DURHAM, NC--(Marketwire - Feb 21, 2013) - As the economy continues to improve, albeit slowly, debate continues about the long-term impact of current monetary policy, specifically the Fed's continued use of quantitative easing to fuel monetary growth. According to Greg Brown, "Given our recent history, we should be very mindful of the unintended consequences of our current unconventional monetary policy. By our estimates, it is increasingly likely that quantitative easing could create a 'bad ending' for segments of the economy and certain market sectors, such as U.S. Treasuries." Gregory Brown, PhD, is Director of Research at Smith Breeden Associates, and a Professor of Finance and the Sarah Graham Kenan Distinguished Scholar at the UNC Kenan‐Flagler Business School. Smith Breeden Associates is a global asset management firm providing a variety of traditional fixed income and absolute return strategies.
In a recent white paper -- "Will U.S. Quantitative Easing End Badly?" -- Brown reviews recent Fed policy actions and explores the risks associated with quantitative easing. According to Brown, the ways in which quantitative easing could end badly are predicated in this particular facet of monetary policy unwinding more quickly than anticipated. The catalyst for this scenario is most likely an upside surprise to economic conditions in 2013 that sparks an "inflation scare." Brown suggests that, "It is not even necessary that actual inflation tick up much, only that inflation expectations increase and markets start to fear a sooner-than-expected end to accommodative Fed policy... it could be that the major risk to the bond markets -- and unsuspecting households -- is upside economic growth."
Brown identifies the following developments that could work either independently or in tandem to spark this "inflation scare."
Housing takes off
Currently, uncertainty abounds about what constitutes the true supply of housing available to buyers. Measures of combined supply that include bank-owned properties suggest there remains one-to-two years of excess supply. However, supply could be much tighter than widely assumed if this supply is not in the locations needed to meet new demand or banks continue to hold a lot of properties off the market. We have already seen positive surprises in home prices and current valuations are low relative to measures of fair value implied by rents. Record low mortgage rates could further juice demand. Pent-up household formation has started to propel housing as deleveraging slows. So, it is certainly possible that recent price increases will bring people off the sidelines as they sense the market has bottomed. A price jump could be self-reinforcing if this causes others to worry about missing the bottom.
Recent academic research suggests that the economic recovery has been hindered by high levels of uncertainty. This uncertainty is rapidly resolving: The Fed has removed most near-term monetary policy uncertainty for the U.S. The ECB has signaled it will do whatever it can to preserve the Euro. The global economy is stabilizing after a second-half slump. The U.S. presidential election is over. Most near-term fiscal uncertainty should get resolved sometime in the second quarter. Equity market volatility has been trending downward since mid-2011.
Consumers come back strong
While the long slog by U.S. households through excessive debt levels continues, there is an increasingly bright light at the end of the tunnel. Household debt as a percentage of disposable income has declined from a peak of 129.4% in 2007 to 107.9% in the third quarter. There is good reason to believe it will start to level off at ~100% sometime in the next year or two, since the debt service burden (debt service payments as a percentage of disposable income) is approaching a 30-year low. Continued stock market gains could lead to a positive wealth effect and further stimulate spending. All of this combined with historically loose financial conditions and an improving housing market means consumers could come back with a vengeance.
According to Brown, "If the economy shows unexpected strength and concurrently we see some surprises in monthly inflation reports, two things are possible: the bond market could get spooked and investors could grow concerned that the Fed is behind the curve and will end quantitative easing sooner than expected. These reactions could, in turn, for instance, result in a rapid climb in U.S. Treasury yields -- much like the sell-off in 1994 when bond traders were caught off-guard by Fed rate hikes. While the Fed has promised to be exceptionally accommodative until the labor markets improve significantly, there is an important caveat. The Fed has conditioned its policy on intermediate-term inflation expectations remaining below 2.5% and longer-term expectation remaining 'well anchored.' With inflation currently running at ~2%, this does not leave much headroom."
Based on his analysis, the potential bad ending Brown foresees pertains mostly to assets exposed to inflation risks, such as conventional U.S. Treasuries. "The crux of the problem lies in understanding how much expected inflation would be 'good' for the economy and markets -- perhaps as much as 3% on a forward-looking basis. However, the combination of surprising growth and current Fed policies makes for a highly flammable combination which could lead to inflation expectations beyond this level," states Brown.
Following is Brown's outlook for various fixed income securities based on a possible inflation scare:
- Treasury Inflation-Protected Securities (TIPS) could be largely insulated from a sell-off if increases in real yields are offset by increases in expected inflation.
- MBS would be hurt by both higher volatility and a lack of Fed buying. Higher nominal rates will extend the duration of pass-through securities, but a strong economy will allow many currently constrained households to qualify for refinancing (via higher incomes and home prices). This means that unique characteristics of mortgage pools would become increasingly important for determining returns.
- Corporate bonds would be adversely affected by the increase in U.S. Treasury rates, but improving credit quality would partly mitigate price changes through tighter spreads. In particular, shorter duration lower quality bonds would outperform longer duration high quality bonds.
While Brown doesn't think there will be either a sudden and disruptive end to quantitative easing or a huge rate increase, he concludes that, "It's important that we remain very mindful of the possible unintended consequences of unconventional monetary policy so we can guard against these possible bad endings coming to fruition."
About Greg Brown, PhD
Gregory W. Brown is Director of Research at Smith Breeden Associates, and a Professor of Finance and the Sarah Graham Kenan Distinguished Scholar at the UNC Kenan‐Flagler Business School. His research centers on financial risk and the use of financial derivative contracts as risk management tools. Brown's research has been published in leading academic and finance journals, including The Journal of Finance, the Journal of Financial Economics, The Review of Financial Studies, The Journal of Derivatives, and the Financial Analysts Journal. Earlier, Brown worked at the Board of Governors of the Federal Reserve System in the Division of Research and Statistics. He also serves as a consultant for the American Board of Pediatrics, the U.S. Federal Government, and Fortune 500 companies on various aspects of financial risk. Brown holds a PhD in Finance from The University of Texas and a BS with honors in Physics and Economics from Duke University.
About Smith Breeden Associates
Smith Breeden Associates, founded in 1982, provides full discretion fixed income asset management and advisory services to pension funds, endowments, foundations, funds-of-funds, and banks. Focusing primarily on the major U.S. fixed income sectors -- MBS, ABS, CMBS, corporate bonds, Treasurys -- Smith Breeden's product line includes a variety of traditional fixed income and absolute return strategies. Additional information about Smith Breeden Associates may be found at www.smithbreeden.com.
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