By Richard Bernstein
The Fed has raised the issue of reversing their policy of quantitative easing (QE), and investors have become more anxious. It’s important to remember that the Fed is generally a lagging indicator, and that a tightening of monetary policy is unlikely if overall economic growth and inflation remain anaemic.
Investors’ high levels of anxiety contribute to why the Fed is unlikely to begin reversing policy anytime soon. The Fed doesn’t want to prematurely tighten monetary policy and cause financial markets to quickly reverse, the cost of capital to simultaneously rise, and investor and business confidence to rapidly decrease. History suggests that changes to monetary policy lag most cycles, and instances during which the Fed negatively shocked the markets have been rare. We believe that isn’t the case today.
Extricating from QE and potential unexpected results
Investors should consider these aspects to the Fed unwinding quantitative easing. Will the central bank lead or lag the economy? Fed statements suggest that Fed policy, whether at the short end or long end of the yield curve, is likely to lag the cycle. If the policies are reactive, the markets will give plenty of warning that a tightening of policy at the long end of the curve might occur. Consensus may form that the Fed is “behind the curve”. Investors should consider how the unwinding of QE might affect the overall economy. Most investors, and the Fed, believe the economy will necessarily slow if the Fed begins to reverse QE by selling longer-dated bonds and steepening the yield curve. It is more likely that the Fed might perversely stimulate the economy by improving the profitability on loans and carry trades.
Playing catch-up once again to the inevitable end story
The Fed believes reversing QE will slow the economy but a steeping yield curve and stronger business confidence argue otherwise. The Fed could again be forced to play catch-up to the markets during the mid- and late-cycle. As most cycles mature, the Fed typically realises that their policies have been too accommodative for the maturity of the cycle. The Fed then rushes to tighten monetary policy in an attempt to make up for the earlier hesitancy to tighten. The traditional end result has been that the Fed’s late-cycle aggressive policies go too far, the yield curve inverts, and recession follows. This cycle seems poised to follow that historical pattern. The Fed remains fearful of tightening too early and said they will react to the economy’s strength. If reversing QE stimulates the economy as we predict, the frequency and magnitude of Fed tightening is likely to accelerate as they realise they’ve created a monster.
Near-term investors seem overly worried. When it’s time to worry, they’ll likely be complacent
We think the Fed will be slow to tighten and we’re not sure their efforts will succeed. We believe investors’ fears today will morph into confidence which will transform into the overconfidence that has characterised every late-cycle environment. Will this bull market end any differently than other bull markets? We doubt it. When the curve inverts and the consensus is that the inversion doesn’t matter, that’s probably when investors should worry. Until that occurs, we think it should ultimately pay to be bullish.
Richard Bernstein is CEO and CIO at Richard Bernstein Advisors
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