Additional U.S. monetary stimulus beginning with the November 2–3 Federal Open Market Committee (FOMC) meeting is a foregone conclusion. Policymakers have openly discussed ways to counter the downtrend in inflation expectations and revive economic growth, including an inflation target, a price level target or a nominal income target. These “open mouth operations” have been rewarded with lower market yields on 10-year and 30-year Treasuries. These are positive signs that the U.S. will not fall into a Japanese-style trap in which ultra low rates and deflation expectations doom the economy.
Most likely, the Fed will extend its existing quantitative easing (QE) program by committing to purchase additional Treasury securities in the open market. The Fed could even increase the impact of its new program by leaving it open-ended; i.e., by indicting that it has no specific amount in mind, but will simply keep buying Treasuries until it achieves its objectives. The Fed’s goal is not just to drive Treasury yields lower, but to compress all private market borrowing rates as low as necessary to stimulate growth.
Interestingly, although Bernanke and the Fed garner most of the news headlines, the Fed has accounted for only 16% of Treasury purchases since QE began in early 2009. The major purchasers have actually been U.S. households and foreign investors, accounting for 65% of net acquisition. In other words, there has been plenty of demand for Treasuries outside of the Fed.
The main impact of a more aggressive asset purchase program will be to raise the price of risky assets. The stretch for yield among retail and institutional investors has already benefited municipal and corporate securities equally as risk aversion has waned. The Fed will soon be intensifying investors’ search for yield. If the Fed buys government bonds from the non-financial private sector, the sellers are unlikely to hold on to the extra cash. Many bond investors will be forced by low government and money-market yields to shift more capital into corporate and municipal issues and thus take on a little more risk. At least some will rebalance their portfolios into buying other financial assets – high yield bonds, equities and commodities.
It is much too early to bet on a rise in realized inflation. Nonetheless, long-term inflation expectations may edge higher following the Fed’s actions, consistent with the idea that additional rounds of QE should eventually help the Fed err on the side of inflation as opposed to deflation. However, the output gap is massive, deflationary forces remain rampant and a revival in inflation risk would require an imminent and sustained resurgence in economic growth – such a turn of events in unlikely against the backdrop of deleveraging, caution, reregulation, and only mild fiscal stimulus. Moreover, the potential downside risks remain ever-present: a renewed downdraft in home prices, over-reliance on emerging markets (including China), and European sovereign debt quality. The most likely U.S. scenario continues to be a very gradual and sluggish economic recovery.
Michael Ashley Schulman, CFA
Hollencrest Capital Management