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May we
suggest a Twitter version of today's FOMC statement: "Don't worry, be
happy! " - No, the economic outlook hasn't
improved. In fact, the Fed may want you to take a vallium
to stomach the ride ahead. Alternatively, if you don't get mollified by the
Fed's "communication strategy", you may want to consider taking
action to protect the purchasing power of your hard earned dollars.
 
Here's the
challenge: the Federal Reserve (Fed) wants to keep interest rates low across
the yield curve (from short-term to long-term rates) to aid the economic
recovery. But good economic data might send the bond market into a tailspin,
i.e. raise long-term rates and thus cause massive headwinds to the economic
recovery. We got a taste of how quickly the bond market can sell off earlier
this year when the economy appeared to pick up some steam. Higher interest
rates would further encourage the major deleveraging that market forces still
warrant, not a desirable scenario from our understanding of Fed Chairman
Bernanke's thinking.
Engaging in
further rounds of asset purchases ("Quantitative Easing",
"QE3", "QEn+1") may alleviate some of those upward
pressures on interest rates, but the moment a program is announced, the
market prices it in and looks ahead, threatening to mitigate any lasting
impact of QEn+1. Picture the Fed as trying to hold a carrot in front of the
donkey, well, market, to make us believe another stimulus is coming, without
actually giving it. That way, the Fed can print less money to achieve its
goals. The Fed calls it communication strategy.
Some have
suggested a more open-ended approach to asset purchases. But that would
likely come with some sort of guidance as to when to stop it, such as when a
certain level of unemployment or nominal growth is reached. Given that
everything Bernanke has done has been signaled well ahead of time (the
blogosphere is full of the "best kept secret", the likelihood of
more QE), introducing a completely new concept is rather un-Bernanke-ish. You may not agree with Bernanke, but as an investor please don't act surprised.
In recently
released FOMC minutes, the Fed tells us that it might communicate to the
market that rates may remain low even as the economy recovers. Bingo! We have
long argued that Bernanke considered the early monetary tightening during the
Great Depression as a grave mistake, as it undid all the "progress"
that had been achieved. But more to the point, the Fed needs to get our attention
away from the economy. By keeping the link to the economy, the Fed will
always struggle to keep the upper hand on the bond market. So forget about
the carrot: we need vallium, not carrots. By
communicating with the market that rates will remain low independent of how
the economy might perform, the bond market just might not be selling off as
aggressively as economic growth picks up.
That's
exactly the path we believe the Fed is going to go down. It will be
interesting, however, to see what the Fed's explanation will be. We doubt
they will use the vallium analogy. Some Fed
watchers would like to see a nominal GDP target or something similar, but
don't bet your donkey on Bernanke going that far.
The basic
challenge is - and we are interpreting here as we don't think the Fed or any
central banker in office would ever frame it this way: the Fed wants to have
inflation, wants to move the price level higher to bail out home owners,
wants to push up nominal wages, and wants to push up nominal GDP to make the
debt burden more bearable. But the Fed doesn't want the market to price in
inflation, as that would push interest rates up. That's why we may be heading
ever more into the "Land of Make-Believe." But as investors enjoy
their vallium, the U.S. dollar is at risk of
melting away under their feet. Drugged up, we are too busy laughing at Greece
and doling out advice to Europe to notice that our "don't worry, be
happy" approach might lead to rather unhappy purchasing power. If you
think you are above the fray, let me just ask whether you have watched the
euro in recent months? As of late, that perceived weakling of a currency
appears to be giving the greenback a run for its money. We are not suggesting
that investors dump their U.S. dollars and exchange them all for euros.
However, we would like to encourage investors to consider embracing currency
risk, for example through a managed basket of currencies, as a way to manage
the risk posed to the purchasing power of the U.S. dollar. Adding currency
exposure to a portfolio may have valuable diversification benefits.
Some
sympathize with the ever greater complexity of monetary activism around the
world. But it's really rather simple: there's too much debt in the world. To
deal with the debt, countries may deflate, default or inflate. In the US, we
have what both Bernanke and his predecessor Greenspan have
called the printing press; as such, so their argument goes, the U.S. dollar
is safe - in nominal terms at least. Greece is not capable of procuring vallium, which creates a different set of challenges. But
stop pitying Greece and consider taking action to protect your purchasing
power at home.
Axel Merk
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