Serious Money: Charlie Fell
Sombre mood on Main St is not reflected on Wall St
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.