Financial firm failures began to rise during WWI and spiked during the Great Depression. The regulatory environment focused on stability until the 1980s, when deregulation began. The goal of deregulation was to improve the efficiency of the banking system. Although it did improve efficiency, it also made it more fragile. The rise in failures in the 1980s was due to the S&L Crisis, while the recent rise was due to the Great Financial Crisis.
From the mid-1930s into the early 1980s, the Federal Reserve did not have to concern itself with financial stability. In a world of widely distributed, heavily regulated commercial and investment banks, the odds of failure were low and the impact from any particular failure was insignificant. Thus, monetary policy could be conducted simply to manage the goals of controlled inflation and full employment. However, in the current deregulated environment, the Fed now has to be concerned with financial system stability. This is why we believe the central bank has opted to become more transparent. The problem is, that by adopting this policy, the central bank has lost control over financial stress. The data indicates that when the FOMC raises rates, financial stress tends to remain stable…until some sort of crisis occurs. And, perversely, easing policy seems to have little effect on reducing stress.
Instead, what seems to happen is that monetary policy, by being transparent and designed not to increase financial stress, leads to overconfident investors who tend to build asset prices to unsustainable levels. This leads to eventual asset price corrections and easier monetary policy. Following Hyman Minsky’s theory, low financial stress becomes the catalyst for rising asset prices that eventually become problematic; unfortunately, the usual response of easing monetary policy does little to reduce financial stress.
What does this mean for investors? Sadly, it means that monetary policy seems designed to maintain low levels of financial stress and tends to lift asset prices to the point of unsustainability, which then leads to painful corrections. This isn’t the only factor involved; this same monetary policy tends to foster long economic expansions which also support asset prices. Although each investor’s goals and risk tolerance is different, this analysis suggests that risks are higher than they first appear and balanced portfolios are one of the better longer term responses to this condition.
This article is courtesy of Confluence Investment Management, a participant in the ETF Strategist Channel.
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Past performance is no guarantee of future results. Information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Opinions expressed are current as of the date shown and are subject to change.
This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell any security.