It's alive!!! The Fed prepares the ground for QE3
11/08/2011 8:30 am EST
What would move the Fed to actually pull the trigger on a program that would result in a political fire storm—remember Republican president nominee Rick Perry has already said he’d regard Fed Chairman Ben Bernanke as a traitor if the Fed tried to increase U.S. economic growth ahead of the 2012 Presidential election?
Two things, I think:
Signs that the U.S. Congress will not only let the 2010 Lame Duck Stimulus expire this December but also either do something that would endanger the U.S. AA credit rating or move to reduce near-term government spending, applying the brakes to an economy that’s already barely moving ahead, or
And signs that the euro debt crisis—and the “solutions” to it—are likely to let loose another round of global deleveraging like we had after the Lehman bankruptcy in 2008.
The Fed is likely to get confirmation of its worst fears on both those fronts over the next two to six weeks.
A new round of quantitative easing would by no means be as powerful a force in the markets as QE1 or QE2, but it would definitely push the U.S. dollar lower, increase fears of inflation, prop up commodity prices, and revive the gold market. What it would do for stock prices is much less clear although a replay of the rally that followed the announcement of QE2 is certainly a strong possibility.
Wednesday’s meeting of the Fed’s Open Market Committee ended the way that the meetings of this interest-rate setting body always do—with a statement to the press. Last weeks statement was as cryptic as these statements always are and you had to study the wording very carefully to see that the Fed was even contemplating any change in policy.
But there it was.
In September the committee had said that it had “discussed the range of policy tools available to promote a stronger economic recovery in the context of price stability.”
Last week the committee said that it was “prepared to employ its tools to promote a stronger economic recovery in the context of price stability.”
Significantly, there was only one negative vote at this meeting and it came from Charles Evans who wanted the Fed to do more to bolster the economy. After the September 21 meeting the committee registered three negative votes to a much weaker statement on the need to act to increase economic growth. And they came from Richard Fisher, Charles Plosser, and Narayana Kocherlakota, who have been strong advocates of the Fed doing less. In other words, in the course of a month the votes on the Open Market Committee have swung decisively in favor of more, rather than less, intervention.
Why? Let’s start again with the committee’s press release.
“Information received since the Federal Open Market Committee met in September indicates that economic growth strengthened somewhat in the third quarter…. Nonetheless, recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated….The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.”
So this is how the Fed sees the economy—only slow growth with unemployment staying elevated for far longer than in the typical recovery from recession. And with the risks all to the downside.
The Fed might not feel compelled to move if Operation Twist looked like it was working. This was the Fed’s effort, short of a full-scale QE3 debt-buying program, to push down long-term interest rates by switching its purchases of bonds from the middle of the Treasury market at three to seven year maturities to the longer end at seven to ten year issues. The thought was that as bonds in the Fed’s portfolio matured and it rolled the proceeds over into longer bonds rather than simply renewing its purchases of shorter-term bonds, this would force down the yields of the longer-term bonds that provide the benchmarks for mortgages. That, in turn, would send mortgage rates lower and stimulate home buying and the housing market.
Hasn’t worked. In fact by the Fed’s own models mortgage rates are about 0.5 percentage points higher than they should be. (We’ll leave aside the issue that since banks have tightened their credit rules fewer buyers can actually qualify for a mortgage at all.)
And there’s nothing in the news flow to suggest that it is going to work. In fact the news flow looks down right negative. The euro debt crisis is slowing economic growth in the EuroZone to the point that the Organization for Economic Cooperation and Development is predicting almost no growth for 2012—just 0.3%. With growth in the big developing economies of China and Brazil still slowing for first half of the year, it now looks like the U.S. economy is going to struggle through another year of sub-2% growth in 2012. Hard to see that reducing unemployment.
And from where the Fed sits that’s actually the best-case scenario.
The biggest dangers come from the U.S Congress and from the continued crisis in the EuroZone.
Of the two, the danger from Congress is more predictable and less potentially catastrophic. The super committee designated to tackle the U.S. budget deficit in summer deal to end the debt ceiling standoff is scheduled to report on November 23. One of two things will happen. The committee will deadlock triggering $1.2 billion in budget cuts in 2013 or it will deliver a plan to cut $1.2 billion or more in budget cuts beginning in 2013. Such a plan would be subject to an up or down vote in Congress.
From the Fed’s point of view budget cuts in 2013 won’t have a significant effect on the economy in 2012. Much worse is the good chance that Congress will consider voting to over-ride the mandatory budget cuts of the debt ceiling deal. If that effort were to succeed, it could trigger another downgrade of the U.S. credit rating or a least the announcement of a negative credit watch from the debt rating companies. The immediate practical effect of that—as long as the U.S. dollar is supported by the euro debt crisis (you don’t have to have a good currency, just the least bad currency)—would be small, but it certainly wouldn’t help restore confidence among U.S. businesses or consumers. And confidence is one thing you need to get an economy growing more quickly.
Of at least equal concern to the Fed is the extreme likelihood that Congress will allow the tiny bit of stimulus it added in the 2010 Lame Duck session to expire and instead either do nothing or actually move to cut the budget. Both would hurt an economy that in the short-run needs more stimulus rather than less.
But it’s the next step in the euro debt crisis that may be the strongest force pushing the Fed toward QE3. As part of the October debt deal—which now seems likely to pass the Greek Parliament as soon as Greek politicians can decide who should sit in the government—European banks are supposed to raise their risk-adjusted capital ratios to 9%. Europe’s banks have made it very clear that they’re not going to pay the price to raise the capital they need in the financial markets. Instead they’ll look to reduce their balance sheets. That could well produce a storm of deleveraging as everybody looks to sell assets, especially their riskiest assets since getting those off the books is the quickest way to improve a bank’s risk-adjusted capital ratio.
And who’s going to be the buyer for those riskier assets? Not other European banks, for sure. Not U.S. banks that are looking to get their own capital ratios high enough to meet coming regulatory standards. Not Chinese banks that have their own bad loan problems, thank you very much.
And who will be the buyer of last resort when the banks won’t or can’t step up? Not the European Central Bank, which has its hands full buying Italian debt to fend off a crisis in that bond market. Not the International Monetary Fund, which is trying to make sure it has enough money to cover its likely European obligations and has recently very clearly repeated that it doesn’t do private sector rescues. (Or windows, I assume.) Not the People’s Bank of China or the Banco Central do Brazil, which have both been reluctant to buy European debt unless someone guarantees them against losses.
So who does that leave?
The Federal Reserve stepped in as buyer of last resort after Lehman and I’m sure Bernanke and Co. are aware that they might have to do it again.
Which goes a long way to explaining why the Fed might have QE3 in its plan book now and why rumors and leaks say that the likely form of such an intervention might be as purchases of mortgage-backed assets. Putting the purchase of these debt instruments at the heart of any QE3 would have two advantages. First, mortgage-backed assets are exactly the kind of risky assets that banks looking to improve their risk-adjusted capital ratios would be looking to sell. And second, buying these mortgage-backed assets would retain the Fed’s focus on the U.S. housing market. The move wouldn’t constitute a radical change in direction and it wouldn’t open the Fed to charges that it was acting to bailout European banks.
That kind of positioning might be politically important for the Fed, but I don’t think it will change the reaction of the financial markets to a QE3. In the short-run news of another Fed intervention is likely to prop up stock prices and could even lead to a rally like that QE2 set off in the fall/winter of 2010.
In the longer run, though, by expanding its balance sheet the Fed will increase worries about higher inflation, about a weaker dollar, and about further down grades to the credit rating of the United States. As long as the euro remains in crisis, the dollar’s weakness will be against currencies such as the yen, the Brazilian real, and the Australian and Canadian dollars. Fears of inflation and any dollar weakness will work to increase the prices of commodities—which would then feed back into global stock markets making commodity sectors the most likely to lead in any QE3 rally. Gold would, of course, get a performance kick out of inflation fears and any dollar weakness.
If you find my arguments for a QE3 convincing, or even just partly convincing, I think you’ve got some time to look to shift some assets to commodities and commodity stocks, to strong currency assets, and to gold. Those sectors haven’t totally run away from investors during the October rally and have given up some of those gains during the weakness of early November. I’ll have some concrete suggestions for individual stocks in the next couple of weeks.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this past as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/