Today, the Fed has engineered a situation in which the really unattractive asset classes are the ones we have always thought of as low risk: government bonds and cash. And unlike the internet and housing bubbles, this time it isn’t a quasi-inadvertent side effect of Fed policies, but a basic aim of them. The Fed has repeatedly said that a central part of the goal of low rates and quantitative easing is the creation of a wealth effect by pushing up the price of risky assets. By keeping rates very low and taking government bonds out of circulation, the Fed is trying to entice investors into buying risky assets. The question we are grappling with today is whether we should take the bait. So what makes this different from 2007? We’ve got some very unattractive assets and some others that look a good deal better by comparison. The trouble is that if those unattractive assets are cash and bonds today, moving to the relatively attractive assets involves increasing portfolio risk, whereas in 2007, moving away from risky assets lowered portfolio risk.
This is an excerpt from GMO’s Quarterly Letter, published April, 2012