It’s funny that at the August FOMC meeting, everyone was talking about “baby steps” towards more QE, and then after the September meeting the consensus suddenly became that the Fed was ready to buy somewhere around $1 trillion worth of US debt.It’s not totally clear how that happened, but it may be more due to a communications blunder at the Fed than anything else.
That’s at least the theory of Mike O’Rourke at BTIG who has a must-read note ahead of Bernanke’s big speech:
CNBC has been tracking street expectations for QE2, and the expectations are staggering. According to expectations, there is little doubt that the FOMC will launch QE2 at the November meeting. The average expectation is for a $500 Billion program, with some expectations of $1.5 Trillion. Our view is we would expect a $100 Billion program (talk about being out of consensus). Such a large disparity of expectations is again a clear indication that just as they did in August, the FOMC has totally botched the communication of this policy. We believe the highest probability that we are wrong will be related to the fact that the FOMC has let expectations run so high. The Fed has created the awful situation where the current action in financial markets is being nearly wholly driven by QE2 expectations, now they are starting to put themselves in a box that there will be a reaction if those expectations are disappointed.
Why does O’Rourke think the Fed never intended to communicate such large QE?
Here is why we are so far out of consensus on the low end. First, we expect improvement in the economic data in the coming months. As usual, nothing explosive, but we expect the next 6 months to be better than the last 6 months. So part of the reason is the modest pickup in the economy. The balance of our view comes from listening to the FOMC regarding this policy for the past 23 months. QE1 was initially announced in late November 2008 it was a $600 Billion program consisting of $100 Billion GSE debt and $500 Billion of GSE MBS. That was during a quarter when GDP contracted 6.8%. Considering that this is an environment of growth, albeit slow, a similar size announcement appears aggressive to us.
Then there is the manner in which this story has unfolded. The Fed has been deliberately telegraphing the strategy through the Wall Street Journal. The first story about a potential return to quantitative easing in September quoted a very recently retired Fed Vice Chair saying he did not think “Shock and Awe” was necessary and he thought the Fed would start small and do more if necessary. In that manner, QE2 strategy appears to be shaping up in the manner that St. Louis Fed President Jim Bullard has been advocating over a year now. The Journal even highlighted that point earlier this month, explaining that “His proposal for the Fed to gradually buy Treasury debt in response to the weak economy is gaining traction inside the Fed. And his warning over the summer that the U.S. economy could fall into Japan-style deflation got the attention of investors and quiet criticism inside the Fed for some of his suggestions.” Bullard made serious attempts to get the FOMC to keep QE1 open to pursue this program but was unsuccessful.
So now what? Is the Fed boxed in?
The real question in our mind is whether the Fed is going to do what they said they were going to do, or are they going to buckle to these high expectations which they permitted to escalate unchecked. There is little doubt in our mind that this is a cut off the tail risk measure. It is widely believed that as well as prevent deflation, this is intended to boost equity prices (it probably is) and thus, net worth. The FOMC is missing one very key aspect of the market structure that is very different today than previous situations in which the Fed cut the tail risk by additional easing. There are few, if any, vanilla flows in the equity market. During the Great Moderation, there were always the consistent flows into equities that were helped by such policy, but also supported such policy. These days, those flows are all going to bonds. The predominant trading action or the incremental investing dollar is the fast money and they are playing it on a more sophisticated level where asset prices are being pushed higher. Look at Gold, Commodities, Emerging Equities and Treasuries, but they are not the assets for which the Fed really wants to see prices rise. Most investors who are long U.S. Equities tend to like them for other reasons, such as valuation as we do. Maybe they have gotten some lift from this theme, but obviously the other assets have been the easier way to play the theme. There is little doubt in our mind that there are many who have QE trades on and we believe there is high risk that they will be disappointed if FOMC walks the walk the way it has been talking the talk.