Serious Money: Charlie Fell

William McChesney Martin, who served as chairman of the Federal Reserve for the best part of two decades from April 1951 to January 1970, told the New York Group of the Investment Bankers Association of America in the autumn of 1955 that a central bank’s decision to begin a cycle of tighter or less accommodative monetary policy put it “in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up”.

More than half a century later, Martin’s words seemed apt as, during the early-summer, various members of the Federal Open Market Committee signalled the central bank’s intention to take the first step on the long road back to monetary normalisation before the end of the year.

Not surprisingly, the Fed’s forward guidance saw most market participants assume that a tapering of the Federal Reserve’s asset purchase programme was almost certain to be announced in September, and the resulting repositioning of portfolios contributed to a notable increase in financial market volatility through the summer months.

Market expectations were frustrated however, as the Federal Reserve decided to keep the pace of quantitative easing unchanged and "await more evidence that the recovery's progress will be sustained". The central bank's unexpected decision reflected the fact that hard economic data confirm there were few if any signs that "the party was really warming up" on Main Street, and fears that the increase in long-term interest rates which followed the Fed's forward guidance earlier in the year might derail the tentative recovery.

The sombre mood on Main Street stands in sharp contrast to the atmosphere on Wall Street, where the yields on credit market debt hover close to all-time lows, while stock prices remain within touching distance of record highs.

Importantly, the Federal Reserve’s decision not to reduce the extraordinary level of monetary accommodation would appear to suggest that the central bank will not tolerate nominal yields on 10-year Treasury debt in excess of 3 per cent, which could lead to the propagation of dangerous asset bubbles as investors mistakenly believe they can safely move out the risk spectrum in their search for incremental returns.

It is important to appreciate that quantitative easing’s positive impact on real economic activity and inflation stems primarily from the “portfolio balance effect”. The large-scale asset purchases undertaken by a central bank as a result of quantitative easing will reduce the duration of private sector portfolios as the monetary authority exchanges a short-dated asset, bank deposits or freshly-created bank reserves, for a long-dated asset – Treasury bonds or mortgage-backed securities.

Most investors are likely to use the proceeds of their asset sales to restore the duration of their portfolios and, since the central bank’s asset purchases reduces the quantity of long-dated assets and thus duration risk available to the private sector, investors are likely to require less compensation – lower prospective returns – to hold long-dated securities. In other words, term premiums and yields are likely to decline.

Lower yields and higher asset prices are likely not only for the type of long-dated assets purchased, but for other long-dated assets as well. This is because private-sector investors constantly evaluate the relative return prospects of different asset classes, and the yield changes arising from large-scale central bank purchases should prompt a rebalancing of private-sector portfolios towards competing long-dated securities with more attractive prospective returns.

Quantitative easing stimulates economic growth via lower yields and higher prices across the broad gamut of risk assets. The former is likely to stimulate spending via lower long-term borrowing costs for firms and households, while the latter is likely to provide stimulus through the improved net wealth of private sector asset holders. This is the “portfolio balance effect” of large-scale asset purchases.

There is little doubt that three rounds of quantitative easing have contributed to lower yields and higher prices than would otherwise be the case across the broad array of risk assets. However, the positive link between higher asset prices and stronger economic growth is notably absent.

Indeed, the Federal Reserve itself has consistently overestimated growth – 12 months ago for example, it forecast a 3 per cent growth rate for 2013, but that has since been revised down to just 2.2 per cent as the recovery failed to reach escape velocity.

The persistent upward move in asset prices in the face of poor economic data means that financial markets are increasingly been driven by the outlook for liquidity, as relatively disappointing fundamentals are conveniently ignored. The coefficient of correlation between stock prices and the monetary base for example, has been 0.9 since the start of 2010, while the relationship between equity prices and key indicators of economic activity has been the wrong sign over the same period. Correlations across other risk assets are equally troubling.

Quantitative easing has allowed financial markets to decouple from economic fundamentals, and the sustained upward move in asset prices means that valuations have reached dangerous levels for many risk assets. The decision by the Federal Reserve not to taper asset purchases means that this process is unlikely to come to an end, as investors continue to push valuations to extremes in their misguided search for yield in a low-return world.

Ultra-accommodative monetary policy means the bull market in risk assets is alive and well, but investors would do well to remember that liquidity-driven asset bubbles always end badly.