4Q2017 Market Commentary

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It's Time for U.S. Monetary Policy to Take a Back Seat

What is Monetary Policy?

The topic of monetary policy is at the forefront of today's global market discussions. Missing from the conversation about what the Fed might do next is context around what is monetary policy? How do global central bank activities affect U.S. markets? What are negative interest rates and how do they impact asset values? These contextual questions, and monetary policy and its effect on our financial markets are important to explore and understand.

Monetary policy simply refers to control over an economy's money supply, usually by a centralized authority such as a government or central bank. It is an interest of mine, not only because of its impact on our investment portfolios, but also because it's at the heart of where I began my career. My first job after college was with the Federal Reserve Bank of Kansas City, one of twelve Federal Reserve Banks across the country. It was during my time at the Federal Reserve that I learned about the basic tenets of monetary policy that I want to share with you in order to shed some light on what's happening in our financial markets.

The Federal Reserve is our nation's central bank. It is charged with three objectives with respect to monetary policy: maximize employment, stabilize prices, and moderate long-term interest rates. To oversee these objectives, the Federal Reserve has created the Federal Open Market Committee (FOMC) that consists of members of the Federal Reserve Board, the president of the New York Federal Reserve Bank, and four other rotating members from the remaining eleven regional Federal Reserve Banks. The primary tools the FOMC uses to achieve their objectives are setting short-term interest rates, and buying and selling bonds in the open market (termed open market operations). (www.federalreserve.gov)

Federal Open Market Committee

The FOMC will hold eight meetings this year to discuss monetary policy actions. They recently met for the seventh time in 2017 on October 31. Twice this year the FOMC raised short-term interest rates based on improving economic data. While there were no changes in interest rates at the October meeting, they did announce that for the first time since 2008 they would restrict their bond buying to reduce spending and unwind the trillions of dollars in domestic bonds purchased in the wake of the Great Recession. This process is known as monetary tightening and is a technique used by the FOMC to cool down markets that could be overheating.

Let's take a step back for a moment. In response to the 2008 financial crisis, the FOMC began buying bonds on the open market to increase the money supply and stimulate the U.S. economy (monetary easing). Any time there is a strong increase in demand for bonds, prices of these bonds riseBalance Sheets - December Market Commentary causing the corresponding yield to decline due to the higher price being paid. Since financial assets are evaluated based on their returns relative to available alternatives, the extensive bond buying by the Fed (roughly $4.5 trillion over a six year span), that resulted in relatively low yields on bonds, made the return on equities more attractive to investors.

It's hard to ignore the timing of the bond buying program (termed quantitative easing or "QE") and the corresponding rise in the stock market. The S&P 500, gained at an annualized rate of 14.86% since year-end 2008, marking one of the longest bull runs in the market's history. (Bloomberg L.P.)

This strong monetary-induced equity performance becomes even harder to ignore in light of relatively poor economic fundamentals such as high unemployment, low GDP growth, and declining corporate earnings, which followed in the immediate years after the recession. There is little doubt that the Federal Reserve's actions have served to prop up U.S. equity markets. In fact, the FOMC has become so effective at communicating their intentions beforehand that markets will move based on subtle changes in tone and wording in their communications, long before any action takes place.

Global Central Bank Activity

We now know that central banks control monetary policy in their respective countries, but the current question is how could these effects extend globally? The central bank of Japan is currently engaging in their own version of easing monetary policy buying roughly $727 billion of assets annually on the open market to boost economic growth and increase inflation and these actions can be felt in the U.S.

Long-term interest rates were thought to be historically determined by supply and demand based on investor expectations of growth and inflation. However, the actions by central banks may have introduced another determinant of bond yields. The yield on a 30-year U.S. Treasury bond is just 2.89%, which is historically low on an absolute basis and underwhelming from the standpoint of an investor who views yields in real terms (subtract 2% for expected inflation leaving you with a 0.89% increase in purchasing power). However, when you compare this yield to other 30-year government bond yields around the world, you get a much different perspective. In Germany, a 30-year government bond will yield 1.29%, while in Japan you receive just 0.87% for your 30-year investment. (Bloomberg L.P. 10/5/17)

Easy monetary policy in Japan and elsewhere may have driven foreign investors into the U.S. market to earn higher yields, despite our relatively low returns. As a result, we have seen our domestic yield curve flatten as rates on the short end of the yield curve rise on recent FOMC actions to increase overnight borrowing rates, while floods of foreign investment into U.S. Treasuries has pushed yields down at the far end of the yield curve impacting returns on domestic bonds.

How Can Interest Rates be Negative?

Negative interest rate policies are an extreme example of monetary policy used to combat deflationary pressures. When central banks set interest rates, they are controlling the overnight borrowing rate that banks lend to each other (called the federal funds rate here in the U.S.). As it turns out, the most active borrower at these low rates is the very central bank that sets them. When a country sets interest rates as negative, they are effectively charging banks a fee to hold cash, and these fees are then passed on to depositors, thus encouraging banks to lend and depositors to spend rather than pay to store their cash. There are currently 22 countries in Europe that have instituted negative interest rate policies. (Bloomberg L.P.)

On the surface that might not sound so bad, right? I suspect that many of us faced with the alternatives of spending money or guaranteeing a loss on your savings account would all take some form of comfort in the former. But, it turns out it's not that simple.

Negative interest rate policies often extend beyond overnight borrowings into longer term assets such as government bonds. According to James Grant, founder of Grant's Interest Rate Observer, there is currently $11.7 trillion invested in negative yielding sovereign debt. Negative rates squeeze bank profit margins, and very low rates could cause many to become less profitable. Furthermore, pension funds depend on bond yields to meet their payment requirements and insurance companies invest their premiums in bond yields to meet future claims. (Borin, CFA Institute Blog)

The conundrum of negative interest rates is just one example of the impact and complexity that require consideration when monetary policy is being set.

Has U.S. Monetary Policy been successful?

The Federal Reserve has three objectives with respect to monetary policy: full employment, stable prices, and moderate long-term interest rates. So how have they done?

Unemployment levels were 4.1% as of October (generally anything less than 5% is considered full employment).

On interest rates, even after two rate hikes this year, the target rate remains at a relatively low 1.25% with one more rate hike expected this year and three more forecasted for 2018.

Lastly, despite popular belief, the Federal Reserve's stable price mandate does not cover equity markets and stable prices do not refer to asset values. Rather, stable prices refers to a target level of inflation, generally 2%. Current inflation levels of 1.3% are below target and continue to be a key talking point at each FOMC meeting.

Conclusion

With global central banks taking extreme measures to stimulate their respective economies, they have created a few unexpected consequences. Perhaps the most important of these consequences is the pulling forward of potential of future equity returns; that is, realizing higher equity returns today and lowering expected returns in the future. Combine this with negative and low interest rates on foreign sovereign debt, and you get foreign investors into U.S. markets pushing down long-term bond yields and impacting foreign exchange rates.

Over the long-run these actions are unsustainable. We need monetary policy to finally take a back seat to fiscal policy such as infrastructure spending and tax reform in order to achieve the forward- looking growth we're all hoping for.

Matt Heimann, CFA
Portfolio Manager

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