The Fed continues to sway over its QE policy

What's the cause of this oscillation?

If you listened closely after the US Federal Reserve’s surprising September policy announcement, you might have heard confused investors around the world saying, "Ben, you’ve lost us."

Fed Chairman Ben Bernanke reported that the US central bank had chosen to keep its $85-bn-per-month quantitative easing (QE) programme intact, a decision that starkly contrasted with the strong signals it sent in May that it would start winding down the open-ended QE effort that it had begun only nine months earlier.

US GDP growth, employment and inflation numbers have all been relatively consistent for the past year, so the seemingly wide swings in policy stance during that period have left the market with big questions about the Fed’s future direction.

Bond investors need to rapidly come to terms with this new source of market uncertainty, find ways to build portfolios that mitigate these new risks and take advantage of opportunities stemming from increased volatility when they present themselves.

Before we start parsing the Fed’s recent announcements, it is important to note how the signalling effect works within the Fed’s policy statements. The theory goes that if the market knows the Fed’s intentions, it will do some of the Fed’s work for it. For example, if the Fed says it plans to gradually cut rates over the next few years, businesses may start to ramp up hiring and spending well in advance of the actual rate cuts.

The market doesn’t really need to know exactly what the Fed will do with interest rates, but it does need to understand the general rules of how economic events will trigger Fed action. If we know, for example, that the Fed will hike rates when inflation rises above a certain threshold, we worry less about the Fed’s monthly announcements and focus simply on trying to forecast inflation. 

It’s exactly those rules of engagement that have been blurred by recent Fed decisions. In September 2012, the Fed announced a new open-ended QE programme that would continue until the economy achieved specific targets for inflation (2.0 to 2.5 per cent) or unemployment (6.5 per cent). This sent a clear signal to investors that they could build their Fed scenarios around their economic projections for inflation and unemployment.

Then in May 2013, the Fed reversed course and announced that it would likely start tapering its bond purchases "later this year", with an implication that tapering could begin in September. The market was taken aback by this announcement, as neither inflation nor unemployment had come close to hitting the Fed’s previously stated targets.

Finally, we heard in September that the Fed would leave its QE programme unchanged. Once again, the change in direction was not triggered by any big changes in economic data – if anything, data since May has progressed toward the Fed’s original goals, with a bump in inflation, a drop in unemployment and healthy results in manufacturing activity.

Since the Fed’s vacillations over the past year weren’t consistent with any shifts in the economic data they claimed to be watching, the market no longer knows what data the Fed thinks is important. Was QE3 designed for some other, non-stated purpose – to depress the dollar, or to offset fiscal budget tightening, or to buoy the stock market? Does the Fed see risks that it is not articulating publicly? We just don’t know.

Complicating all of this further is the fact that Federal Reserve Chairman Ben Bernanke is retiring in January, and President Obama has yet to nominate a successor. Investors need to be prepared for a wide range of 2013 outcomes, but also need to consider that Bernanke’s successor may chart a different course entirely for monetary policy in 2014 and beyond.

It all adds up to a market with no true compass for how Fed policy and economic reality interact, so we believe that the market’s recent spike in volatility and sensitivity to economic news is likely to become the norm rather than the exception going forward.

Building an investment thesis around the Fed’s short-term moves may be more difficult now, but it has always been difficult. We build our portfolios on fundamentals: we focus on identifying a select group of sturdy bonds from stable issuers, with attractive upside potential. This provides opportunity for total return but also provides the relative stability of bonds that will do well when held to maturity.

While this is an all-weather philosophy, we believe that our approach is particularly well-suited for this market. Whether it acts in 2013 or 2014 or 2015, the Fed will eventually reduce its monthly bond purchases and begin to hike interest rates. Given that, we are focused on shorter-duration bonds, as we have been for several years, to mitigate the potential impact of rising rates on our portfolios.

The yield curve is also exceptionally steep at the moment, meaning that the yield gap between very short-term and longer-term bonds is unusually high. We have positioned portfolios to benefit from this yield gap narrowing. Finally we keep a constant watch for moments when volatility produces opportunity.

In US municipal bonds, for example, fund flows have been persistently negative for much of 2013, as investors have reacted to rising rates as well as isolated solvency crises in Puerto Rico and the city of Detroit. The downward pressure on municipals across the board has enabled us to buy favoured bonds at attractive prices. We expect similar instances of market dislocation – and resulting opportunity – as we go forward in this uncertain period.

On the heels of the Fed’s recent communication breakdowns, the outlook for the bond market is more uncertain. Now more than ever, it’s important to focus on the factors we can control, and be ready to capitalise on opportunities that materialise when the market is blindsided by factors that, for the moment, no one can see clearly.

Thomas DD Graff, CFA is Head of Fixed Income at Brown Advisory

This piece first appeared in Spear's Magazine

Ben Bernanke. Photograph: Getty Images

This is a story from the team at Spears magazine.

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How Donald Trump is slouching towards the Republican nomination

There was supposed to be a ceiling above which Trump’s popular support could not climb.

In America, you can judge a crowd by its merchandise. Outside the Connecticut Convention Centre in Hartford, frail old men and brawny moms are selling “your Trump 45 football jerseys”, “your hats”, “your campaign buttons”. But the hottest item is a T-shirt bearing the slogan “Hillary sucks . . . but not like Monica!” and, on the back: “Trump that bitch!” Inside, beyond the checkpoint manned by the Transportation Security Administration and the secret service (“Good!” the man next to me says, when he sees the agents), is a family whose three kids, two of them girls, are wearing the Monica shirt.

Other people are content with the shirts they arrived in (“Waterboarding – baptising terrorists with freedom” and “If you don’t BLEED red, white and blue, take your bitch ass home!”). There are 80 chairs penned off for the elderly but everyone else is standing: guys in motorcycle and military gear, their arms folded; aspiring deal-makers, suited, on cellphones; giggling high-school fatsos, dressed fresh from the couch, grabbing M&M’s and Doritos from the movie-theatre-style concession stands. So many baseball hats; deep, bellicose chants of “Build the wall!” and “USA!”. (And, to the same rhythm, “Don-ald J!”)

A grizzled man in camouflage pants and combat boots, whose T-shirt – “Connecticut Militia III%” – confirms him as a member of the “patriot” movement, is talking to a zealous young girl in a short skirt, who came in dancing to “Uptown Girl”.

“Yeah, we were there for Operation American Spring,” he says. “Louis Farrakhan’s rally of hate . . .”

“And you’re a veteran?” she asks. “Thank you so much!”

Three hours will pass. A retired US marine will take the rostrum to growl, “God bless America – hoo-rah!”; “Uptown Girl” will play many more times (much like his speeches, Donald J’s playlist consists of a few items, repeated endlessly), before Trump finally looms in and asks the crowd: “Is this the greatest place on Earth?”

There was supposed to be a ceiling above which Trump’s popular support could not climb. Only a minority within a minority of Americans, it was assumed, could possibly be stupid enough to think a Trump presidency was a good idea. He won New Hampshire and South Carolina with over 30 per cent of the Republican vote, then took almost 46 per cent in Nevada. When he cleaned up on Super Tuesday in March, he was just shy of 50 per cent in Massachusetts; a week later, he took 47 per cent of the votes in Mississippi.

His rivals, who are useless individually, were meant to co-operate with each other and the national party to deny him the nomination. But Trump won four out of the five key states being contested on “Super-Duper Tuesday” on 15 March. Then, as talk turned to persuading and co-opting his delegates behind the scenes, Trump won New York with 60 per cent.

Now, the campaign is trying to present Trump as more “presidential”. According to his new manager, Paul Manafort, this requires him to appear in “more formal settings” – without, of course, diluting “the unique magic of Trump”. But whether or not he can resist denouncing the GOP and the “corrupt” primary system, and alluding to violence if he is baulked at at the convention, the new Trump will be much the same as the old.

Back in Hartford: “The Republicans wanna play cute with us, right? If I don’t make it, you’re gonna have millions of people that don’t vote for a Republican. They’re not gonna vote at all,” says Trump. “Hopefully that’s all, OK? Hopefully that’s all, but they’re very, very angry.”

This anger, which can supposedly be turned on anyone who gets in the way, has mainly been vented, so far, on the protesters who disrupt Trump’s rallies. “We’re not gonna be the dummies that lose all of our jobs now. We’re gonna be the smart ones. Oh, do you have one over there? There’s one of the dummies . . .”

There is a frenzied fluttering of Trump placards, off to his right. “Get ’em out! . . . Don’t hurt ’em – see how nice I am? . . . They really impede freedom of speech and it’s a disgrace. But the good news is, folks, it won’t be long. We’re just not taking it and it won’t be long.”

It is their removal by police, at Trump’s ostentatious behest, that causes the disruption, rather than the scarcely audible protesters. He seems to realise this, suddenly: “We should just let ’em . . . I’ll talk right over them, there’s no problem!” But it’s impossible to leave the protesters where they are, because it would not be safe. His crowd is too vicious.

Exit Trump, after exactly half an hour, inclusive of the many interruptions. His people seem uplifted but, out on the street, they are ambushed by a large counter-demonstration, with a booming drum and warlike banners and standards (“Black Lives Matter”; an image of the Virgin of Guadalupe, holding aloft Trump’s severed head). Here is the rest of the world, the real American world: young people, beautiful people, more female than male, every shade of skin colour. “F*** Donald Trump!” they chant.

After a horrified split-second, the Trump crowd, massively more numerous, rallies with “USA!” and – perplexingly, since one of the main themes of the speech it has just heard was the lack of jobs in Connecticut – “Get a job!” The two sides then mingle, unobstructed by police. Slanging matches break out that seem in every instance to humiliate the Trump supporter. “Go to college!” one demands. “Man, I am in college, I’m doin’ lovely!”

There is no violence, only this: some black boys are dancing, with liquid moves, to the sound of the drum. Four young Trump guys counter by stripping to their waists and jouncing around madly, their skin greenish-yellow under the street lights, screaming about the building of the wall. There was no alcohol inside; they’re drunk on whatever it is – the elixir of fascism, the unique magic of Trump. It’s a hyper but not at all happy drunk.

As with every other moment of the Trump campaign so far, it would have been merely some grade of the cringeworthy – the embarrassing, the revolting, the pitiful – were Trump not slouching closer and closer, with each of these moments, to his nomination. 

This article first appeared in the 28 April 2016 issue of the New Statesman, The new fascism