Much was made of the Federal Reserve's surprise decision in
September to refrain from tapering its quantitative easing
program, but the more important news for long-term investors was
the central bank's so-called forward guidance.
Fed policy committee members expect the target Fed Funds rate
to sit near 2% at the end of 2016, even though they anticipate
real GDP growth, unemployment, and inflation all to hit the Fed's
long-term targets by then. That pronouncement, alongside our view
that the Fed wants to exit from QE as soon as practicable,
suggests we are in the midst of an important policy
I think this transition represents a more positive policy
path, particularly as QE has only marginally influenced the real
economy. It's true that QE supported financial asset prices, in
turn contributing to the wealth effect, but it hasn't been enough
to counter the structural and cyclical headwinds the economy
faces. The early rounds of QE illustrated the positive influences
monetary policy can have on a troubled financial system:
- It calmed volatility.
- It substituted for reduced money velocity (i.e., lending)
by increasing the size of the monetary base.
- And it cheapened the currency, stimulating export
Today, however, I think QE is adding risk to financial
stability by virtue of its sheer size, $85 billion/month. The
size alone can lead to significant market distortions and capital
misallocations, hampering the market's natural price-setting
In fact, with proper distance and perspective, I believe we
will see that the financial crisis was exacerbated and extended
by the easy monetary policy in the years prior to the crisis that
led too many to chase returns through the use of leverage, and
that removed a proper appreciation of risk from markets.
The graph below illustrates this behavior:
Federal Funds Effective Rate Could Tell an Alternate History
The financial crisis was exacerbated and extended by the easy
monetary policy in the years prior to the crisis.
Yes, soaring housing and equity markets played a role. But
those excesses should be seen more as symptoms of the crisis
rather than taken for "the crisis" itself. The lack of
appropriately priced risk in markets was the real culprit. And
that stemmed from overly easy monetary policy and excessive
leverage in key parts of the financial system. Due to the
deleveraging that has taken place, we don't foresee a reprise of
the worst periods of 2008-09, but we're still concerned that
monetary policy can destabilize rather than support the economy.
In other words, we're concerned that the Fed not repeat past
Thus, keep a close eye on the Fed's forward guidance in the
months ahead, as well as on how QE tapering is implemented. What
does policy transition (and policy risk), imply for bond
portfolio positioning? In my view:
- I believe structured credit remains the fixed-income option
of choice - especially shorter-term issues: Asset-backed
securities, commercial mortgage-backed bonds and collateralized
loan obligations offer the better opportunities.
- Second, I would "barbell" such positions with select
equity-sensitive assets, such as high-yield and
- Third, think globally, as sovereign bonds from the
so-called European peripheral countries can potentially offer
attractive returns, as can some of the region's bank debt,
which benefits from continued monetary stimulus in Europe.
- Finally, emerging-market opportunities are still there, but
are not a broad-based bet, so security selection is key.
Rick Rieder, Managing Director, is BlackRock's Chief
Investment Officer of Fundamental Fixed Income, Co-head of
Americas Fixed Income, and a regular contributor to
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