The Fed's #1 Assumption About QE Relies On A Misunderstanding Of Basic Portfolio Management

Ben Bernanke on TV at the NYSE

For several years now, the Federal Reserve has been buying up Treasury bonds in an attempt to boost the economy with monetary stimulus.

One big channel through which this quantitative easing (central bank bond buying) is supposed to work is known as the “portfolio rebalancing channel,” and the idea is that as central banks draw supply out of government bond markets and bond yields fall, investors will sell their bonds and rebalance their portfolios by investing in riskier assets, like stocks.

“Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy,” said Federal Reserve Chairman Ben Bernanke in an August 2012 speech.

Toby Nangle, who heads multi-asset portfolio management at Threadneedle Investments, says this idea, which implies that stocks and bonds “compete” for investor interest in a portfolio, actually fails to acknowledge a basic tenet of portfolio management.

As it turns out, stocks and bonds don’t necessarily always compete. In fact, a lot of times, they do just the opposite – they complement each other in a good portfolio that seeks to minimize volatility.

Volatility of diversified portfolios versus all-stock or all-bond portfolios

The chart at right is a pretty good illustration of why this is the case.

Equity returns are volatile – and so are bond returns.

When one combines the two in a portfolio, however, the overall volatility of one’s investments falls substantially.

“The more government bonds an investor owned, the more equity they could have owned for their given risk tolerance,” says Nangle. “Thus, in this sense, government bonds did not compete with equity for capital, but complemented investment in equity.”

Thus, bonds essentially are a “positive-yielding portfolio hedge,” says Nangle – which, of course, is the best kind of hedge.

Now, that’s all been changed by quantitative easing.

Here’s the upshot from Nangle (emphasis added):

Now that we understand government bonds as complementary assets, or portfolio hedges, let’s think again about the consequences of QE.

By bidding yields on government bonds down to current levels, monetary policymakers have largely extinguished government bonds as an effective portfolio hedge.

Investors can now decide to either increase their risk appetite on a structural basis and hold more risky assets (that is to say assets that are positively correlated with equities), or increase their cash positions and hold less equity than they would otherwise do to retain the same level of portfolio risk…

But, paradoxically, zero-yielding cash is becoming increasingly attractive. Central bankers have reduced rates to zero to scare me out of this horrible asset, but the alternative for volatility-aware portfolios – close to zero-yielding core government bonds – look less attractive given the asymmetric profile of downside capital risks with which they are associated.

In short, quantitative easing is succeeding in forcing people out of bonds. However, for investors looking to minimize portfolio volatility, simply loading up on equities may not be sensible, which presents a sizeable headwind to the Fed’s economic goals.

“I hope that Econ 101 wins out if this is accompanied by economic growth,” Nangle concludes, “but Portfolio Management 101 is not helping.”

Read Nangle’s full note here >

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