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What Constitutes a Crisis? Lessons From Recent Monetary History
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 transition.
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 growth.
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 mechanisms.
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 policy mistakes.
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 convertibles.
- 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 The Blog . You can find more of his posts here .