Fed Puts Credibility at Risk with Latest Move
Fed Puts Credibility at Risk with Latest Move
Last week, the U.S. Federal Reserve (Fed) raised the bar on its already unprecedented monetary policies. First, they changed the money printing program known as Quantitative Easing (QE) by making it open-ended instead of pre-specifying dollar amounts, as they had done in the past. QE is now unshackled, which means that the Fed has no limit on how much new money it can create. Second, the Fed stated that it will maintain interest rates at or near zero into 2015 and even beyond the early stages of any economic recovery. The Fed has for the first time in its history explicitly chosen to focus on one side of its dual mandate at the expense of the other – that is, jobs over inflation. The message from the Fed is that they are deploying all of their available firepower to address our economic problems and they are now, all-in.
Why did the Fed take such drastic action? Will these radical policies yield the results they are looking to achieve? What possible implications will this have on the economy and investment strategy?
This first thing we have to ask ourselves is why did the Fed wait until now to pull out the bazooka? Especially 60 days before a Presidential election! In prior commentaries we have expressed our concerns about the durability of the U.S. recovery, and over the last few months we have observed a meaningful slowdown in the forward-looking economic data. Based on the Fed’s actions last week, they are even more pessimistic than we. Maybe they feel that their policies can be more effective by being ahead of any emerging economic shock (fiscal cliff, Euro crisis, Israel attack on Iran, etc.) instead of just reacting to one.
Remember that in prior iterations of QE (QE1, QE2 and even QE-Twist) there was widespread deflation: home prices were declining, banks were not lending, the economy was losing jobs, household income was contracting, and food and energy prices were much lower. Most important, interest rates were much higher so any move to lower rates made sense. When the first QE was initiated the 30-year mortgage rate was 5.8% and now that rate is 3.5%. Does lowering the mortgage rate from here really have much of an impact? Prior QEs also followed economic shocks such as addressing the fallout from the Lehman Brothers bankruptcy, the U.S. debt downgrade, and the Euro crisis. Also, at the time of prior QEs being announced, the stock markets were at depressed levels and reflected the uncertainty in the economy.
Today’s prevailing view is that the economy is not contracting (it is not growing very fast). The U.S. stock market is even at multi-year highs. Bernanke (Chairman of the Fed) explained the reasons for the change in policy were to encourage bank lending, address a stubbornly sluggish labor market, and to support assets prices (such as housing and stock markets). His reasoning is that an upward move in asset prices will improve consumer confidence (by making individuals feel wealthier), making them more willing to spend. This increased spending will lead to renewed business confidence which will ultimately lead to hiring, thereby addressing the jobs problem. Those are the stated reasons.
What are the indirect effects (good/bad) of this type of policy? First, let’s put into context how large the prior QEs have been. In the last three years, the Fed has (with money that did not exist) purchased over 70% of new U.S. Treasury debt issuance. The Fed now owns more U.S. debt than China or Japan. This is before the new open-ended QE begins! With interest rates (cost of servicing debt for U.S. Government) so low it is no wonder that a divided Congress has failed to pass a budget in three years (or even come close). Low interest rates have eliminated the urgency for Congress to tackle the pressing issues of debt, spending, and taxes. We assure you that if interest rates were 10% this would magically inspire both parties to cross the aisle and start to make compromises in order to reach some bona fide solution.
Also, remember that the U.S. Dollar is the chief global reserve currency and accounts for over 60% of financial transactions around the world. As a result, many countries (including China) peg their currencies to the dollar. Fed stimulus of this magnitude creates an array of negative side-effects around the world from high inflation in emerging markets to pressure on developed nations to counter-act a weaker dollar, thus perpetuating the cycle of money printing around the world. Higher food and energy prices can easily spark geopolitical instability in poorer countries, like we saw in the Middle East and Africa. Additionally, a weaker dollar helps U.S. exports (Fed doesn’t bring up QE weakening the dollar because it would acknowledge U.S. as a currency manipulator, a title we reserve for China) which is good for the U.S. but bad for competing export countries like Euro-area, who now are in even more desperate need of growth. Their response would be to print money to stay competitive.
Another effect of pumping money into the system is that it has to find a home. This distorts prudent risk management by forcing investors and savers to take on more risk. Put another way, if money doesn’t cost anything, then savings doesn’t reward anything. Given this wave of liquidity, the Dow Jones at 25,000 is not even remotely a joke, unless the Fed money-pump breaks and we hit an air pocket, in which case the market would crash.
In an earlier commentary we wrote, “There are two potential outcomes that we see affecting portfolios in 2012 and beyond. What is unusual about these two scenarios is that they are opposing outcomes, and yet both are rising in likelihood (compared to muddling along).” This is truer today than when we wrote that commentary. We were surprised (we put the odds of “open-ended” QE being announced this September at less than 15%) that the Fed responded this aggressively so early, but in a way the Fed has boxed itself into a corner by setting high expectations and now needs to deliver.
The good news is that now that the full force of the Fed has been deployed we can truly measure its impact on the economy. The markets will be hard pressed to embrace bad economic data like before when bad data meant more Fed money printing. However, improving data along with the new Fed policy could be a catalyst for a very strong bull market. In this bullish scenario we will be looking for the following leading data:
1) Bank loan expansion – the consumer represents over 70% of the economy and given weak labor market the only conceivable catalyst for growth will come from an increase in credit, e.g. credit cards, mortgages, car loans, etc.
2) Business Investment – Regulatory and tax uncertainties along with a global slowdown has caused business to be defensive and stockpile cash. Unlike the consumer, a change in sentiment alone could quickly turn companies offensive given their strong fundamentals.
3) China – China is the only country large enough to change the momentum in the global economy. If we see a stimulus follow through from China, this could bring back much needed global demand, especially in the industrial and commodity sectors.
Where does this leave us? It is undeniable that money printing has a positive effect on stock prices and open-ended QE presents a tsunami of potential new liquidity. You have this newly pledged liquidity from the Fed as a strong tailwind against the backdrop of a very poor economy, declining earnings, and a stock market that is up 33% from last year and 15% from a few months ago. Our view is that without any improvement in the economy (as measured by the three bullet points above), taking greater risk at this time is not an investment strategy but a trade – one that is speculative and puts too much faith in the Fed being a panacea to all of our problems. We will sit tight for now until we have more information.
Thank you for your trust.
The Vigilare Wealth Management Team