Every investor, sadly, has to be a Fed watcher given that US asset markets are supported, if not levitated, by quantitative easing.
Sadly because, and Ben Bernanke himself might agree with this, we could all probably find more productive ways to spend our time. Sad, too, because the US Federal Reserve’s reach actually seems to be diminishing amid doubts about how well QE is working.
Perhaps never before has the market been this dependent on the Fed and perhaps never before has there been as much doubt over its eventual success.
That makes the latest Fed policy meeting minutes, released last week, the markets’ most under-sung story of the week.
The minutes, which hinted at further accommodation in 2013, showed that “a number” of Fed officials believe the US central bank will have to buy additional assets when its current program, Operation Twist, wraps up at the end of the year. This is counter-balanced, somewhat, by “several” others, including Jeffrey Lacker of the Richmond Fed, who doubt this is needed.
Put your money with the easers, led most likely by Chairman Bernanke.
Operation Twist, under which the Fed sells $ 45 billion a month in short-term paper and uses the funds to buy longer dated debt, is intended to drive down longer-term interest rates. It is also a support for equities; when investors see pitiful government debt rates, they are likely to throw up their hands and buy dividend stocks and other risk assets.
What comes after Operation Twist may be, if anything, slightly better for risk assets. Operation Twist keeps the size of the Fed’s portfolio constant, as they sell a dollar of short-term debt for every dollar of Treasuries they buy.
After Twist expires the Fed may well simply print money and buy Treasuries, not only driving down yields but also creating more money which can support equities. With the Fed already spending $ 40 billion a month to buy mortgage bonds, we could see about $ 85 billion of new money being pumped into the markets every month in 2013.
What would happen if the Fed allowed Twist to end? While interest rates might not spike higher, they would certainly drift, and risk-asset investors would then face a poor outlook for profits and the risk of a fiscal-cliff-induced recession. The market would tumble. Since the Fed has tied its policy more explicitly to unemployment, it is not going to allow that to happen, so QE4, or, if you like, QE4ever here we come.
The inevitability of continued Fed easing is supported by the discussion, in the minutes and recent speeches, of so-called quantitative thresholds. Under such a threshold, the Fed would commit itself to buying so many Treasuries until a specific level of unemployment or nominal GDP growth were met.
That’s still controversial, both inside and outside the central bank, but the very discussion is a fat signal that we won’t see any passive tightening when Twist comes to an end.
The impact of additional QE is much harder to determine.
Thus far QE has shown mixed results. It’s been more a supportive therapy than a cure, at least in terms of the economy. And surely the experience in Japan, where QE has a long track record and where they’ve gone as far as buying equities, offers no assurances of success.
In market terms, however, QE has likely been quite important. It has supported equities, particularly those paying reasonable dividends, as well as other risk assets. It is hard, though, to get very excited by the prospect of more QE-induced gains.
Equities, even with support, face too many other hurdles: The fiscal cliff, earnings, the euro zone and, of course, the possibility that Fed support fails to work. If the US, even with massive QE, were to head into another steep recession investors would quite rightly lose confidence in the central bank. It is more a case of downside if they don’t than upside if they do.
The counterbalance: An utter lack of attractive alternatives to risky assets. Treasuries surely have much risk and little reward and while corporate debt is well supported by clean balance sheets, the corporations must sell to governments and households with real balance-sheet problems.
The expiration next year of unlimited FDIC account insurance may actually make things worse from a fixed income investor’s point of view, driving huge amounts of cash out of bank deposits and into government debt. This, in combination with proposed new money market rules which will make them also more likely to hold government debt, might actually lead to negative short-term interest rates in the US.
So there you may have it: pay the US to lend its money or take your chances with the Fed and equities.
— James Saft is a Reuters columnist. The opinions expressed are his own.