“There is a danger that the Fed has missed its window of opportunity. If it’s waiting for some degree of fiscal certainty, this really could turn into QEternity.” — Paul Ashworth, chief U.S. economist at Capital Economics
Wall Street was completely convinced that the Federal Reserve would begin to taper its quantitative easing program following its September FOMC meeting.
There were several compelling reasons why it had to happen in September. In short, Committee members had raised concerns over both frothy markets and the economic effectiveness of QE in previous meetings, putting the central bank’s credibility on the line by priming market participants for a tapering announcement and doing nothing to change expectations thereof.
When the FOMC concluded its meeting on September 18 and announced that it would refrain from tapering on the grounds that economic data weren’t improving quickly enough, market participants were completely caught off guard. Bond prices soared as investors re-calibrated their positions to reflect this new reality.
We have never heard investors as angry as the day after the Fed decided to not taper its asset buying program.
“We have never heard investors as angry as the day after the Fed decided to not taper its asset buying program,” said BofA Merrill Lynch economist Ethan Harris. “Some investors argue that it was a deliberate attempt to introduce volatility into the market. Others said Fed credibility is shot.”
In a recent report, ISI vice chairman Krishna Guha, a former New York Fed official who served as a senior adviser to New York Fed president Bill Dudley until just a few weeks before the FOMC’s September decision, sums up nicely the confusion the FOMC has created over the outlook for quantitative easing.
Quoting minutes from recent FOMC meetings, Guha writes (emphasis added):
The forward guidance on the balance sheet is provided by the QE policy rule. The problem here — as I have pointed out repeatedly — is that there is not one single policy rule but two elements of the policy rule that are not properly integrated.
The first element is the economic outcome based rule — that the committee will continue its purchases of Treasuries and MBS “until the outlook for the labour market has improved substantially in a context of price stability.” The second element is the cost-benefit rule — Committee decisions about the pace of purchases will “remain contingent on its assessment of the likely efficacy and costs of such purchases.”
In my opinion the May/June taper talk was a tightening in monetary policy because it was not consistent with the forward guidance on the balance sheet provided by the economic outcome based policy rule. Put another way, it suggested that the Committee was pivoting from the first element of the policy rule to the second (cost-benefit analysis).
And markets fell for the head-fake.
Then, less than two weeks later, Congress shut down the U.S. government for 16 days, scaring market participants with the prospect of a debacle in which warring parties failed to raise the impending debt ceiling, resulting in a default on U.S. debt. And at the same time that major money-market funds were dumping U.S. Treasury bills, consumer confidence was plummeting.
The shutdown was eventually lifted, and a true debt ceiling crisis was averted — at least, temporarily. But the resolution didn’t stop Bank of America from slashing its Q1 2014 GDP growth forecasts to reflect the next round of fiscal sparring set to take place in January and February, when the current deals struck by Congress this month expire.
Meanwhile, today we got the first look at the impact the fiscal crisis had on the American economy with
Markit’s flash October U.S. PMI survey, and it wasn’t pretty. American manufacturing output contracted for the first time since September 2009. Manufacturers cited weakening domestic demand for the drop in output, even as new export orders rose, reflecting an improving economic picture overseas.
“It is clear from the September minutes that most Fed policymakers thought ex-ante that the no taper decision at that meeting meant taking time out for 6-12 weeks, during which time they would be able to review some additional data in housing and employment in particular, to validate the forecast before starting to taper,” says Guha. “However, ex-post it is likely to take much longer to get the data they need to see consistent with the economic outcome based element of the QE policy rule reasserted in September.”
Initially, when the Fed didn’t taper in September, Wall Street analysts and economists quickly coalesced around the view that it would probably do so in December.
Then, when the economic effects of the shutdown came into view, expectations were pushed out to January, and now, many say they don’t expect the Fed to act until March.
Guha, for one, sees chances for when the Fed is most likely to announce the taper like this: 25% in December, 30% in January, 30% in March, and 15% after March.
And amid a big rally in the bond market, many are wondering if tapering is quickly becoming a distant September memory.
In a new report making the rounds on Wall Street bond trading desks today, Medley Global Advisors analysts Regina Schleiger and Jeremy Torobin argue that, “more than simply standing pat, the Federal Open Market Committee has effectively hit the reset button and is back where it was six months ago — at the very start of a long process of building the case for a downward adjustment to the Large-Scale Asset Purchase program.”
Right now, the potential costs of withdrawing even the slightest bit of support from the economy appear much greater than they were.
“That [tapering] eventuality is now a riskier proposition (and, consequently, the process of getting back to within striking distance is more difficult) because of troubling signs that economic momentum is slowing,” write the Medley analysts. “The potential costs to financial stability of continuing purchases at the current $US85-billion per month may, down the road, start flashing red and embolden FOMC hawks to push for an aggressive conclusion of the program. But right now the potential costs of withdrawing even the slightest bit of support from the economy appear much greater than they were.”
The consensus on Wall Street is that U.S. economic growth finally takes off in 2014, which will give the Fed the opportunity to taper.
But what if it doesn’t? Consider this: some believe the U.S. economy is actually entering a “late-cycle stage” — in other words, the upward acceleration may not be coming.
“A growing number of indicators are showing late-cycle dynamics, and while this need not imply a recession it might well indicate a shift into a period of slower growth and lower inflation,” says Deutsche Bank global head of rates research Dominic Konstam.
“So much for animal spirits,” he writes in a recent note to clients:
All else equal, our investment model that is derived from profits now clearly shows falling investment spend in 2014. So much for animal spirits: the corporate sector has little economic reason to invest, animal or not.
This is also apparent in corporate free cash flow, or internal funds available for investment. The first issue is that corporate cash flow growth has turned negative in recent data — levels not seen since 2007. The second issue is that year-over-year growth in corporate cash flow has historically tended to follow the contribution of labour input to profits, with a four quarter lag. This observation also argues that labour input is the moving part that is used to restore cash flow growth via profits. The recent increase (less negative decrease) in profits attributed to labour input could then be seen as the beginning of attempts to strengthen cash flow, with the bad news being that a positive contribution to profits implies cutting labour input.
Because free cash flow can be seen as the funds available for potential investment, another potentially disquieting implication for the longer run is that in order to increase investment, the corporate sector will necessarily reduce labour input, in terms of growth or outright. Either of these would provide a means for pushing productivity and capital/labour ratios (higher) back toward historical norms.
Labour input is high relative to productivity, which typically predicts a sharply slower labour market 2 years ahead. In fact, simply conditioning on the relative gaps of labour input to productivity when it is negative predicts an almost stagnant labour market. In the absence of further fiscal or monetary stimulus, a lower household savings rate, or some combination of these, the implication is lower, not higher, rates.
“This is hardly a recipe for above trend growth,” says Konstam. “We note that recent trend real growth is less than 2%, so if inflation is stuck in the 1-1.5% range, then nominal growth is stuck closer to 3%, not 4%. In that environment, nominal yields become restrictive over 3% and become inhibitive to growth.”
Here, Konstam is talking about a notion that Nomura chief economist Richard Koo has picked up on in recent weeks: that the Fed has backed itself — and the American economy — into a “QE trap.”
Koo visited U.S. clients and Fed officials in a recent trip, and he said no one was able to refute his theory, which goes like this: the Fed talks about tapering, sparking a rise in long-term interest rates as investors dump bonds. The rise in interest rates then weighs on rate-sensitive sectors of the economy — like housing and automotive — which causes the Fed to call the whole thing off because economic data aren’t showing adequate improvement.
“This is ultimately the logic to our argument earlier this year that the sell-off driven by the shock of Fed taper rhetoric and the resulting positioning shift was self-limiting and could be said to preclude, rather than reflect, recovery,” says Konstam.
Perhaps the FOMC eventually decides that, regardless of the trajectory of economic growth, QE represents too big a stability risk to be worth it, as the Medley analysts suggest.
ISI’s Guha also foresees such a scenario if the data don’t, in fact, improve.
“I think we are now in a zone of true data dependency in which QE will be driven almost entirely by the data flow and how this affects the Fed forecast,” he says. “I am confident this zone of true data dependency lasts through January and it will probably last through March. By contrast, from the March meeting onwards (if not before) the decision to taper becomes a question of monetary policy strategy, not just data flow — specifically, whether the Fed is willing to contemplate ‘QE infinity’ in a context of 2% growth.”