Fighting the Fed

Last night’s market action screams QE3. Anything physical – grains, oil, gold – went bonkers, whilst the $US and Treasuries got thrashed. Welcome to QE3 and a new  “undollar” rally.

An “undollar” rally is, of course, the process of buying anything physical that is priced in US dollars and therefore is set to rise in price as the dollar falls on monetary easing.

The last round of this trade, QE2, was a complete no-brainer, taking the S&P from a low around 1040 to a high of 1360 some 8 months later. Will it last again this time?

There are some parallels that offer hope. For instance, in September 2010, the US PMI also dipped and the eurozone was basking in the glow of a new Greek bailout.

Also, here is an important piece from Credit Writedowns:

The third round of unconventional stimulus is now starting

Since then, the economy has weakened considerably. The Fed even said so directly – “economic growth so far this year has been considerably slower than the Committee had expected”. So now the QE3 speculation has begun.

Here’s what I think is happening at the Fed. Fed doves have wanted some sort of easing. Under consideration are targeting long-maturity asset purchases, setting an interest rate target or even eventually buying municipal bonds (see What QE3 could look like from June).

Fed hawks want no part of this. Look at the three dissents at the last meeting and Kocherlakota’s statement on dissenting the Fed’s permanent zero policy. So the doves have been forced to alter QE3. Here’s how I put it last month:

The Fed is likely to soft peddle this policy change because of comments from people like former Atlanta Fed President William Ford questioning Can the Fed Go Bankrupt? The Fed will want to stay to the shorter end so as not to risk its balance sheet by moving out the curve with interest rate caps. However, there could be internal dissent, so the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’. Eventually people will be forced to accept this – and the term structure will flatten further and further out the curve. That’s how Japan got to a 1% 10-year yield because expectations of zero rate policy continued to lengthen in time.

Gross and Rosenberg: QE3 will see interest rate caps

This is what we just got last week, permanent zero. I believe this is the first salvo in a renewed easing campaign by the Fed. I had been saying full-blown QE3 wouldn’t begin until 2012. In fact, the permanence of the zero to which the Fed has committed is much longer than I had anticipated. I would go so far as to call this full-blown rate easing, one of the three easing policies I identified earlier as QE3 contenders. That’s why you got three dissents at the last FOMC meeting, which you will almost never see at the Fed.

The 0.375% US Treasury note maturing on 31 July 2013 is now yielding only 19 basis points. Call this financial repression, call it rate easing, call it permanent zero or whatever you want; What the Fed has just done is effectively guarantee interest rates out to two years. In essence, QE3 has already started – and that’s bullish for fixed income investors because it guarantees a floor for non-credit-related fixed income investment risk. Interest-rate risk is gone for investments up to two years; Private equity and leveraged finance will need to get busy.

Watch the upcoming speeches at Jackson Hole to see how much further the Fed is willing to go.

I’ve been of the view that zero short rates were basically permanent and I have never taken Fed tightening seriously anyway so this is a surprise to me. But, if CW is right, then this is a big deal, as the permanence of zero rates frees capital to pursue its various carry trades worry free for the medium term.

However, there’s also no doubt that the task confronting a Fed reflation this second time around is much greater. The broader global economy is weaker now than it was when QE2 was announced. From Gavyn Davies, look at this chart of aggregated global PMIs:

Moreover, the weakness is broad based:

Downward momentum is much greater in the global industrial economy now than it was in September 2010.

Moreover, in September 2010, global government stimulus was still supportive to growth, as opposed to the 1.5% of GDP now scheduled to be removed from the US economy over the next 12 months. In the Eurozone, the May ’10 Greek bailout was still accepted as effective and 10 year Irish bond yields were sitting around 5%. Now, we have banana republic yields across the periphery and new austerity packages in Greece, Ireland, Portugal and Italy.

China too was still growing strongly and its inflation rate was below 4%, enabling ongoing loose monetary conditions. Today growth is still strong but is slipping slowly as the PBOC tightens and inflation is at 6.5%. A strong QE3 may force further tightening as the slowdown advances.

Likewise, the US inflation rate was about 1%, as opposed to its current 4% or so.

The primary cause of this rise in inflation was the re-pricing of commodities  emanating from QE2. In 2010, the CRB sat some 22% below its current level:

These look to me like very strong headwinds for those looking for an enduring and runaway QE3 rally. If you’re gonna play it, I recommend a short stop.

Houses and Holes
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    • Weimar Republic

      a) no. with his background it was pretty easy to work it out. I was just curious to read you embracing his view when you were indifferent to it last week when I put it forward:

      b) yes 🙂 but didn’t need to be to reach the conclusion re: 2013 date. Using the options analogy, valuing something with an exercise data is easier than something without an exercise date.

      c) yes

      d) no

        • Weimar Republic

          You mean here or USA?

          I’m not a day or 2-3 day trader (apart from last week or so and earlier this year with the tsunami) so make no predictions about what happens today or tomorrow etc.

          Risks appear to be known knowns (which kind of made the sudden volatility breakout a tad surprising). The ECRI called a global slowdown for H2 a couple of months ago but they aren’t seeing a US recession. …but maybe they haven’t factored in austerity yet. Personally I wouldn’t want to be short S&P500 below say 1150 unless Europe implodes. In other words I think we found a short term/medium term bottom the other day.

          But these comments are different to the observation about the importance of locking in 2 years of ZIRP. You are asking me to speculate on unknowns, whereas my comment about ZIRP was about the value of certainty, i.e. known knowns.

          • Weimar Republic

            IMO QE2 didn’t help the economy, rolling over expiring debt (QE2.5) won’t help, and locking in ZIRP for 2 years won’t help the real economy** (despite being a bonus for traders).

            The austerity mentality pretty much locks in lower growth (ceteris paribus).

            ** I suppose it is conceivable that home owners can refinance and in doing so either have more money to spend on consumer goods or more money to pay down debt. The economic effects would be quite different. But I’d want to hear from a US housing expert on the effects of locked in ZIRP. Has Shiller commented since the Fed announcement?

  1. In a nutshell: Wall Street has no growth story to run up on, other than hang on to Bernanke’s beard. What is this world coming to?

  2. I still disagree with Weimar on the fed statement 🙂 They said:

    “The Committee currently *anticipates* that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are *likely* to warrant exceptionally low levels for the federal funds rate at least through mid-2013”

    Basically that’s their forecast: but they are known to be very wrong, ain’t they? Look at their forecast for GDP growth in 2011!

    Anyway, I really do not understand why they don’t focus on oil prices instead of interest rates? Oil at $80 is a much bigger boost to the economy than any QE they can dream of. That’s now obvious to everyone. With their constant market pleasing monetary policy, they allow the markets to mis-price oil. If a world economic slow down is coming oil prices should be much lower, but they are kept inflated by central banks useless monetary policies, like all other commodity prices.

      • Yes.

        Can they pleeeeaaaaase try, for more than a millisecond, to let the “free” markets discover the right price of things???

        Can they let the market drop 20% if that is the right price today?

        Last week market action was obvious: it would have bounced back no matter what. I bought into that. Even if the fed would have announced an interest rate increase. The computers are just playing around.

        It’s now the time to get out of the box. The longer they wait the worse it’s going to be. Interest rates could not be lower, there is more than enough liquidity. The economy has to run its course, but it needs a working price discovery mechanism in place.

        Will they really send oil prices back to $100 at Jackson Hole????

    • Weimar Republic

      The thing is that they never mention dates explicitly. It is always “for an extended period” etc. That is why it reads as a lock-in. Note that 3 dissenters disagreed with the use of that specific language.

      Agree with H&H, it paint them into a corner.

      • Thanks.

        He does not say if he agrees with the others that the economy is *likely* to warrant exceptionally low levels for the federal funds rate at least through mid-2013, or he just wanted to leave it open as before…

        The more I think about it, the more I believe they just panicked, they *needed* to please the markets somehow, so they just added a very vague sentence which looks 2 years ahead while every one knows they can’t even forecast 6 months of GDP!

        • Weimar Republic

          in the Fed announcement the dissenters dissented because they wanted to stick with the open ended wording. That is already on the record. In this statement, also a tad extraordinary I would have thought, he explains his views in more detail.

  3. Once again, your focus is purely on demand side.

    Tell me, how much crude oil do you expect the world will be producing in the next 20years?

    The chaps at Uppsala university (working for the Assocation for Peak Oil) predict total liquids (crude oil, NGL, tar sands) at just 75mbd by 2030, compared to 82mbd produced today.

    (Note that 82mbd is in barrels of oil equivalent, and that the numbers supplied by the IEA are lower than the those from BP, possibly because biofuels and drawing down of strategic reserves are not included in the IEA numbers.)

    In contrast to Uppsala uni, the IEA predicts world oil production will reach 102mbd by 2030. The difference is that the Uppsala group has used the HIGHEST possible depletion rate and found that it is simply not possible/would severely jeapordize the ultimate recoverable resource if anything higher was achieved.

    But Uppsala are still assuming that the ‘fields yet to be developed’ and ‘fields yet to be discovered’ are feasible resources i.e. they have optimistically assumed that above ground factors (civil uprising and wars in the Middle East, financial crisis in the west) will have no impact on oil production.

    And you want to pretend that $80/barrel is expensive?!

    • You are talking about *real* demand driven oil prices. I am talking about oil prices going from US$115 to US$75 in a matter of days: a BIG difference for an economy (US) that is trying to recover from the worse recession in years.

      I do not know if $80/barrel is expensive. It depends on the value of the US$.

    • “If a world economic slow down is coming oil prices should be much lower, but they are kept inflated by central banks useless monetary policies, like all other commodity prices.”

      So have you looked at the current production of oil?

      1mbd brought offline by Libya since the start of the year will have no impact?

      Is it a good sign for oil supply if we are using strategic reserves?

      I’m not saying that extraordinarily low interest rates have no effect. But to ONLY consider them is fallacious.

      And you are obviously only considering WTI, as Brent (for European markets) is still at $108/barrel, and Tapis (for Australia) is still at $116/barrel. It seems as US consumption of oil has been crushed (from 21mbd in 2007 to 18.5mbd now) that demand for American oil is lower than the blends in other parts of the world.

      • I agree on longer term demand/supply view on oil prices: they ain’t going to come cheaper (they are coming down measured in Gold however)

        But volatility such as WTI US$115 to US$75, in a matter of days (similar in Brent) can only be explained by Ben destroying the US$ and providing cheap money and a green light to investors to chase returns. Oil fundamentals do not change that much in a couple of weeks!

        The scenario above is the risk you run when monetary policy is not aligned to the real state of the economy. 3 years of zero interest rates and multiple QEs are distorting market prices and harming the economy, that is my take.

  4. I take this a sign that the US is well on the way to Turning Japanese.
    Anemic growth punctured by bouts of deflation and zero interest rates for as far as the eye can see…

  5. I can’t eat an ipod! The donkey is waking up to the fact that plastic carrots, even bright red/orange ones dipped in carrot essence ain’t going to inspire anyone.

    Plastic carrots with financial repression or just financial repression with more financial repression?(in different forms).

    Does the Fed actually have dissenters as per Hegelian dialect-thesis, anti-thesis. synthesis. Or is it just a case of good cop, bad cop routine? They only appear to be human friendly after leaving office.

    If the Fed (or other CB’s) needs to be so covert and secretive then they must have equally powerful enemies. So who is in control?

  6. how long does it take to load all of the guns (for the (QE)3th,4th,5th time) when it’s a no-brainer?
    and then what? 🙂
    it will sure backfire through rising inputs and weakening demand thus destroing real economy further (look at Quantas for example)
    and then what? more of the same? for a week, a day, few hours? 🙂