposal and the Fed lowered interest rates close to zero. To keep interest rates near zero, the Fed implemented a never-tried-before technique called Quantitative Easing (“QE”). Without getting too technical, this operation is called money printing and is equivalent to dropping money from helicopters. In 2008, the Fed had to do this to save the economy.  In 2020, the Fed did it again because of the COVID-19 pandemic but at greater speed and intensity. Most likely, this was an overkill, and we believe it will lead to a sustained level of higher trend inflation.

Where are the bond vigilantes? After all they have been in hibernation for a long time. There is one reason and one reason only. Inflation was low until now. However, the U.S. economy may be at a pivotal turning point. If history is any guide the bond vigilantes will most likely wake up in the next several years. In the 1930-1950 period, inflation spiked because of dollar devaluation during the 1930’s and to finance World War II (Chart 1). During this period the Federal Reserve accommodated fiscal spending by their massive power of the printing press.

When President Lyndon B. Johnson wanted to eliminate poverty and pay for the Vietnam War, known as “guns and butter,” he did so without raising taxes. This set off a stagflation period that lasted from 1969 to 1985 and only ended when Federal Reserve Chairman Paul Volcker raised interest rates to 20% (Chart 2). Volcker had no choice. He had to stamp out inflation and the bond vigilantes forced his hand.

By mid-decade, we believe the bond vigilantes will come out of their long-lasting sleep because the U.S. fiscal position will become unsustainable. The budget deficit, and trade balance of payments is exploding upwards. The major reason why the United States is not in the same situation as Buenos Aires, Argentina, is because the U.S. Dollar is the global reserve currency, but that exclusivity is eroding.

At some point investors here and abroad will say “enough is enough” and want increased compensation for the risk of holding U.S. government debt. That is when the bond vigilantes will awaken from the dead like the rise of the Phoenix and sing “Don’t Cry for Me Argentina”.

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