In the aftermath of the financial crisis, the Fed launched its now well-known and closely followed quantitative easing (QE) program to stimulate the economy. Five years after the crisis, the U.S. housing and manufacturing sectors appear to be in recovery mode, but as recent nonfarm payroll trends have made clear, the labor market continues to be stuck in second gear.
With investors anxious over the prospects of reduced quantitative easing, is it possible the central bank might begin to cut its asset purchases at the same time its view of U.S. economic growth is dimming? The answer might seem to be “no.” After all, to do so would likely heighten market volatility as investors worry the central bank is pulling back too soon. But I say the answer is actually, “yes,” and investors need to be prepared for this paradox: Fed QE tapering is likely to come alongside downward revisions to the central bank’s projections for real GDP growth (see graph).
Evolution of Recent Fed Real GDP Growth Forecasts Suggests Downward Revisions are Coming (%)
Source: Federal Reserve, data from FOMC meetings 4Q/4Q.
Why is this? Well, the Fed’s projections for real GDP growth tend to be overly optimistic and often have to be revised downward. As it currently stands, the Fed’s economic projections for real GDP growth are still too high, and I believe they should come down over the next few quarters. It may be unsettling to see the Fed lowering its growth forecasts while also removing its asset purchase program, but I don’t believe it means the central bank is pulling back too soon.
Overall, while we believe QE was an effective monetary policy tool in its early rounds, it has generally proved to be an inefficient method of achieving full employment, and lately its potential costs, such as distorting interest rate and asset markets, have grown too high with its large size. In addition, meaningful factors are in place to support the U.S. economic recovery, inflation remains moderate and policy rates will likely stay low.
In this context, I think QE tapering can begin to take place now without overly unsettling markets or causing the economy to stumble.
For investors wondering what this means for their portfolios, I expect that over the next few months equity markets will likely be flat-to-higher with nominal interest rates having a better-than-average chance of drifting modestly higher. In other words, it’s the type of environment where you can see decent performance from selected spread sectors, such as structured products, as well as out of equity-sensitive sectors, such as high yield.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Fundamental Fixed Income, Co-head of Americas Fixed Income, and a regular contributor to The Blog. You can find more of his posts here.