By signalling its intention to purchase another $600bn of longer-term Treasury securities by the end of June 2011, the Fed hopes its injections of cash will lower interest rates, bolster asset prices, increase wealth and encourage households and companies to spend and hire. Moreover, by noting the possibility of doing more if the data disappoint, it is also hoping that markets could price in the institution’s future asset purchases, turbo-charging the direct policy impact before those purchases have even been specified.
For a little more color you can check in with Cullen Roche, aka Pragmatic Capitalism who has been writing about this in a lot of detail. My focus has been to be more concerned with portfolio implications as this is my job, not trying to solve the world's problems.
However, it is important to be cognizant of what I will call a malignancy in the US stock and bond markets being unleashed by Ben Bernanke and his Federal Reserve Posse. Between all of the commentary on what the Fed is doing and Bernanke's op-ed in the Washington Post you should realize that policy is now targeting asset prices. If you do some blog reading you will find comments saying that the Fed is making it so that just holding cash is stupid, that by keeping interest rates so low investors are forced into buying risk assets. To the extent this is true it is heinous.
It is heinous for what could be several different bad outcomes, outcomes that could be worse than what is trying to be fixed. While I don't know if that will be the outcome this is one conclusion to draw from keeping interest rates at 1% for too long seven or eight years ago (although this was only one factor and not the biggest factor). If the rally in US equity prices we have enjoyed for the last few months has nothing but air under it then the consequence could be another painful decline--this would not be unprecedented obviously but could push any non-government induced recovery further down the road if the wealth effect actually does matter.
In years past I've talked about fast moves being about emotion and not being particularly healthy because of the panic embedded. Since August 31 the S&P 500 is up 16.4%. Whatever else is going on in the world that is a fast move and to the extent you believe the Fed is forcing people into risk assets then it is also a panicked rally. Trying to guess when something like this could peter out is not my strong suit so much as remembering that these moves often go back the other way scaring the hell out of people as it happens. In that light the important thing becomes remembering that it can go the other way and not succumb to some sort of freak out.
I used the word "remember" twice in the above paragraph because people forget what large declines feel like and end up making the same mistakes as before. Twenty six years being around markets tells me this and I see it in some comments from readers here and at Seeking Alpha (apologies if that is harsh).
To be clear I am not one of these guys you see on the teevee saying they are 50% in cash. We are plenty long, up about in line with the market for the year despite the whatever drag there might be from the cash we do have and any other defensive steps we've taken--we've had luck picking a couple of correct countries and underweighting domestic financials has still been the right position.
I would describe the mindset as going along for the ride but not willing to give the US market the benefit of the doubt should it turn down. I am willing to give the benefit of the doubt to the foreign markets we are in as they, repeat point coming, are on much firmer economic footing and have proven to me that over a reasonably long period of time they can do well without the US. Of course if the S&P 500 drops 30% in the next six months I would expect the markets we own to drop as well although some would go down later, come back sooner and or not drop as much as was the case in 2007-2008.
It would only take a couple of domestic stock for foreign stock swaps to meaningfully reduce our US exposure. This has been happening slowly for years but obviously the timetable could be moved up at anytime. Long time readers of the blog will know that this has been a very long range plan (moving to more foreign) because of perceived troubles in the US from a long time ago, readers will also know that while I got out in front of the event I greatly underestimated the magnitude which fortunately turned out to be less important.
Long range planning is very important in the context of portfolio construction and cycle navigation. It creates a framework based on reasonable expectations and obviously as time goes on an investor can be flexible with such a path.