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.


As the “taper tantrum” in May-June demonstrated vividly, when there was indiscriminate selling of all fixed-income securities, fixed-income investors have no certainty regarding the impact of the Fed’s novel and previously untried policies.

And now a new question looms: “Will the Yellen Fed carry out the same policies as the Bernanke Fed?”

The answer is, of course, that the Fed will continue its accommodative policy mix. But will Yellen succeed in reducing investor uncertainty?

It is difficult to imagine how she could, even if she follows the same policies as the Bernanke Fed.

Key to understanding what is going on is the fact that investors may hear the same words from Bernanke or Yellen:

  • They may all know what the target unemployment rate is before the Fed begins tapering.
  • They may all read the Fed minutes or understand that the Fed will not begin tightening until late 2014 or 2015.
  • They will hear the Fed’s announcement regarding the future path of MBSs and Treasury purchases.

But knowing all of these things will not dispel or even reduce investor uncertainty because they do not know what impact any or all of these policy actions by the Fed will have on Treasury prices.

That’s because Treasury prices are determined by the interaction of all fixed-income investors, who almost certainly now have vastly differing models for estimating how Treasury prices will be affected by Fed policies.

In a world where the Treasury pricing models no longer work, and where investors are unsure which models to use in pricing Treasurys, restoring investor confidence in pricing Treasurys correctly poses a massive challenge for Fed officials.

The Yellen Fed will likely increase its insistence that Fed policy will be “data dependent.”

The concept of policy being data dependent is intended to reduce uncertainty because all investors have access to approximately the same data on the labor market and inflation rates that the Fed does.

What the Fed cannot do is compel all investors to interpret the data in the same way.

Moreover, the future does not repeat the past.

Not only is the meaning of the data uncertain, but the future path of the data will remain highly uncertain, particularly because no one fully understands how Fed policy will impact the real economy.

Dr. James Breech founded Cougar Global Investments, a Toronto-based money management firm that uses only ETFs in its top-down global asset allocating strategies. He perfected a downside risk management system since founding Cougar in 1993. Contact Cougar Global at 800-387-3779 or [email protected]. Contact Dr. Breech at [email protected].



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