While the markets reacted positively to Wednesday’s non-action by the Federal Reserve, there are a number of reasons for investors to remain cautious, according to Fran Rodilosso, fixed income portfolio manager at Market Vectors ETFs.
“I believe there are two ways to interpret yesterday’s announcement by the Fed,” says Rodilosso. “First, one could take Chairman Bernanke at his word and accept that the Fed has modified its views on US economic growth, having seen unanticipated tightness in the lending markets since originally suggesting that tapering was on the horizon in the spring.”
“Second,” he adds, “one could arrive at the conclusion that the Fed would have announced it was ready to begin tapering purchases if it had a good handle on the consequences of doing so, both for financial markets and for the overall economy.”
“Neither theory provides much encouragement in my view, even if yesterday’s announcement left the markets positively giddy,” he says. “If theory number one is true, then I believe Quantitative Easing has not worked that well, the economy is still quite fragile, and prospects for returns on financial assets in real terms are therefore less attractive. If theory number two is true, then I believe the Fed is merely postponing a presumably negative event and is doing so because it has engaged in an experimental policy from which it is not quite sure how to exit.”
Rodilosso says the existence of a counter-argument to these views that would point to the assumption that tapering will begin only when the economy is considerably stronger and will therefore be able to sustain itself even amid potential tighter liquidity.
“What that argument misses, however, is that tapering does not remove a highly accommodative policy, it only makes existing policies somewhat less highly accommodative. In my opinion, the Fed’s views on future rate hikes give strong confirmation that easy money is a given into 2015.
“The near-term euphoria around the idea of the punch bowl being replenished, rather than taken away, may ultimately lead to a much more severe hangover.”