In a bygone era, risk and reward were inexorably linked. Managing an investment portfolio was like turning a series of dials on a dashboard. Today, not so much.
Investors have choices ranging from risk-free to downright speculative. These old trade offs, when guided by prudence, were governed by clear-eyed calculus. Cash offered the lowest return and the greatest peace of mind. Stocks offered a chance for higher returns, given enough research, time and guts. And, in between these poles, sat other investment options like bonds of varying maturities and quality. With each step investors took along the path of risk, the deal was clear; higher risk, higher returns. It was all so quaint.
The Federal Reserve now has its heavy fingers gripped to the master dial used to calibrate the sensitivity of every other dial on the financial market’s dashboard. Their master dial is both simple and powerful. It sets short-term interest rates and it changes investor behavior.
Today, cash pays nothing. U.S. Treasury bills pay next to nothing. High-quality bonds offer paltry returns. Even junk bonds issued by financially-weaker companies offer historically slim yields. And, with so many of the dials on the dashboard unresponsive, investors have driven up stock prices to levels that befuddle the green eyeshade types. These are the number crunchers who still care about fundamentals and still believe in the relationship between price and value!
In all fairness, the Fed has been fiddling with the master dial for some time now. Remember when they set interest rates so low, and for so long, that bankers had no choice but to fuel a real estate bubble? The Fed finally woke up to that reality and pulled away the punch bowl. Then, they wildly spun the master dial in reverse to deal with the aftermath. Incredibly, interest rates were pinned to zero for a decade. When even zero rates didn’t work as hoped, they just printed trillions of dollars to tweak the sensitivities of the other dials on the dashboard.
Well, what the Fed has done since March has made their past efforts look restrained. What took them years back then, only took a matter of weeks this time. With one mighty blow, interest rates have hit the floor and are unblinking. Trillions of dollars have been printed to push up asset prices, and drive down yields, everywhere. And, the Fed has credibly promised to starve risk-conscious investors for many years to come. For added impact, politicians have joined the effort. It’s basically free money, after all.
Let me be clear. The Fed, and the bankers they ultimately work for, understand the present situation. Our finance-fueled economy depends mightily on high asset prices. When prices decline, the Fed’s fingers twitch. They seem to have concluded our free-market system cannot be left up to investors alone. Their fingers are twisting every dial now, whether we like it or not. To make matters even worse, I’m starting to feel like my once-stylish green eyeshade is dating me.