Quantitative easing followed by tapering – the newest diet fad? No, but they are concepts that may be of importance to your fiscal health. These are the buzzwords repeated by financial reporters before, during, and after each policy meeting by the Board of Governors of the Federal Reserve System. While the media often seems more interested in catchy headlines than conveying information, these topics are important, and should be understood by investors. This article defines and clarifies these concepts, and explains their relevance to an individual’s investment portfolio.
Quantitative easing (QE) is an unconventional form of expansionary monetary policy used by the Federal Reserve in response to the 2008 Financial Crisis. Expansionary (or loose) monetary policy is undertaken with the goal of stimulating the economy. It works by encouraging capital expenditure and thus discouraging excessive saving. The primary way in which such stimulation is generally achieved is by lowering market interest rates (via changes in the Federal Funds rate). Lower rates make borrowing and investing cheaper for businesses. Lower interest rates also reduce the return from saving money, which may induce some people to consume more and save less of their incomes. Both the increased business investment and higher levels of personal consumption have an expansionary effect on the economy. In contrast, contractionary (or tight) monetary policy1 would involve raising interest rates, which would have the opposite effect on investment and consumer spending. While the Federal Reserve would generally prefer to use the interest rate as their primary tool, there are circumstances under which interest rate changes are no longer effective or feasible; for example, when rates are at a lower bound, meaning that the Federal Funds rate is at 0%. Clearly nominal rates cannot be lowered below 0% (as this would mean that lenders were paying people to borrow their money), so other methods must be used to implement expansionary policy. This is where quantitative easing enters the picture.
Quantitative easing involves the Federal Reserve purchasing fixed income securities (generally Treasury bonds or mortgage-backed securities) on the open market. This accomplishes two goals; it lowers market rates lower than can be achieved by the Federal Funds rate by itself, and it also increases the amount of money in the economy. Both of these results are expected to have a positive effect on the economy. However, the Fed has to use caution when employing this type of monetary policy, as increasing the supply of money in the economy can lead to inflation if not monitored closely. The latest round of quantitative easing, commonly known as QE3, involved the Fed purchasing $85 billion worth of bonds each month, starting in December 2012 and with no specified end date.
Because QE3 was open-ended, it received the nickname “QE-Infinity”, despite the fact that the Fed made it clear that they would reduce the bond purchases as the US economy showed signs of recovering. On May 22nd, 2013, Fed Chairman Ben Bernanke announced that if the economy continued to show signs of improvement, the Federal Reserve would begin to “taper” their bond purchases, meaning that the $85 billion per month would be reduced and eventually eliminated. On December 18, Chairman Bernanke announced that the Fed would officially begin tapering, reducing purchases to $75 billion per month. This number has since been lowered to $65 billion per month, and is expected to continue to be reduced as long as the economy appears stable.
While it is important to know how Federal Reserve policy affects the country on a macroeconomic level, investors are also concerned with how this policy will affect their investment portfolios. As most investors have likely noticed, low market interest rates have greatly reduced the yield on fixed income investments like bonds and money market accounts. As yield and price are inversely related, this reduction has actually been beneficial for bond holders over the period of rate reduction, but it puts current fixed income investors in a difficult situation. Because Fed tapering will result in interest rates rising, bond prices will be negatively affected, particularly bonds with longer maturities. When the Fed announced the possibility of tapering in May, interest rates rose sharply, with the yield on 10-year US Treasury bond increasing over 1% before the end of 2013. This led to a difficult year for bonds; the Barclays Aggregate US Index2 lost 2.02%, which was its worst performance in nearly two decades.
Since the beginning of 2014, interest rates have erased some of their previous gains, however it is expected that rates will continue to rise in the future as the Federal Reserve continues its tapering policy, and eventually raises the Federal Funds rates. This means that the current environment holds various risks for bond-holders who are not careful with their investment strategy. As mentioned above, rising interest rates can hurt bond prices, at least temporarily, and this is exacerbated in longer bonds. This effect is what is known as interest rate3 (or duration) risk. At Empirical, we are very conscious of interest rate risk, and only expose our portfolios to risks that are adequately compensated through higher expected returns. Our Targeted Credit strategies are specifically designed to avoid large levels of interest rate risk, and thus are well-equipped for various interest rate scenarios. If you have specific questions about the effects of rising rates on your portfolio, or want a second opinion on your investments, please feel free to contact an Empirical advisor.