When making investments on behalf of our clients our views are being shaped by monetary policies both in the U.S. and abroad.
The Taylor Rule
A number of years ago John Taylor, a Stanford professor and noted economist, came up with a formula to guide how our central bank should set and change their interest rate policy in response to changing economic environments in light of fulfilling a dual mandate of low inflation and maximum employment. The formula, known as “The Taylor Rule” is based on the long term equilibrium real interest rate plus adjustments for the difference between current inflation measures and the central bank’s inflation rate target, as well as the current level of economic growth (GDP) compared to economic growth associated with full employment. Although few central banks have an explicit dual mandate, when the Taylor Rule is applied to the central bank interest rate policies of developed and developing countries the conclusions are pretty clear. Developed and developing countries have had interest rate policies that are more accommodative (interest rates lower than they should be) than is necessary to stabilize prices and promote full employment. This accommodative policy has been the case for much of the last decade.
However, interest rates are not the only tool in central banks’ policy making toolbox; to really understand the full potential impact of monetary policy we have to look at interest rate policy in combination with “other” policy measures. Open Market Operations are typically the activity of a central bank buying and selling government bonds on the open market. In response to the financial crisis and in an attempt to stabilize the banking sector and stimulate the economy (the “maximize employment” part of their mandate) the U.S. Federal Reserve (Fed) significantly expanded the types of securities they buy in the open market. They have also grown the size of their balance sheet by holding and accumulating large amounts of these (nontraditional) securities that they have purchased from banks. This activity is referred to as “Quantitative Easing”. The European Central Bank (ECB) also has interest rates at record lows and has engaged in its own form of quantitative easing by lending more than a trillion Euros to European banks at 1% interest over three years.
In response, the Chinese central bank has kept interest rates very low, not because they wanted to stimulate their economy but so as not to attract foreign capital. If there was a large positive interest rate differential between China and the U.S. or Europe it could put upward pressure on the Chinese currency making their export led economy less competitive. But they were also concerned that low interest rates could spur domestic inflation pressures so they significantly increased banking reserve requirements last year to reduce the supply of money.
According to the Taylor Rule, interest rates are too low in China, and elsewhere in emerging markets. This behavior by emerging market central banks can be understood as an attempt to keep competitive currency exchange rates versus the US dollar and Euro with other monetary policy tools being used to counteract the potential inflationary effects of those low interest rates. Whereas the open market operations of the Fed and ECB are being used in an “accommodative” way to expand the money supply and stimulate the economy further than is possible with just a zero interest rate policy.
Monetary Policy In The News
September was a very busy month for policymakers with the ECB announcing unlimited buying of European sovereign debt (so long as the countries that want to take advantage of this ask for help and agree to austerity measures). Not to be outdone, a week later the Fed announced their third quantitative easing program dubbed by some as “QE Infinity”; referencing to the fact that it is open-ended in terms of time, amount and types of securities.
The End Game
While an end to the printing of money by the Fed and ECB doesn’t seem to be on the minds of policymakers, at some point the market could force their hand. Inflation is currently running at the top end of the Fed’s range and they will have to sell more than $2 Trillion in various securities they have previously purchased from banks to bring their balance sheet back to the level it was in early 2008. We believe that policymakers have already erred, and will continue to err, in the direction of too much easy money. While it might take a few more years for “all of the chicken to come home to roost”, we believe there is a high potential for inflation, rising interest rates and significant devaluation of the U.S. dollar and the Euro versus other currencies.
To hedge against this outcome we believe it is important to have exposure to foreign currencies, emerging markets, commodities and real assets. Our dilemma as investors is that these asset classes have proven to be volatile and susceptible to selloffs in “risk off” environments like we saw in the summer and fall of 2011 and spring of this year. Our use of structured notes for part of our client’s allocation in these areas provides a hedge against inflation but does so in a way that we can lessen the downside risk associated with these investments (or asset classes) in a “risk-off” environment.
Within fixed income securities we have focused on short to intermediate maturity investment grade bonds with high credit ratings. To add yield and diversify fixed income portfolios we have used high yield and emerging market bonds. Large cap U.S. stocks with strong balance sheets, reasonable and growing dividends also represent somewhat of a bond substitute in the current low yield environment and are a core part of our equity allocations. At this point we believe through diversification and our focus on approaches that offer some downside protection, we have client portfolios well positioned. While the policies of the Fed and ECB could end badly, we think it is important to wait for the market’s signal to reduce risk further or add significantly to inflation hedges.