On a day when it appeared Congress was closer to bridging the divide on the fiscal cliff, the minutes came out from the Federal Reserve’s 23–24 October policy meeting indicating that the Federal Open Market Committee would most likely announce a new bond buying program in December to jump-start the labor market.
Operation twist (in which the Fed sells shorter-term U.S. Treasuries and purchases longer maturities) is scheduled to end, and the Fed seems intent on replacing it with a program of buying longer-term U.S. Treasuries. Now more than ever, there seems to be a dramatic divergence between the paths of monetary and fiscal policies.
Central bankers continue to increase the dosage of medicine while our legislatures debate the degree of spending cuts and/or tax increases that are necessary. Given the lessons of the past and the results of monetary policies thus far, it is reasonable to wonder whether the United States is engaging in the wrong policies at the wrong time. In other words, although the “doctors” have prescribed looser monetary policies and (most likely) somewhat tighter fiscal policies going forward, is the exact opposite what is really needed?
Few would disagree that the Fed’s QE (quantitative easing) programs have produced a number of desired effects despite failing to meaningfully chip away at unemployment. For starters, the Fed’s policies have crushed interest rate volatility, as illustrated by the MOVE Index, which measures volatility of U.S. Treasuries and continues to set new lows.
Next, both individuals and corporations have benefitted from the policies of QE. No, it hasn’t helped everyone. As David Zervos has said, “QE works, but QE is regressive. The easy money does not make it to all corners of the economy.” Individuals have benefitted from record low mortgage rates, which have dramatically lowered principal and interest payments as a percentage of median income. Corporate bonds (both investment grade and high yield) have benefitted from debt issuance costs that are at historic lows. This benefit obviously lowers debt service costs and boosts EPS and, therefore, stock prices.
How Far Will Central Banks Stretch?
Kyle Bass of Hayman Capital, a hedge fund, succinctly describes the extent of central bank balance sheet expansion in a recent letter: “Central bankers around the world have expanded their balance sheets beyond $13 trillion, from only $3 trillion 10 years ago. Global central banks’ assets now comprise at least a quarter of all global GDP — up from only 10% in 2002.” Part of the problem is that the average investor reads those sentences, says “wow,” but doesn’t think of any consequences.
From my experience, the degree to which you believe that QE affects the markets is directly proportionate to how closely you interact with the specific markets that are most affected. Like throwing a rock in a lake, there is a big splash at impact but smaller ripples are still seen further away.
So it is with QE. Participants in agency MBS (mortgage-backed securities) see the impact clearly, whereas investors down the risk spectrum — in investment-grade corporate bonds, municipal bonds, and equities — feel it to a lesser extent.
A common belief is that the Fed will never have to unwind QE, but in my opinion, that ignores the bigger issue: Does massive balance sheet expansion have repercussions?
Failure to expand the balance sheet size and then failure to reinvest runoff would both be forms of tightening and could very well be necessary at some point in time. I can’t articulate exactly what I fear about the massive balance sheet expansion of the Fed and other central banks, but I believe the massive distortions occurring in fixed-income markets — such as the renewed popularity of payment in kind (PIK) bonds and collateralized loan obligations (CLOs) — could have dramatic consequences one day.
“Fiscal Stimulus Excels When Monetary Policy Is Impotent”
Nomura economist Richard Koo used this phrase in a 23 October report titled “Macroeconomic Policy Debate Has Lost Its Way.” It is an interesting view that appears to be at odds with the United States’ current plan. Koo goes on further to say:
Fiscal policy is most effective precisely when monetary policy is most impotent — i.e., when zero interest rates are unable to stimulate the economy. That is the situation we face today. When a recession has been triggered by a private-sector decision to save more and work off debt, there is no risk of crowding out, distortions in resource allocation, or other potential downsides to fiscal policy. Crowding out is impossible when the private sector is trying to minimize debt. Moreover, there is a massive pool of private savings today that must be lent to the government because there are no other borrowers. (This argument does not necessarily apply to the eurozone, where funds can flee to the government bond markets of other eurozone nations.) Nor should we be concerned about a misallocation of resources. If the government did not borrow and spend the surplus savings, the result would be greater unemployment, the worst possible allocation of resources.
On the other hand, an economy that does respond to monetary policy indicates that it has robust private demand for funds, which means the government should be running a balanced budget. That is the time for “small government.” The above suggests that an economy’s path can be divided into “yang” phases, where the private sector is seeking to maximize profit and monetary policy is effective, and “ying” phases, where the private sector aims to minimize debt and only fiscal policy has an impact. Economists until now — including Keynes — have only addressed the former. The “ying” world, where the private sector seeks to work off debt even though interest rates are at zero, has been completely overlooked. That is why orthodox economists at universities and the IMF wheel out their recommendations for fiscal consolidation and monetary accommodation whenever something happens to the economy. Such prescriptions are all valid in a “yang” world, but they will have the opposite of the desired effect in a “ying” world, which is where Japan, the US, and the UK find themselves today. We therefore need new policy proposals.
Heading in the Wrong Direction
I am not proposing that the United States go on a reckless debt-fueled government spending binge or that some sort of spending reform isn’t a positive thing long term, but at the margin, it appears that the United States is heading the wrong way in terms of monetary and fiscal policies, with loosening monetary policy and tightening fiscal policy.
As a friend recently commented, we are almost living in a mirror image of the early 1980s, when very tight monetary policy and loose fiscal policy were arguably sterilizing each other. Today is almost the reverse. On one side, you have the Fed’s zero interest rate and QE policies encouraging investors to move out along the risk spectrum in a desperate attempt for yield, and on the other side, politicians provide headwinds to the economy in the form of high income taxes (at the current time, it looks like at a minimum the payroll tax holiday will expire at year end, increasing the taxes of a family earning $50k in annual income by $1k) and potentially higher dividend tax rates.
With the possibility of dividend tax rates increasing to more than 40% from 15%, investors who are being pushed into dividend stocks as “bond substitutes” could see after-tax yields plummet as they do just what they have been pushed to do by monetary policy: move further down the risk spectrum into stocks. Heading into 2013, the environment is challenging for income investors as they navigate the continued low interest rate environment and now face the prospect of potentially higher income, dividend, and capital gains taxes.
As investors face these tough questions, it is worth asking whether the current policies in place are the best choices. Is it possible that the focus of many on tightening fiscal spending is actually wrong and that additional spending is the very thing we need most, whereas the “sugar highs” of QE that markets have grown to love are precisely the thing that needs to be tightened?
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