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Investment e.Perspective

Current Issue | April 27, 2017

Countdown to Liftoff: T Minus Zero and Holding…

By: Mark Green, CFA, Chief Investment Officer and Oxford Investment Fellow


For nearly a year, policy makers at the Federal Reserve have been preparing the world for the eventual end of the monetary stimulus that began during the financial crisis in 2008. Last October marked the end of their third asset purchase program (Quantitative Easing or QE3), which served to hold down long-term interest rates. The Federal Funds rate – interest that banks charge each other for overnight loans and the benchmark for other short-term lending rates – has been at roughly zero for the past seven years.

The combination of these tools, the use of which has been truly unprecedented, was meant to increase the amount and availability of credit as the economy recovered from the Great Recession. It has been a strange time in the history of Central Banking, to say the least, and the results of these unconventional tactics have been mixed. Whenever governments intervene in markets, even with good intentions, there is always a worry that the seeds of the "next crisis" will be sown in the unanticipated consequences of their efforts to fix things.

Indeed, as we have seen over and over again, when credit is essentially free for banks and primary dealers, price discovery for securities gets distorted, so-called "carry trades" get leveraged beyond normal reason, volatility in most asset classes is dampened and investors generally take on more risk than they otherwise would. To some degree, that's the whole point - to get things moving in an economy that is otherwise stalled. The longer the intervention lasts, however, the more likely problems will result either through policy overshoot or an outright blunder in efforts to go back to a more "normal" condition.

The Federal Reserve deserves a great deal of credit for managing policy this far. But the history of their and other Central Banks' efforts to unwind this type of situation is not good. If they move too soon or too fast, they risk driving us into a deflationary recession. If they move too slowly, they risk new distortions of their own making which can threaten financial market stability. And, of course, the economy and the financial markets are tightly intertwined, though in complex ways not well understood by the average investor.

Consequently, since the end of QE3 last year investors have focused sharply on speeches, announcements, press conferences, economic data, etc., for signals as to the timing of an increase in the Federal Funds and other short-term lending rates – the so-called Liftoff. The Fed has been remarkably open about their policy deliberations, perhaps to a fault, explaining in detail the indicators they evaluate and the targets they hope to achieve. Through the lens of their statutory mandate – promoting full employment, stable prices and moderate long-term interest rates – all systems were finally go. Or so it seemed.

After all was said and done, however, the Federal Open Market Committee (FOMC) chose not to raise short-term interest rates at their meeting in September, as was highly anticipated only a few weeks ago. In the end it was a coin flip at best, in the wake of the market turmoil of late-August, and nobody was really surprised at the outcome. Confused by the logic, and possibly disappointed, but not surprised.

While the Fed's primary focus is on business conditions in the US, they know full well that we live in a global economy. Their actions at home can have far reaching and sometimes unanticipated consequences overseas – which can blow back around on us in some peculiar ways. It was largely these "heightened uncertainties abroad" that kept monetary policy on hold, not just consideration of our own domestic economic conditions. So, what are these uncertainties abroad? Basically, there are three - all of which are interrelated:

  • Global growth slowdown, led by a sharp deceleration in China and other emerging markets
  • Deflationary scare, prompted by the collapse in prices for oil and other commodities
  • Financial market instability, caused in part by the bubble-then-collapse of the Chinese stock market

A fourth consideration for not tightening monetary policy, though much less talked about in the open, is the liquidation of foreign reserves by China in an effort to control their currency devaluation. By effectively dumping billions of dollars of US Treasury securities on the market, China has created a backhanded version of "Quantitative Tightening," putting upward pressure on longer-term interest rates. To some extent China has done the Fed’s work for them, though not in the way the FOMC would like to have gone about it.

So, the countdown is on hold for now. Official statements subsequent to the last FOMC meeting suggest the next window for Liftoff is in December. Given all the hype and anticipation, expectations are high. And yet, rather than a spectacular Space Shuttle-type launch, investors will likely see a single bottle rocket-type pop, as the Fed moves slowly toward a less accommodative policy. More fireworks may follow, but given the challenges that remain, interest rates are likely to stay low for some time to come.

In the following two articles, Brendan O'Sullivan-Hale discusses the economic slowdown facing the emerging markets, and Jared Nishida unpacks the commodity price bust and its implications. These developments factor significantly into our overall investment advice. You are encouraged to contact us for further information.

The above article represents the opinions of the author as of 9.30.15 and is subject to change at any time due to market or economic conditions or other factors.