The Fed, the Markets and Capped Rates
When the Federal Reserve, or more specifically the FOMC, meets to discuss monetary policy and the state of the economy, it is always a big deal. Interest rates and liquidity are undoubtedly two of the most powerful drivers behind asset pricing. The importance of Fed’s decisions has clearly been stressed even more since their aggressive policies were implemented as a response to the 2008 crisis and now as the most immediate tool fighting the dire economic consequences of COVID-19.
In our recent missives, we have highlighted the rapid “shock and awe” approach of Jay Powell’s Fed as a key element in stabilizing financial markets. The result of such action is an almost sudden doubling of the central bank’s balance sheet from less than $4 trillion to just about $7 trillion.
Since 2008, we have gotten accustomed to a much blunter management of the yield curve, way beyond the short end which was traditionally the target area of the Fed. However, the COVID-19 pandemic might have ushered in another, even more drastic, approach to monetary policy.
In the post-meeting press conference, Chairman Powell sounded worried about the length of the economic recovery and accordingly stressed a very dovish path for future monetary action. Interest rates will be kept at zero probably at least until 2022 along with the Fed’s readiness to continue to act pre-emptively to help the economic healing process.
However, there was more…. Chairman Powell hinted at conversations about capping rates for some specific maturities (probably the 3 and 5-year notes). Yield-curve control policies would essentially institutionalize infinite Quantitative Easing (QE) preventing the market to set long term rates in response to aggressive monetary AND fiscal policy.
A free bond market acts as a “vigilante” on fiscal and monetary policy increasing or reducing the cost of such policies by increasing or decreasing yields. In a capped environment, the price discovery process will lose meaning and transparency of pricing for many assets and credit related vehicles will greatly suffer. Such a significant course of action seems inevitable as the predicament in which we find ourselves grows in magnitude after each crisis. Reducing the central bank balance sheet and the public debt load would require strong organic growth and some inflation. Both elements are predicted to lack for a while. But not forever… eventually a resurgence of inflation might become a reality as we witnessed in a previous loose monetary and fiscal cycle in the 1970s.
On a more short-term basis, the implementation of capped rates should make Treasury bonds unattractive and only utilized as risk-off, risk-on tradeable tools. This scenario may push investors once again out on the risk curve and specifically, it may force them to chase the usual suspects, growth stocks. If yields are artificially low, the discount rate on equities is reduced and higher valuations are possible. Also, in a world of chronic low growth, companies that can still find ways to grow at a higher clip will command a premium. Conversely, value stocks, which usually are characterized by large debt loads and low growth might continue to underperform.