Breech: Fed Policy = Uncertainty

December 02, 2013

QE pushes investors into risk and uncertainty.

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 James Breech, president and chief executive officer of Toronto-based Cougar Global Investments.

Quantitative easing seemed like such a good idea.

The Federal Reserve said it would reduce long-term mortgage rates to resuscitate the housing market. It also said it would reduce the cost of borrowing by reducing long-term Treasury yields through quantitative easing to encourage households and businesses to increase their borrowing and spending.

In this way, the Fed hoped its unprecedented policy could help to stimulate real economic activity.

One of the intended consequences of the Fed’s use of quantitative easing was to push investors into riskier asset classes, boosting equity prices, hence raising the net worth of those households that own equities.

Investors were also pushed into other asset classes considered riskier than Treasurys. This is widely understood among investors who have had to endure the consequences of the Fed’s experimental and novel policies—including its asset purchases and its “forward guidance” on future policy changes.

What is not widely appreciated, I believe, is that “interest rate oppression”—forcing down yields on longer-dated Treasurys and mortgage-backed securities (MBSs)—has impelled investors to seek higher yields through various carry trades. Neither is it appreciated that asset allocators, like us at Cougar Global, have lost an important tool for constructing portfolios, namely fixed-income securities.

What is definitely not widely appreciated is that the Fed, instead of reducing uncertainty, has increased uncertainty for investors.

Specifically, the pricing model for an asset class that heretofore exhibited the highest degree of certainty in how to price—namely, U.S. Treasurys—has lost that privileged status.

For decades, fixed-income investors have priced bonds with reference to 10-year Treasurys. Knowing how to price 10-year Treasurys provided the key reference point for pricing of all other fixed-income securities.



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