To The Contrary - QE-3 Is Not Coming Soon
On yesterday's radio program (1st hour - Second Half) we discussed the release of the Fed's minutes and why we felt like the market, and the media, had wrongly interpreted the notes. The following is the Bloomberg headlines post the release of the minutes:
- FOMC PARTICIPANTS SAW ECONOMY DECELERATING AFTER JUNE MEETING
- MANY FOMC PARTICIPANTS SAID MANUFACTURING WAS SLOW OR FALLING
- FOMC PARTICIPANTS DISCUSSED QE, EXTENDING 2014 FORECAST ON RATE
- FED STAFF SAID MARKETS HAVE LARGE CAPACITY TO HANDLE MORE QE
- MANY FOMC PARTICIPANTS SAW NEW QE AS BOLSTERING U.S. RECOVERY
- MANY ON FOMC FAVORED EASING SOON IF NO SUSTAINED GROWTH PICKUP
It was the last two headlines that the market keyed in on yesterday and reverse the mild losses of the day to close at breakeven (more on that issue in just a minute.) Here is the key part of the minutes that got the market excited yesterday:
"Many members expected that at the end of 2014, the unemployment rate would still be well above their estimates of its longer-term normal rate and that inflation would be at or below the Committee's longer-run objective of 2 percent. A number of them indicated that additional accommodation could help foster a more rapid improvement in labor market conditions in an environment in which price pressures were likely to be subdued. Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery."
However, what the media and the markets failed to read was the following:
"Several worried that additional purchases might alter the process of normalizing the Federal Reserve's balance sheet when the time came to begin re-moving accommodation. A few participants were concerned that an extended period of accommodation or an additional large-scale asset purchase program could increase the risks to financial stability or lead to a rise in longer-term inflation expectations."
While QE-3 (another round of asset purchases) was discussed it was not the only option on the table. One of the key sentences in this regard was:
"One of the policy options discussed was an extension of the period over which the Committee expected to maintain its target range for the federal funds rate at 0 to 1/4 percent. It was noted that such an extension might be particularly effective if done in conjunction with a statement indicating that a highly accommodative stance of monetary policy was likely to be maintained even as the recovery progressed."
This statement was very important in my opinion because this is exactly what has been occurring for the last several meetings. Each meeting since last September has been capped with a statement that the FOMC stood ready with accommodative action if necessary. With that the markets have continued to rise in anticipation of such action. Yet no action has arrived.
That statement is key because the FOMC has effectively used "jawboning" to get the effects of QE without having to implement a QE program. This has been a brilliant strategy by the Fed and has allowed them to reserve what is effectively their last "bullet" to combat a recessionary drag on the economy or a systemic event out of Europe.
Lower Long Term Rates
There was one perplexing statement in the Fed minutes that warrants some discussion.
"Many participants expected that such a program could provide additional support for the economic recovery both by putting downward pressure on longer-term interest rates and by contributing to easier financial conditions more broadly."
There are two important points relating to that statement. First, both previous QE programs have INCREASED both borrowing costs and inflationary pressures on consumers and small businesses. Operation Twist, so far, has been the only program to reduce interest rates without spurring inflationary pressures. Therefore, with oil prices close to the century mark, gasoline prices rising sharply in the last month and food prices surging due to drought concerns since the last meeting it is likely that the Fed will opt to wait on a program that would exacerbate the inflationary pressures on the economy at the headline.
Secondly, interest rates have consistently declined ever year since the financial crisis yet "easier financial conditions" have not increased economic activity or supported an organic economic recovery. Why? Because lower interest rates will not spur economic activity unless there is sufficient aggregate end demand to warrant borrowing money for expansion. Access to credit is not a concern by small businesses - they do not want it. The primary concerns of small businesses accross the country are poor sales and uncertanity.
The Fed is well aware of these problems, as well as the diminished returns of each previous accommodative program, which has been a footnote to every Fed testimony to Congress. Bernanke has been clear that the monetary policy tools of the Fed are limited and it is the fiscal policy tools of Congress that are needed to pave the way for economic recovery. The "fiscal cliff", increases in taxes from ObamaCare, regulatory hindrances, etc. are creating an environment of uncertainty for businesses which is keeping hiring constrained. With Congress remaining at a stalemate it is unlikely that any assistance will come prior to 2013, or longer, depending on the outcome of the election.
QE 3 Not The Only Choice
The markets are fixated on another round of Quantitative Easing to further boost asset prices while ignoring many of the other policy tools that the Fed has at their disposable. This was clearly stated in the minutes:
"Some participants commented on other possible tools for adding policy accommodation, including a reduction in the interest rate paid on required and excess reserve balances. While a couple of participants favored such a reduction, several others raised concerns about possible adverse effects on money markets. It was noted that the ECB's recent cut in its deposit rate to zero provided an opportunity to learn more about the possible consequences for market functioning of such a move. In light of the Bank of England's Funding for Lending Scheme, a couple of participants expressed interest in exploring possible programs aimed at encouraging bank lending to households and firms, although the importance of institutional differences between the two countries was noted."
These ideas combined with extending the overnight lending rates past 2014, accommdative policy statements and other stimulative measures such as the recent "Operation Twist" program, gives the Fed other options to work with apart from an outright balance sheet expansion program.
The Markets Are Locking The Fed Out
The most important point is that the notes are three weeks old and looking at even older data. Just this morning non-voting Fed St. Louis Fed president Bullard confirmed that since the last meeting the FOMC minutes "are a bit stale" and that, since the last meeting, some of the data has come in stronger. What is important is that he does state that there is a "different constellation" of data versus what was seen in 2011 and that he isn't sure that the current data warrants big FOMC action.
However, he does state that unemployment remains "very high" but , most importantly, they are "not going to react" directly to the stock market's desires. The problem is that another balance sheet expansion program will complicate the Fed's exit strategy in the future. This is the same problem for the ECB who does not have an unlimited amount of purchasing power to continue to bail out member countries.
The comments by Bullard are important. Since the last Fed meeting the S&P 500 index has risen 2.5%, the Nasdaq is up 5% due to an 8.5% rise in APPL, the 10-year treasury yield is up 30 basis points, Spainish and Italian bond yields have declined, employment came in better than expected, jobless claims have dropped, housing numbers have improved and inflation remains subdued. The following chart is the Citi US Economic Surprise Index which shows the near record increase in the economic data surprising to the upside since the last Fed meeting.
With the economic variables improving and the markets near 2012 highs it is highly unlikely that the Fed will act with a balance sheet expansion program prior to the upcoming election. First, the Fed does not want to be seen as potentially influencing the outcome of the election; and secondly with asset prices already surging this year it reduces the effect of any program that might be implemented.
Furthermore, with China already in a hard landing economically a further round of QE in the U.S. would absolutely crush their economy as commodity prices spiked. The side effects from increases in commodity prices will further impact an already recessionary Eurozone as well further exacerbating their debt problems.
The following interview with Dennis Gartman reiterates these points.
No QE 3 For Now - Maybe Later
Therefore, given that environmental conditions have changed, not only domestically but globally, the bandwidth available to maneuver with regard to loosening policy measures has become greatly constricted. The start of both QE 1 & 2 had much lower starting points for commodities escpecially in food and energy prices. They also followed one major major market sell-off and fears of a second. However, the exact opposite environment exists today as the markets have surged in anticipation of further action.
For all the reasons discussed there will likely be no QE announcement before the election. If the market corrects 15-20% in the coming months ahead, commodity prices contract, employment falls and the economy slows to below 1% growth - then it is likely that the Fed will act will further accomodative action. That action could very well happen outside of an FOMC meeting in order to surprise and stabilize the markets. Therefore, expect no announcement on QE at the coming "Jackson Hole" meeting at the end of the month or at the next FOMC meeting in September. This is likely to be a disappontment to the markets in the short term and will negatively impact unhedged investors.
The markets may already be figuring all of this out. Yesterday, when the minutes were announced the market was tradingl lower but finished the day only slightly above breakeven. In the past when rumors of QE have been announced the markets have surged sharply with gains of greater that 1% for the day. My expectation has been that sooner, or later, the markets would begin to become less affected by "talk" and will start requiring "action." This is the same problem that the ECB faces today with Draghi's recent "do anything" speech. As stated above, so far talk has been a cheap, and effective, alternative to expansion of the balance sheet - the problem is now that the markets, both domestically and globally, are potentially set up for a real disappointment.