Investors who have been salivating for reassurance regarding the outlook for more monetary stimulus from Federal Reserve Chairman Ben Bernanke got their wish this last week. It truly is phenomenal that we can flip flop so many times on a consensus for the US Fed in terms of their direction for policy, but as Bernanke seized the opportunity to differentiate between asset purchases versus record low interest rates – the market rallied higher. And that was the key difference that the US central bank governor touched on this week. Winding down asset purchases is entirely different from the prospects of the Fed’s funds rate, their key interest rate, and since it has been record low interest rates that initiated this run of mispriced and cheap credit the story will play on.
In hind sight though, it’s almost as if the volatility and the uncertainty introduced by the Fed at the end of June was all for nothing. The first time around, the thought of tapering or easing back of monthly asset purchases pulled the carpet out from underneath the markets. It started a firestorm in the bond market and sent everything else except the US dollar tanking. As the apparent revelation came to be that asset purchases carried no implications for interest rates, risk assets came into play again. Assets ranging from equities to commodities to currencies all moved higher. And that is why it is important to differentiate between the two policies the Fed currently has in place. One is the extraordinary stimulus known as quantitative easing, and the second is control over the fed funds rate, which has been held at record low levels.
The Fed Funds Rate is akin to the overnight interest rate maintained by the Bank of Canada, and it very much gives the respective monetary authority power over the shorter end of the yield curve. QE was such a phenomenon when first introduced because it stepped beyond conventional monetary policy. It allowed the central bank to alter the prices of long term debt instruments, which carries extreme implications for the amount of control over financial markets. Never has the term free market been so distant since we have seen these policies in place, and now that central bankers have realized this ability to influence the markets in this manner, these policies have become almost common place.
With the world renowned Mark Carney now at the bank of England, awaiting their economy to achieve “escape velocity,” the developed world looks open for more and more easy money. Between the Bank of England, the European Central Bank, the Bank of Japan, and the instigating US Federal Reserve, a new norm has been rewritten in terms of coping with economic crises and let alone any slowdown in the economy. The belief still is that the Fed is likely to start tapering their asset purchases by September of this year. However, just to sit back and watch the markets react to random dialogue from the US fed (when nothing has changed fundamentally) indicates that the amount of uncertainty around how asset prices will fare when this day comes is still unknown.
My bet has always been that when the time comes, moving forward from QE and emergency level interest rates will not be as seamless as anticipated. Particularly because the underlying US economy is not as strong as many perceive it to be, and the outlook over the long term is weak due to the structural changes that have failed to be made.