Bracing for economic volatility

The economic volatility is downstream from financial volatility and the latter process might have started during the last week of May. The extent of government intervention in the markets, via Quantitative Easing (QE), is unprecedented and therefore the ramifications will have a lot of unknowns.

What I think gets lost in the discussion about the cost/benefit of QE, and more importantly, how long it has gone on, is the fact that there are billions of potentially very volatile long duration low coupons on the balance sheets of investment portfolios.  Bond math dictates that for a given duration, the lower the coupon, the more volatile the price.  A 2% 10-year is much more price-sensitive than a 4% 10-year.  Due to the nature of these low, long duration coupons, the adjustment process is likely to be very chaotic, making last week look like a game of tiddlywinks.  This is bound to have a profound impact on portfolios and on sentiment….

The dark side of QE is the idea that no one really knows where the natural rate of interest really is, and finding that equilibrium is going to be a very uncomfortable adjustment process.  Regardless to what extent you believe the Fed has influenced interest rates, the fact is we still don’t know where the curve should trade absent QE.