On Monday, July 19, 2021, the Dow’s worst day of 2021 unfolded. Virus-sensitive assets (energy and travel sectors) sold off as less optimistic growth outlooks emerged from concerns of the increasing delta variant cases. Delta variant concerns coupled with skepticism of transitory inflation, decreasing bond yields, and incomplete economic recovery create a perplexing cocktail of potential economic outcomes. Additionally, directional catalysts for future growth opportunities remain undefined (which is normal in the first few years after a market shock) as investors weigh policy implementation, economic activity, inflation, second-quarter earnings strength, or post COVID-19 international investor norms. Investor risk aversion also roiled the cryptocurrency market as cryptocurrencies sold off on the back of equity markets. Asian and European markets fell on the similar notion of revitalized risk-averse investor sentiment. However, it is essential to note that 5% or even 10% market pullbacks remain a normal growing pain for markets as 2021 appeared overdue for a pullback with only three 5% or more pullbacks of the S&P 500 Index since October. With most stocks trading at a discount to their all-time highs, summer month weak seasonal fundamentals, lower stock participation, and typical seasonal volatility all collectively allude to a higher risk of a market pullback. Ebbs and flows of inter-year performance is an entirely normal market dynamic as pullbacks and corrections define the process of economic growth and bull market sentiment.
However, what remains coincidentally uncertain is the actual effectiveness of modern-day quantitative easing. Before unpacking the efficacy of the current QE, let us establish a definition. Quantitative Easing or QE is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market to increase the money supply, encourage lending, and spur investment. The process of buying securities adds new money to the economy and lowers interest rates as fixed income securities price’s increase in leu of increased demand. For instance, in response to the COVID-19 pandemic, the Federal Reserve announced a quantitative easing program of approximately $700 billion. Then only a few months later, in June of 2020, the Fed extended this program by committing to buy at least $80 billion a month in Treasuries and $40 billion a month in mortgage-backed securities (which is still in effect today). Conversely, the Fed withdraws money from the financial system with transactions coined as reverse repurchase agreements (RRPs) to prevent investors from receiving negative interest rates (pay for someone to take their funds). Therefore, the current conundrum of the Fed injecting money into the system and withdrawing it simultaneously draws parallels to the phenomenon called thermal expansion. Thermal expansion in physics is defined as when the temperature changes from very hot (injecting money into the system) to very cold (withdrawing money from the system), causing materials to expand and repeatedly contract, eventually leading to cracks (market dislocations). In short, the question remains: Is modern-day quantitative easing going to cause a long-term market fissure?
Since the Great Financial Crisis, quantitative easing (QE) has developed into a monetary policy tool to counter recessionary stressors. However, central banks may have set the purchasing program standard to an unattainable benchmark due to the enormous number of purchases made in 2020 and so far in 2021 due to the COVID-19 pandemic (causing present inflationary concerns). In essence, is the Fed quantitatively easing too much? That rhetorical question remains difficult to unwind; however, we know that inflation (CPI YoY) is approximately 5.4% in the U.S., with PCE YoY is 3.39(both at some of the highest levels in the past 20 years). Though the most recent QE aimed to minimize a COVID-induced depression (or recession) and attempted to revive the economy and regain growth traction, the quick increase in inflation illustrates a much more dubious outcome: the economy appears overheated. The inflationary fears coupled with Delta variant uncertainty and the bond market’s mixed signals have led investors to a state of limbo. However, before determining if the current economic nexus is transitory or making a long-term financial system fracture, the limitations of current QE and how the COVID- era monetary policy’s potentially un-canned results must be defined.
Most importantly, the interpretation of inflation varies greatly. In short, the Fed views it as transitory, and investors/consumers view it as persisting. Inflation and QE do not mix. However, when policy and vernacular continue on the sentiment of rates remaining low with no guidance on tapering, QE can create a situation where inflation and the economy overheat. The delayed process of containing inflation may lead to a more acute economic reaction. With this said, the notion that QE is a cure-all remedy to any adverse economic shock is a dangerous assumption. Not all market dislocations and economic shocks are unitary, as different market dislocations and economic shocks merit different monetary policy responses. However, the Fed displayed inconsistent guidance that did not define the proper uses for specific QE programs illustrating that short-term QE implementation may or may not be the best course of action to increase economic output. Considering the misaligned inflationary definition and misguided QE implementation, the Fed, especially throughout COVID-19, has established a subliminal reliance on QE programs. The ease for the government to finance large budget deficits, can come under pressure if the Fed decides to reduce some support. Furthermore, specific fixed income market sectors (those held on the Fed’s balance sheet) have become correlated to Fed purchasing programs leading to inflated performance returns. In addition, QE suppressing bond yields (which we have seen throughout the fixed income arena throughout 2020 to today) also implies that bond prices are too high. This assumption created both opportunity cost risks and actual default risks to escalate when bond prices are artificially high. In this circumstance, bondholders receive a lower return and become exposed to inflationary pressures, losing yield. Therefore, misused QE has a macroeconomic effect and a microeconomic effect in various fixed income markets (and a waterfall effect in equity markets). This leads to my last point: QE lacks the agility to shift monetary policy in anticipation, not in reaction to economic events. QE responds to bad economic data, but there seems to be an unclear illustration as to when QE should be dialed down. Understandably the Fed does not want a taper tantrum like in 2013, but that does not mean that tapering will cause a market reaction. However, the lack of Fed clarity and guidance (and backward-looking implantation) can cause a market reaction, even though this lack of definitive guidance is geared to prevent a market reaction. This seems counterintuitive to me.
Will current QE cause a long-term market fissure? Potentially, if measures are not taken to contain the treacherous dependence of modern QE. Long-term issues can compound the various limitations described above. However, overarchingly the ultimate answer to this question is uncertain because the dynamic environment of politics, policy implementation, economic functionality, and interdependence all remain difficult if not impossible to accurately gauge long-term.
As investors, a few approaches can be employed to avoid any overhanging uncertainty created from assumptions of future economic outcomes. Therefore, investors should remain vigilant in gaining exposure to alternative fixed-income strategies and inflationary hedging assets. For instance, fixed-income strategies focused on non-agency RMBS, floating-rate loans, behavioral insider buying cues, and convertible bonds can all help maintain a low correlation to Fed balance sheets, combat inflationary pressures (whether they are transitory or persisting), and capture yield in the low yielding environment. Additionally, funds focused on managed futures and gold can deliver potential upside as the returns of managed futures have proven to hedge against market bubbles (where monetary policy and QE is usually employed); meanwhile, gold remains a haven asset shielding against inflationary pressures, a weak U.S. dollar, and the decreasing purchasing power of consumers (as the money supply increased by almost $16 trillion over the past 20 years). As current QE continues at $120 billion per month, the money supply seems to be on pace to continue to increase at an exponential rate while the Fed debases our money. Therefore, investors should remain cognizant of how alternative fixed income, managed futures, and/or gold exposure can weather any uncertainty or misguidance displayed by the Fed. Therefore, “don’t fight the Fed,” just walk the other way.