Mordy's Note To Yellen: QE Is Easy Part

February 12, 2014

With the Fed and markets at a crossroad, it’s a good time to reassess.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Tyler Mordy, president and co-chief investment strategist of Toronto-based Hahn Investment Stewards.

One has to be of a certain age to feel nostalgia for the grunge rock band Nirvana.

That said, the band’s seminal 1991 song, “Smells Like Teen Spirit,” managed to garner widespread appeal and can still get a diverse crowd rocking. Lead singer Kurt Cobain’s repeated refrain: “Here we are now, entertain us,” captured the new nonchalance of youth—an early manifestation of the now-ubiquitous “whatever.”

A parallel to the above has played out in financial markets. The risk is that some investors, like their 1990s teenage counterparts, have been lulled into complacency by an entertaining bag of tricks, courtesy of performing world central banks.

All this has clear implications in terms of how ETF investors ought to play this central-banking variable, including gravitating toward securities as diverse as the iShares 20+ Year Treasury Bond ETF (TLT | A-76), the PowerShares Chinese Yuan Bond Portfolio (DSUM | B) or the Market Vectors Gold Miners (GDX | B-54). But before delving into these choices, let’s look at the where the U.S. central bank and investors find themselves.

It’s been quite the show. Ultra-low rates, quantitative easing (QE) and other forms of monetary activism have encouraged risk taking. At the same time, any sign of slow economic growth has been mostly met with a shrugged “whatever” response, implying confidence that central-bank-sponsored risk taking would continue to reward risk assets.

That narrative is now at a key inflection point.

Based on a firming U.S. recovery in late 2013, the Federal Reserve began winding down its huge bond-buying program—the so-called tapering. And, on Feb. 3, the curtain fell on the Ben Bernanke era and opened the era of the new Fed chair, Janet Yellen.

Yellen is stepping onto an enormous stage at a crucial time. She is tasked with orchestrating an orderly exit from QE and, at some point, normalizing policy rates and shrinking the Fed’s swollen balance sheet.

What might change under Yellen’s leadership?

Enter Janet Yellen

Two key points should guide one’s view here. The first is that the Fed’s mandate is strongly institutionalized and unlikely to change, regardless of who heads it.

Although Yellen is a strong supporter of the Fed’s easy-money policies—and much more collegial than the late Kurt Cobain—the institution cannot deviate much from the objectives set out by Congress. In the 1977 amendment to the Federal Reserve Act, the goals are as follows: “To promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

Secondly, it’s now evident that the Fed’s policies have been at least partially deflationary. While low rates and quantitative easing have boosted asset prices, they have also promoted financial engineering to raise earnings (e.g., stock buybacks) at the expense of productivity-enhancing investment. This is a critical point: More liquidity has been driven into asset prices than underlying real capital expenditures.

To be sure, this is not good for economic growth.

 

 

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