Gold, Dollar & Rates Say No QE
There is a consensus as of late that the Fed will launch another round of stimulative action in the form of a balance sheet expansion program (Quantitative Easing) by the next FOMC meeting in September. Of course, this was also the consensus before the June and August meetings - yet each disappointment only led to a stronger belief that the next meeting would be the one. Those expectations have kept stock markets afloat even in the face of weaker earnings, revenue and softening economics.
Note: For the purposes of this report we are excluding "Operation Twist" which was implemented by the Fed in September of 2011 as it was not specifically a balance sheet expansion program.
A Bit Of History
The US Federal Reserve held between $700 billion and $800 billion of Treasury notes on its balance sheet before the last recession. In late November 2008, the Fed started buying $600 billion in Mortgage-backed securities (MBS) to inject liquidity directly into the financial system in an attempt to thaw out a nearly frozen credit market. In March 2009, the Fed began to aggressively buy bank debt, MBS, and Treasury notes until balances reached a peak of $2.1 trillion in June 2010. This operation became known as Quantitative Easing or Q.E.
Purchases of additional securities were halted in the June of 2010 as the economy was showing some signs of nascent improvement. However, such hope was quickly dashed as the economy began to quickly slide back towards recession and the markets declined nearly 14%. The deterioration spurred the Fed into further action in August of 2010, as the Fed worried about the onset of deflation, making further puchases of $30 billion in 2–10 year Treasury notes a month. Then in November 2010, the Fed announced a second round of quantitative easing, or "QE2", buying $600 billion of Treasury securities through the end of the second quarter of 2011. The chart below shows the programs and their respective effects on the equity markets.
QE 3 Coming?
We have been writing for the last couple of months that the recent advances in the markets, now up 12% for the year, combined with unemployment claims falling, slow but increasing employment, and economic variables that are soft but not recessionary, will keep the Fed on hold for now. So far that has been the case. Now, with recent employment, retail sales, and industrial production numbers ticking up in the latest reports, combined with rising energy and food costs, there is even more reason for the Fed to stay sidelined at least through the end of the year.
However, undeterred by the weight of evidence, stock market participants have pushed asset prices relentlessly higher, especially over the past month, based on "hope" that intervention is coming soon. Whether it was Draghi's "do anything" speech, or innuendoes by Bernanke that the Fed will act if necessary, market participants have convinced themselves it is an assured event.
The interesting thing is that other markets are not buying it.
In the past, when QE programs were implemented ostensibly to lower interest rates to spur financing activity - the opposite occurred as interest rates (as measured by the 10-yr yield) rose. This was due to the selling of bonds, which pushed prices lower and yields up, as money rotated into the equity markets reminiscent of the land grab during the 1890's gold rush.
With market participants running stocks up in anticipation of further Fed action - interest rates should be rising sharply as money rotates out of the safety of bonds and into stocks. This is not occurring. More importantly, if the credit markets, which are much larger than the equity markets, believed that Fed action was imminent they would be selling holdings to lock in capital appreciation. This is also not happening. Finally, money flows into equity funds from retail investors should be advancing sharply as well. However, according to the most recent data from ICI, the flow of funds is still largely biased towards bond funds from retail investors.
The US Dollar & Gold - No Fear Of Economic Collapse
It is not just the credit markets that are not buying more Fed intervention in the near term but also the U.S. Dollar and Gold. These two markets have been the prime psychological hiding place to offset fears of economic collapse, hyperinflation, and the coming zombie hoards. During previous Fed interventions the media has been flooded with articles, programs and soothsayers all proclaiming the coming end of the economy as we know it as hyperinflation is imminent and the collapse of the West is all but complete. We have written in the past why hyperinflation is not an issue, but nonetheless, during both previous interventions by the Fed - gold and the U.S. dollar have acted is if it was the case.
The dollar, chart above, declined sharply during the first Fed intervention. However, as QE 1 finished the dollar began to advance. This advance was short lived as realization that further interventions were on their way. Currently, the dollar is remaining a beacon of strength in the currency market and fears of hyperinflation, or economic collapse, are not weighing on the dollar as a reserve currency. If currency holders were anticipating further Fed action, as the equity markets are, it seems reasonable to expect that they would be reducing holdings. Furthermore, if they believed Draghi's "do anything" speech was actionable versus hyperbole, there should be a strong flight from the U.S Dollar into the beaten down Euro.
Speaking of "gold rush" above, gold has been a bet by hyperinflationists and doomsdayers for the past three years and has risen steadily in the face of Fed intervenions. Fears of printing presses running through the night, and reality television shows like "Doomsday Preppers", has made gold a favored topic by websites, newsletters and dealers over the last few years. We own gold for our clients, not because we believe that the end of the world, or hyperinflation, is coming, but because we are betting on those that do. Gold has been in a long term consoldiation phase, and when the Fed intervenes again in late 2012 or 2013, we are likely to see another decline in the U.S. dollar and surge in gold prices. It is a bet worth making.
If the players in the gold market believed that Fed intervention was soon approaching we should be seeing a commensurate rise in gold prices along with the equity markets - but that is not the case.
No QE 3 Coming - Not Until Later
As we stated earlier it is highly unlikely that the Fed will act in the August or September time frame as the run up in the equity markets has removed much of the benefit that an intervention might have. The purpose of these interventions have been to boost asset prices from distressed levels that were potentially leading to a decline in consumer confidence. The Fed's purpose was to boost asset prices in order to restore consumer confidence to bolster spending and boost the economy. However, with the markets already sporting strong gains for the year - consumer confidence is still lagging as the reality of a stagnant economy weigh on them.
For the Fed an intervention must come at a time where the economy is showing real signs of weakness that could lead to a recession, deflationary pressures rising and markets at levels that are negatively impacting consumer confidence through lower net worth. That is not the case today.