During our Strategy Workshop (Oct. 12) we laid out rationale on where global risk sentiment lies, ho...
Fed’s Next Rescue Ready to Roll
11/08/2011 8:00 am EST
With Europe a mess and the US economy at risk, the Federal Reserve seems poised to announce a third round of stimulus. It could mean another rally.
Virtually unnoticed amid the sturm und drang last week from Europe, on November 2 the US Federal Reserve inched closer to a new round of quantitative easing.
The likely shape of such an economic stimulus effort would reflect the Fed’s fears that US economic growth is still much too weak and fragile, that the big problem is a lack of any real recovery in the housing market, and that its "Operation Twist" has failed to significantly lower mortgage rates.
What would move the Fed to actually pull the trigger on a program that would result in a political firestorm? (Remember, Republican presidential contender Rick Perry has already said he’d regard Fed Chairman Ben Bernanke as a traitor if the Fed tried to increase US economic growth ahead of the 2012 presidential election.)
Two things, I think:
- Signs that Congress will not only let the 2010 lame-duck stimulus expire in December, but also either do something that would endanger the nation’s AA credit rating or move to reduce near-term government spending, applying the brakes to an economy that’s barely moving ahead as it is.
- 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 Brothers bankruptcy in 2008.
The Fed is likely to get confirmation of its worst fears on both of those fronts over the next two to six weeks.
A third 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 US dollar lower, increase fears of inflation, prop up commodity prices, and revive the gold market.
What it would do for stock prices is less clear, although a replay of the rally that followed the announcement of QE2 is a strong possibility.
The Fed Is Getting Worried
Last week’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 media.
Last week’s statement was cryptic (as these statements always are), and you had to study the wording carefully to see that the Fed was even contemplating any change in policy.
But there it was.
In September, the committee 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 Chicago Fed chief Charles Evans, who wanted the Fed to do more to bolster the economy. After the September 21 meeting, the committee registered three negative votes on a much weaker statement on the need to act to increase economic growth.
And those votes came from three other Fed presidents—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 statement.
"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 what the Fed sees for the economy—slow growth, with unemployment staying elevated for far longer than in a typical recovery from recession. And with the risks all to the downside.
NEXT: Twisting in the Wind|pagebreak|
Twisting in the Wind
The Fed might not feel compelled to move if Operation Twist appeared to be working.
This was the Fed’s effort—short of a full-scale, QE-style 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-term bonds—rather than simply renewing its purchases of shorter-term bonds—this would push down the yields of the longer-term bonds that provide the benchmarks for mortgages. That, in turn, would send mortgage rates lower, and stimulate homebuying and the housing market.
It 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 mortgages.)
And there’s nothing in the news to suggest that it is going to work. In fact, the news looks downright negative. The Euro debt crisis is slowing economic growth in the Eurozone to the point that the Organisation for Economic Co-operation and Development is predicting almost no growth for 2012—just 0.3%.
With growth in the developing economies of China and Brazil still slowing for the first half of the year, it now looks as if the US 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 Real Dangers Ahead
The biggest dangers ahead come from Congress and from the continued crisis in the Eurozone.
Of the two, the danger from Congress is more predictable and less potentially catastrophic.
The supercommittee designated to tackle the US budget deficit in a 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 mandatory budget cuts in 2013, or it will deliver a plan to cut $1.2 billion from the budget in a different way beginning in 2013. Its 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 chance that Congress might consider voting to override the mandatory budget cuts of the debt-ceiling deal. If that effort were to succeed, it could trigger another downgrade of the US credit rating—or at least the announcement of a negative credit watch from the debt-rating companies.
The immediate practical effect of that would be small, as long as the US dollar is supported by the Euro debt crisis. (You don’t have to have a good currency, just the least-bad currency.)
But it certainly wouldn’t help restore confidence among US 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 at the end of 2010 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 lead the government—European banks are supposed to raise their risk-adjusted capital ratios to 9%.
Europe’s banks have made it 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, because getting those off the books is the quickest way to improve a bank’s risk-adjusted capital ratio.
And who’s going to buy those riskier assets? Not other European banks, for sure. Not US banks, which are looking to get their own capital ratios high enough to meet coming regulatory standards. Not Chinese banks, which have their own bad-loan problems, thank you very much.
So 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 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 Brasil, which have both been reluctant to buy European debt unless someone guarantees them against losses.
So whom does that leave?
The Federal Reserve stepped in as buyer of last resort after Lehman Brothers, and I’m sure Bernanke and Co. are aware that they might have to do it again.
NEXT: Fed Could Spark a Rally|pagebreak|
Fed Could Spark a Rally
That goes a long way toward explaining why the Fed might have QE3 in its planbook now, and why rumors and leaks say that the likely form of such an intervention might be through 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.
- Second, buying these mortgage-backed assets would retain the Fed’s focus on the US 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 bail out 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 the one QE2 set off in the fall and winter of 2010.
In the longer run, though, expanding the Fed’s balance sheet will increase worries about higher inflation, a weaker dollar, and further downgrades to the US credit rating. 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 these areas in the next couple of weeks.
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