Are the Days of Easy Money and Low Interest Rates Over?Monday, March 4th, 2013
That’s the question many nervous investors are contemplating after the Federal Reserve hinted two weeks ago that it might end its quantitative easing (QE) policy sooner than analysts anticipated. Currently in its third round of QE since 2008, the Fed is essentially printing money (~$85 billion per month) to buy mortgage-backed securities and Treasuries from banks. The goal is to encourage banks to use the proceeds to make loans to individuals and businesses. This stimulates the economy, since the fresh loans help businesses invest in new equipment and hire additional employees. Until two weeks ago, most market participants had expected the QE bond buying spree to continue well into 2014, or at least until labor markets improved significantly. However, minutes released from the Fed’s Open Market Policy Committee meeting in January suggest the Fed might pull the plug on the program sooner. Although Fed Chairman Ben Bernanke was quick to assure investors the bond purchases would continue, some have been paring back on assets that have benefited from the Fed’s easy money policy, including commodities, stocks, and bonds. That explains some of the market’s volatility of late, notwithstanding uncertainty stemming from Italy’s post-election chaos and, to a lesser extent, the US budget cuts.
We don’t think the Fed will cut the cord on QE until 2014, at the earliest. In our view, a sustainable GDP growth rate of 3% and an unemployment rate of 6.5% need to be within reach before the Fed abandons the easy-money policy. Today, we’re nowhere close to those targets, even though the economic recovery remains on track. For example, economists are forecasting GDP to grow 1.8% in 2013 and 2.7% in 2014, according to a Bloomberg survey. To achieve an unemployment rate of 6.5% by the end of 2014, we believe the economy needs to create about 200,000 jobs per month. That’s not unrealistic, but it seems a bit lofty when compared to the 157,000 jobs added in January.
There are several other reasons the Fed may be hesitant to end QE at this point. First, inflation is modest (although anyone who’s bought food or gasoline recently may disagree). The personal consumption expenditures index (PCE), which is the Fed’s preferred measure of inflation covering a wide range of household spending, rose 1.2% year-over-year in February, according to the Bureau of Economic Analysis. This is comfortably below the Fed’s 2% long-term target. Second, despite low interest rates and QE, many potential borrowers can’t get loans. Banks, which are still healing from the 2008 financial crisis, have largely been reluctant to loosen loan standards and terms, despite seeing their excess reserves expand, thanks in part to QE. To be sure, over the past two months, we have seen some banks relax their terms, but until this drives a big uptick in lending, we think inflation will remain in check. Third, austerity measures aimed at reducing the US budget deficit ought to put some pressure on GDP growth, although it’s hard for us to quantify the impact. Fourth, the European Union, which is America’s largest trading partner, remains trapped in a recession and faces mounting sociopolitical pressure, which will likely temper the outlook for global GDP growth.
Although we don’t see a big change in near-term interest rates, we are wary that a prolonged policy of easy money could eventually usher in a nasty mix of inflation and high interest rates, should the Fed have challenges liquidating the bonds it’s been buying. Since bond prices have an inverse relationship to interest rates, this could expose many fixed income investors to potential losses. We acknowledge these risks and have made slight changes to our fixed income portfolios. However, at this time, we are reluctant to let the fear of higher rates dominate our investment strategy, and remain committed to maintaining diversified portfolios for our clients.
*The information contained in this email was derived from sources believed to be reliable, but completeness and accuracy are not guaranteed. The opinions expressed constitute our judgment as of the date of this email, but are subject to change without notice. Past performance may not be indicative of future results. This information is not intended as an offer or solicitation for any financial instrument. The opinions expressed do not take into account individual client circumstances, objectives, or needs and are not intended to be investment recommendations or strategies.