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Don't Fight The Fed

This was one of the key mantra’s I heard repeatedly early in my career when I traded mortgage-backed securities and sat on the bond trading desks at two major investment banking firms.  Back then, in the 1980’s, the mantra seemed to me to overstate the power of the Fed’s ability to move markets.  The concept of QE, or printing money to buy securities, was unimaginable then.  The main power of the Fed rested in its ability to influence only the shortest end of the yield curve (or short term rates, for those of you who don’t come from the finance world).   It seemed back then, in the days of what seemed to be free markets, that the forces of the marketplace, expressed by the thousands of participants coming together to by and sell securities and to borrow and lend money, set the more important longer term rates that directly affected most borrowings – including home mortgages, commercial real estate loans, and corporate borrowings.
In the wake of what we now call The Great Recession, the Fed has changed its approach to markets rather dramatically, as many know but I believe too few question.  For the past five years the Fed has become the major mover of financial markets, literally not permitting interest rates to rise.  Of course, given our country’s relative financial health and stability when compared to the rest of the world, it isn’t hard to say that this policy has worked magically and we ought to applaud those at the Fed for a job well done.  If only life was that simple. 

With rates as low as they’ve been, investors who require a reasonable return on their capital, historically in the vicinity of 6-8%, have been forced to shun high quality fixed income securities and reallocate primarily into stocks and lower quality (high yield) fixed income.  This has created a situation whereby a retrenchment of the Fed from its market dominating position and commitment to ultra-low rates is very difficult, if not impossible.  Such a retrenchment would certainly cause rates to drift higher, which would have a negative impact on general stock prices, as well as home values and real estate values overall.  The market losses and “negative wealth effect” this would cause is surely weighing heavily upon the minds of those at the Fed today.  Further complicating matters is the fact that the Fed, with its immense balance sheet and its ability to manage the market, is generating significant profits which flow through to Treasury and are now being counted upon to pay for a good part of our nation’s budget.  In sum, it is difficult to imagine how the Fed will reverse the dominating position it has taken up since 2009. 

As I reflect upon the market that I grew up in, which was driven by the input of many thousands, I wonder what all of this means for the future of finance in the U.S.  And, finance being an integral element of our society, I am deeply concerned about the trend towards government dominance of our markets.  Freedom, like air or like a pain-free body, is something that most people take for granted until it is lost.  Freedom seems to be under siege in the U.S. and in the world, and a free market financial system has long been a cornerstone of American freedom.  I’ve heard many recently applauding those who have brought us to this place, crediting them with having sufficiently revived our economy.  I fear that the price we will pay for this fix will ultimately prove to be very high.

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