Crescenzi: The Fed, the Curve, and Structural Challenges

The Federal Reserve’s actionis meant to preserve and or promote the movement by investors further out the risk spectrum.

The goal is to engender an environment where investors and economic agents take risks they might not otherwise take, with the ultimate goal of reflating financial assets substantially enough to boost demand for goods and services, thus warding off deflation and creating conditions for lasting economic growth.

Ben Bernanke, Federal Reserve Chairman
Ben Bernanke, Federal Reserve Chairman

By creating conditions that stabilize the value of financial assets, the Federal Reserve entices investors to believe that volatility in financial markets will be kept low, which boosts their value to investors, who place a premium on low volatility.

In bond land, the Federal Reserve’s attempt to lower the perceived volatility of bonds reduces the term premium on maturities across the yield curve; in other words, lower volatility means lower yields, generally. (Track the Bond Market Here)

Low policy rates engender more of what we’ve seen:

  • A reach for duration
  • Expectations for a steep yield curve
  • Expectations for low interest rate volatility
  • Movement into credit
  • An inclination to look abroad to obtain better real yields

Low policy rates cannot solve all that ills the U.S. economy because much of the U.S. dilemma relates to structural issues. For example, at the peak of the housing market 7.5 million people were employed in the construction sector. Two million people have been displaced since then. Similarly, throngs of people have been displaced in the automobile, finance, retail, and commercial real estate industries, each of which is left structurally impaired. Workers displaced in these industries do not fit easily into job openings (the few that exist) suited to their craft.

One solution to the structural dilemma is to redirect spending toward investments rather than toward promoting consumption. Doing so helps promote productivity gains, which are vital to improving a nation's standard of living.

Second, the U.S. can promote its exports through new Free Trade Agreements (FTAs). The U.S. signed 14 trade agreements over the past decade and has 17 of these outstanding. Interestingly, although the nations that make up the 17 FTAs combined represent just 8% of the world economy, these nations account for over 40% of U.S. exports. Three FTAs are in limbo: South Korea, Colombia, and Panama.

Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."