Those of you who have followed our thoughts about evolving Federal Reserve policy here and here and here will appreciate a forthcoming paper by economists at the Federal Reserve Bank of Chicago which concludes that changing demographics have dramatically lowered the number of jobs it will take to impact the unemployment rate in the future. The Wall Street Journal’s take on the new research should sound familiar to our readers: “the authors’ conclusion is significant for two reasons. First, it has potential implications for Fed policy: It suggests that even if job growth stays at its recent level -— or even if it slowed somewhat — the unemployment rate will continue to fall. That could lead the Fed to tighten monetary policy earlier than some experts now project.”
The portfolio implications are also significant. Most bond sectors are already negative for the year and those who have built out ‘safety’ through a traditional asset allocation are very likely participating in those losses. It gets worse however. Rising rates will continue to devastate traditional bond portfolios and Fed ‘tapering’ will begin the long process of soaking up excess liquidity in the system. Less liquidity, almost by definition, means more volatility. In other words, volatility will likely emerge in many other asset classes that were supposed to be working when bonds aren’t. The traditional asset allocator is now faced with a big problem: a colorful pie chart, with a single risk factor – liquidity – that is likely to dominate returns and risk for the foreseeable future.