Forget the ‘bond vigilantes’.
Now it’s the ‘feral hogs’ that governments across the world have to fear. That’s how Federal Reserve decision maker Richard Fisher described ‘big money’ in an interview with the Financial Times yesterday.
Investors have been throwing a bit of a tantrum at the idea that the Fed might stop printing money at some point in the near future. Fisher was basically saying that they can throw as much of a fit as they want, but the Fed’s not for turning.
“We’ve had a 30-year bond market rally. These things do not go on forever,” said Fisher.
It’s easy to dismiss his stance as a bluff. But that would be a mistake. Things have changed – and you need to be aware of the impact that’ll have on your portfolio…
Why the Fed is apparently unworried about deflation
The Fed is making some attempt to calm markets down a little about the end of quantitative easing (QE). But it’s not showing any signs of rowing back on its plans.
And while that could change, I wouldn’t want to stake the health of my portfolio on Ben Bernanke and team doing a U-turn.
Various commentators have wondered why the Fed is even talking about pulling QE, given that inflation is low (on official measures at least). Surely deflation (falling prices) is what the Fed should be worrying about?
But think about this for a moment: the big risk to the Fed in pulling out of QE is the ‘normalisation’ of interest rates. In short, if the Fed stops buying, people get worried that bond prices will fall hard, and interest rates will rise sharply.
However, the Fed has to stop some time. Is it better to stop when inflation is higher or lower? If inflation is rising, investors expect a higher return from bonds before they buy them; if inflation is low, then rates don’t have to rise much before you can get a ‘real’ (ie after-inflation) return on your money.
In other words, there’s a natural floor under US government bond prices. Even in a panic, they can only fall so far before people start finding them attractive again.
The objections just show what irritatingly imprecise terms inflation and deflation can be. Let’s try to simplify things. ‘Bad’ deflation is what you get when people are being crushed by debt. They’ve borrowed money, and the underlying value of the asset is falling. They stop spending, to try to tackle the debt. Banks stop lending. The economy starts shrinking.
‘Good’ deflation is what you get when productivity goes up. The electronics industry is the classic example. Today you can buy a gadget that does twice as much as it did a year ago, for the same price or less. In a year’s time, the same thing will happen.
Does that process threaten the economy? Of course not – that’s the Holy Grail – getting more output for the same input.
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The reason inflation in the US is tame at the moment, is more due to ‘good’ deflation than to ‘bad’. Energy costs have been lowered by fracking technology. Raw material prices have been hit by a fall in demand from China, but that’s not America’s problem.
As Paul Ashworth of Capital Economics noted of the May US inflation data: “The low level of headline inflation largely reflects the drop back in commodity prices over the past 12 months, with even the low ‘core’ rate partly explained by the indirect impact of those lower commodity prices.”
This is not ‘bad’ deflation. This is not the recipe for a vicious downwards spiral. Yes, the economy is hardly on fire. But it’s hard to deny that things are better than they were. If the economy can’t even think of coming off life support at a time when energy prices are falling and house prices have corrected across the country, then when will it be able to get out?
The dangers are mounting
There are some very real risks to this view – and I’ll get to them in a minute. But first, it’s also worth understanding why the Fed might be worried about continuing with QE.
For a start, QE has created bubbles that even the Fed can’t ignore. The quest for yield has driven the price of almost all bonds well beyond sensible levels. Stocks haven’t been driven to crazy prices yet, but in the US at least, they are historically expensive.
The higher prices go in both these markets, the harder they’ll fall as QE ends. We’ve already seen carnage in emerging markets as the hot money floods back out. Better to try to knock some of the exuberance out of the market before it gets too excited.
But the clincher is probably this: stopping QE – stopping buying bonds – is one thing. That’s hard enough. But reversing QE – actually selling the bonds you’ve bought – would be a nightmare. Our Roundtable experts talk about how bad it could be in the current issue of MoneyWeek magazine – I’ll not go into details here (you can get your first three issues free here if you’re not already a subscriber).
The point is that the Fed would rather not ever have to reverse QE. It would rather have the bonds it has bought sitting on its balance sheet until they mature. Then they can just quietly disappear. The longer they leave it to stop, the harder that will be.
What this means for your money
So what do you do? In theory, it’s actually quite simple. Avoid stuff that has been driven up purely on the promise of more money-printing by the Fed (most bonds). And buy stuff that has some ‘fundamental’ value – in other words, cheap stuff (cheap eurozone markets, and Japanese stocks, for example).
However, there’s another threat to watch out for. That’s China. As I noted last week, China’s having a bit of a crunch moment, too. If we’re going to get deflation – enough deflation to drive more money-printing – then that’s where it’ll come from.
Markets also hate it when the interest rate backdrop changes. This is a big change, and it’ll take them some time to get used to. That means more volatility and more panics.
So I’d be happy to keep drip-feeding money into cheap markets. But if you’ve taken any more speculative punts, or there’s anything you don’t feel comfortable holding through volatile periods, then it’s probably worth considering selling it, if you haven’t already. And I’d make sure you keep a bit more cash on the sidelines, ready to pounce when better opportunities arise.
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