David Rosenberg of Gluskin-Sheff spells out his thoughts on the Fed’s big move:
There was nothing in the Fed press release yesterday that was really surprising. In fact, the market’s initial dramatic reaction (all over the map) was what’s most surprising. The Fed is going to be buying $600 billion of Treasuries (in the 5-10 year part of the curve) through mid-2011 and another $250-300 billion via coupon reinvestments, which they were going to do anyway.
The “number” that was key for the markets is that $600 billion figure, which is about $75 billion per month. That is in the middle of consensus expectations of $50-100 billion. Not “shock and awe”, based on what was broadly expected, but not “light” either considering that the economy, at least so far, has managed to avoid double-dipping.
For all the excitement, this further expansion of the Fed’s balance sheet will add between 0.25-0.5% to real GDP growth; however, this will take the size of the Fed’s balance sheet to a Japanese-style 20% of GDP!
What the Fed is clearly trying to do is reflate asset values in order to generate a more positive wealth effect on personal spending and pull the cost of debt and equity capital down in order to re-ignite business “animal spirits” and hence corporate investment and hiring. In a balance sheet or deleveraging cycle, success is not always guaranteed even by the most aggressive of monetary policies.
Through its actions, the Fed creates excess reserves in the banking system. But with one-third of the household sector gripped with a sub-620 FICO score, 1-in-7 mortgage debtors are either in arrears or in the foreclosure process, and with an estimated 25% of homeowners “upside down” in their mortgage (negative equity), there is at least some non-trivial probability that, as was the case with QE1, there will be no visible impact on the willingness to borrow, the money multiplier or velocity, which is what we would need to see to declare this radical policy experiment a success.
In a nutshell, with core price trends running below 1% and the economy past the peak of growth for the cycle, the Fed is not far off the mark in its deflationary concerns. The critical aggregate here is the unemployment rate — policy is aimed at redressing the glaring “gap” or chronic excess capacity in the labour market.
Go back two years ago when the Fed was on the brink of cutting the Fed funds rate to zero and the central bank was expecting to see, by now, a 7% unemployment rate. On the eve of QE1 in the opening months of 2009, the Fed’s base case was an 8% jobless rate by now. Instead, the jobless rate is sitting near 10% and only an atypically low participation rate has prevented the official unemployment rate from being higher than 12%. Moreover, counting in the vast degree of “under- employment”, the real unemployment rate is closer to 17%.
The one asset that has responded miserably to the Fed announcement is the long bond — it is getting clobbered, in part because the Fed bond buying is in the mid-part of the curve. Looking at the huge spread between 30-year bonds and the 5-year note, if inflation does not rear its ugly head, the best risk-reward is now really at the long end, which is universally despised and may be one reason to like it even more!
The U.S. dollar is on the verge of breaking down — the recent countertrend rally in the DXY may well be snuffed out quickly. The 50, 100, and 200-day moving averages in gold are all in major uptrends despite the corrective phase from overbought levels.
It’s difficult to see how equities can rally on this Fed move alone or the election results for that matter seeing as a GOP victory in the House and QE2 had both been widely discounted in recent months. There have been no surprises here over the past 24 hours. Just confirmations on what had already been priced in.
Meanwhile, risk assets from equities, to credit, to emerging markets have, in recent months, become correlated with a weaker U.S. dollar in an unprecedented fashion. A weaker dollar, in turn, fits in very well with Ben Bernanke’s reflationary strategy by cheapening exports and buying jobs from abroad, not to mention adding extra impetus to foreign-currency translated corporate earnings. The question is whether the dollar’s descent becomes destabilizing or what the responses to this overt weak dollar policy will be in other parts of the world. Currency wars tend to lead to trade wars and trade wars do not tend to end very well (gold being an exception).
In the interim, the risk the market faces in the near-term is economic disappointment from three possible sources that could inflict some pain on the consumer:
1. The five million 99ers who are about to lose their jobless benefits (can even a lame duck Congress be that heartless?);
2. The looming tax hikes on January 1 if a GOP-White House deal isn’t brokered, and;
3. The bite into discretionary spending from the spike in food and energy prices — at exactly the most important shopping time of the year. Look out for a big bite out of GDP from what will likely prove to be at least a sharp upward move in the price deflator (have a look at Food Sellers Grit Teeth, Raise Prices on page B1 of today’s WSJ as well as Apparel Makers To Lift Prices on page B2).
The equity market loves the liquidity boost but as I said, it is priced in. There are twice as many bulls as there are bears in the sentiment surveys and the stock market is trading near the top end of the 2010 range. Moreover, the two “critical” events that got Mr. Market all excited in the last two months are now yesterday’s news. The recent Barron’s Big Money Poll smacked of the complacency we saw in the fall of 2007 when nobody seemed to see a recession looming. Today, 4 in 5 surveyed in the Barron’s poll are dismissive of double-dip risks, perhaps prematurely. The mistake here may be in confusing derailment with delay.