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.

Getty
Show Hide image

The deafening killer - why noise will be the next great pollution scandal

A growing body of evidence shows that noise can have serious health impacts too. 

Our cities are being poisoned by a toxin that surrounds us day and night. It eats away at our brains, hurts our hearts, clutches at our sleep, and gnaws at the quality of our daily lives.

Hardly a silent killer, it gets short shrift compared to the well-publicised terrors of air pollution and sugars food. It is the dull, thumping, stultifying drum-beat of perpetual noise.

The score that accompanies city life is brutal and constant. It disrupts the everyday: The coffee break ruined by the screech of a line of double decker buses braking at the lights. The lawyer’s conference call broken by drilling as she makes her way to the office. The writer’s struggle to find a quiet corner to pen his latest article.

For city-dwellers, it’s all-consuming and impossible to avoid. Construction, traffic, the whirring of machinery, the neighbour’s stereo. Even at home, the beeps and buzzes made by washing machines, fridges, and phones all serve to distract and unsettle.

But the never-ending noisiness of city life is far more than a problem of aesthetics. A growing body of evidence shows that noise can have serious health impacts too. Recent studies have linked noise pollution to hearing loss, sleep deprivation, hypertension, heart disease, brain development, and even increased risk of dementia.

One research team compared families living on different stories of the same building in Manhattan to isolate the impact of noise on health and education. They found children in lower, noisier floors were worse at reading than their higher-up peers, an effect that was most pronounced for children who had lived in the building for longest.

Those studies have been replicated for the impact of aircraft noise with similar results. Not only does noise cause higher blood pressure and worsens quality of sleep, it also stymies pupils trying to concentrate in class.

As with many forms of pollution, the poorest are typically the hardest hit. The worst-off in any city often live by busy roads in poorly-insulated houses or flats, cheek by jowl with packed-in neighbours.

The US Department of Transport recently mapped road and aircraft noise across the United States. Predictably, the loudest areas overlapped with some of the country’s most deprived. Those included the south side of Atlanta and the lowest-income areas of LA and Seattle.

Yet as noise pollution grows in line with road and air traffic and rising urban density, public policy has turned a blind eye.

Council noise response services, formally a 24-hour defence against neighbourly disputes, have fallen victim to local government cuts. Decisions on airport expansion and road development pay scant regard to their audible impact. Political platforms remain silent on the loudest poison.

This is odd at a time when we have never had more tools at our disposal to deal with the issue. Electric Vehicles are practically noise-less, yet noise rarely features in the arguments for their adoption. Just replacing today’s bus fleet would transform city centres; doing the same for taxis and trucks would amount to a revolution.

Vehicles are just the start. Millions were spent on a programme of “Warm Homes”; what about “Quiet Homes”? How did we value the noise impact in the decision to build a third runway at Heathrow, and how do we compensate people now that it’s going ahead?

Construction is a major driver of decibels. Should builders compensate “noise victims” for over-drilling? Or could regulation push equipment manufacturers to find new ways to dampen the sound of their kit?

Of course, none of this addresses the noise pollution we impose on ourselves. The bars and clubs we choose to visit or the music we stick in our ears. Whether pumping dance tracks in spin classes or indie rock in trendy coffee shops, people’s desire to compensate for bad noise out there by playing louder noise in here is hard to control for.

The Clean Air Act of 1956 heralded a new era of city life, one where smog and grime gave way to clear skies and clearer lungs. That fight still goes on today.

But some day, we will turn our attention to our clogged-up airwaves. The decibels will fall. #Twitter will give way to twitter. And every now and again, as we step from our homes into city life, we may just hear the sweetest sound of all. Silence.

Adam Swersky is a councillor in Harrow and is cabinet member for finance. He writes in a personal capacity.