Don’t fight the Fed but don’t depend on it either

Crisis or no crisis, the rules of the game have changed for investors.

Before quantitative easing, investors could rely on government bonds and stocks to work together, through the cycle, to reduce portfolio volatility. 

A central bank would cut interest rates when economic times were tough, the outlook for corporate earnings dismal and stock prices under pressure. As interest rates fell, rising government bond prices would typically bolster a portfolio damaged by falling stocks.

The relationship also worked in reverse. As the benefits of lower interest rates stabilised the economy and the outlook for corporate earnings improved, central banks could then normalise their policy rates. For equities, the prospect of stronger corporate earnings overwhelmed the fact that you were discounting them at a higher rate of interest.

In short, the inverse correlation between stocks and government bonds created a perfect symbiotic relationship, helping those investors with a balanced portfolio to sleep easy through good times and bad.

But with the advent of QE, the narrative has shifted. And the scale of that shift has become increasingly apparent during the pandemic, as illustrated by the Federal Reserve’s commitments in March and April to buy assets as far down the risk spectrum as high-yield credit.

The game has changed because the Fed is not operating under the same incentives as private investors. The darker the economic outlook, the more it is willing to buy. Its resources are, in principle, limitless. An investor cannot “fight the Fed”.

If few fund managers are complaining, that is because everything has gone up — stocks, credit and core bond prices. Since the Fed’s major intervention in March, the 10-year US Treasury benchmark has provided a positive return of 1.7 per cent, while the US investment-grade index has risen 16 per cent and US high-yield by 21 per cent. The S&P 500 stock index, meanwhile, has recouped almost all its losses in the year to date.

Investors may be less happy when central banks try to turn off their monetary taps. If the data keep coming in better than expected, as happened last week with the June US jobs report, then central banks should be in retreat.

I am not talking about raising rates or even selling assets back; I am talking about shifting from “emergency” policy to “accommodative” policy — from fully opened taps to a more moderate flow. What happens when policymakers signal that new asset purchases will be scaled back?

We have already had a glimpse of what is in store. At its last policy meeting, the Bank of England announced it would slow the pace of its purchases. The news did not go down well. Gilt prices fell on the day, as did UK stocks.

For global markets it is the Fed that matters. The minutes from its last meeting, released last week, suggest the central bank realises it needs to shift away from its current guidance, which can be paraphrased as “whatever it takes for as long as it takes”.

That message is too ambiguous. Investors are left combing through the weekly purchase report to gauge the Fed’s appetite and intent for different segments of the market. At a minimum, the central bank will have to be clear whether its credit purchase programme will end on September 30, as indicated by the current schedule.

There is some speculation that the Fed will lock the taps on, committing explicitly to capping borrowing costs through a policy known as yield curve control. But what if it does not? Given the new rules of the game, investors should start to consider the implications of a change in the monetary tide. I would suggest two key points of focus.

First, do not assume you will be able to offload assets at the central bank indefinitely. Be comfortable with what you hold. Own the credit and stock of quality companies with manageable levels of debt, good prospects for earnings and those that screen well on sustainability criteria. A purely passive approach to investing may have served its purpose so far. What happens when the tide recedes remains to be seen.

Second, seek shelter in assets that have been less influenced by central bank liquidity. Even the most diligent investor will be hurt if a shift in monetary policy weighs on the price of government bonds, credit and stocks at the same time.

In my view, investors should consider looking beyond public markets to areas that, given their illiquid nature, have been relatively insulated from central bank distortions. Asset classes such as infrastructure and real estate should serve as ballast to a portfolio.

Grudgingly or not, investors must accept these new rules. There is no point fighting the Fed. But you cannot rely on it either.

The writer is chief market strategist for Emea at JPMorgan Asset Management