So, here is what I wrote on the eve of the Jackson Hole conference last year:
The S&P500 tilted at the the key 1040 level again today, the neckline of a scary head-and-shoulders top pattern, and held. The Dow is sitting right at the psychologically potent 10,000 level. Gold is sitting right below all time highs.
And tomorrow the US head of Fed, Ben Bernanke, gives a speech at the Jackson Hole symposium entitled “The Economic Outlook and the Federal Reserve’s Policy Response”.
With US leading indicators clearly signaling impending recession, the markets are set up with remarkable technical precision to make a decisive break one way or the other.
If Bernanke fires up the helicopter for quantitative easing round two then markets can rightly expect that printing money is now the first and only monetary policy response to slowing growth. The US dollar will get crushed and all of the reflationary trends around US demand supporting emerging market growth and the consequent rising commodity prices will re-establish, at least for a while. Gold will soar on the inflationary implications (which will fade over time).
If Bernanke stays in the hangar, markets are likely to plunge through the key technical support levels and the US dollar rocket on safe haven buying.
My guess is he will do neither, probably jangling the keys to the helicopter a little but leaving them in his pocket. After all, it is only a couple of weeks since the Fed announced its decision to reinvest proceeds from maturing MBS into Treasuries. Any shift now would surely look panicked.
That will leave bulls and bears slugging it out around the key technical levels. A rally in an oversold market is possible but it will be temporary. After twenty years of Greenapan rescues, markets have a total psychological and structural reliance on the Fed saving the day. Therefore, if there is no Fed move tomorrow, equity markets will break lower in the near term and force it.
The rest is history. I was wrong of course. Bernanke fired up the whirly bird. I was not wrong on the outcome.
So, can we expect a repeat?
In New York, Goldman Sachs says yes, with both hands:
Following the sharp deterioration in the economic outlook, we now see a greater-than-even chance that the Federal Open Market Committee (FOMC) will resume quantitative easing later this year or in early 2012. We recently discussed that such a step might involve either another expansion of the balance sheet or an increase in the duration of the Fed’s balance sheet without expanding it (see “For More Easing, Will Fed Go Big or Go Long?” US Daily, August 15, 2011.) But given the disappointing growth performance since the adoption of the second round of asset purchases (“QE2”) late last year, many commentators question how effective QE3 would be in boosting the sluggish recovery. In today’s comment we attempt to shed some light on this question in two steps.
First, we reexamine the link between quantitative easing and financial conditions. As discussed on many occasions in the past, we think that the Fed’s unconventional policies work primarily through easing financial conditions via lower interest rates, higher equity prices and a weaker dollar. Specifically, we estimated in the run-up to QE2 last summer that $1trn of asset purchases would boost our financial conditions index (GSFCI) by around 80 bps. (This estimate was derived as the average effect from three models that ranged from 25-115bp.
Goldman factors in likely fiscal cuts, a surge in the oil price and a struggling consumer and concludes:
…Taken together, our analysis suggests that QE3 is unlikely to be a panacea for growth. Nonetheless, our estimates suggests that $1trn of asset purchases–or an equivalent increase in the duration of the Fed’s balance sheet–might increase GDP growth by up to 0.5 percentage point in the first year after any announcement of QE3.
That doesn’t sound unreasonable to me, but we have to ask, what’s the point? That would mean a US economy stumbling along at 2% next year with an inflationary surge building via emerging markets. In short, stagflation. And that’s if the advancing freeze in European bank funding doesn’t deteriorate, leaving the Fed naked. Mind you, it’s hard to believe a gale of new dollars whizzing around the planet wouldn’t ease the freeze to some degree.
Still, I’d rather see the Fed steer clear at this stage. As Mohammed El Erian advises in the FT today:
In the event, QE2 pushed financial investors out of the risk spectrum and delivered higher asset prices. But it failed to convince companies and households to consume, invest and hire more. As a result the Fed-induced wedge between market levels and underlying fundamentals eventually collapsed under the weight of artificially high valuations.
To be sure, Mr Bernanke was among the first to acknowledge that the benefits of unconventional policies come with costs and risks. Specifically, QE2’s benefits – in the form of “good” inflation (higher prices for equities and corporate bonds) – were coupled with collateral damage (“bad” inflation via surging commodity prices) and unintended consequences (technical market dislocations and the Fed becoming more vulnerable to political attack).
With America’s economy again losing momentum this summer, I suspect that Mr Bernanke feels a renewed urge for policy activism – both to meet the employment part of the Fed’s dual objectives and to relieve some of the mounting pressures on the financial system. However, I also suspect that he is aware of his reduced degrees of freedom, both in an absolute sense and relative to a year ago.
Compared with August 2010, inflation is higher, structural impediments to job creation are deeper, the global environment is less co-operative, and the independence and credibility of the Fed are under greater pressure. Moreover, judging from the fleeting impact on risk sentiment of last week’s Federal Open Market Committee statement on interest rates, markets seem less sensitive to Fed shock therapy.
El-Erain suggests rather that Bernanke should:
…reframe the national policy debate and, in the process, set the stage for President Barack Obama’s key economic announcements on September 5.
He should do so in three steps. First, acknowledge that the considerable headwinds undermining economic growth and jobs have important and growing structural elements. Second, explain why a sustainable solution must go well beyond Fed financial engineering and, specifically, incorporate co-ordinated structural reforms on the part of agencies responsible for housing, the labour market, public finances, infrastructure and directed credit. Third, and most delicate, caution that another round of unconventional Fed policies would only be effective if accompanied by these other policy initiatives.
In other words, excersize some real leadership. Sadly, this looks to me rather utopian. The Federal austerity deal is done. Getting it done cost the nation its AAA rating. Expecting Bernanke to overturn it and instil this level of reason is tilting at windmills, at least in an investment sense.
No, Bernanke is boxed in. He will do something. The only question is, what? Gavyn Davies gave us a useful tour of the options a few days ago:
The leading candidate, according to many Fed watchers, is that the chairman might talk about extending the duration of the Fed’s portfolio of bond holdings, in effect replacing some of its holdings of short dated bonds with larger purchases of longer dated bonds. This would be intended to reduce longer dated Treasury yields, thus stimulating the economy without creating the political flak which would follow from a further increase in the absolute size of the Fed’s balance sheet.
This would be a repeat of “Operation Twist” which was undertaken by the Fed and Treasury from 1961-63, when the Kennedy administration wanted to ease monetary policy without cutting short term interest rates. Short rates needed to stay high to support the dollar’s exchange rate, which was fixed under the Bretton Woods system at the time.
Most economists believe that Operation Twist had relatively little impact on the economy. A recent study by the San Francisco Fed concluded that the size of the operation, relative to the then size of the Treasury market, was about two thirds as big as QE2, and that it cut Treasury yields by only about 15 basis points.
In present circumstances, that might seem to most investors to be little more than a drop in the bucket.
I agree. Nothing short of a full blown QE announcement will avert a US recession and ongoing market falls, yet in current circumstances, I can’t see Bernanke firing up a full round of QE3 until both growth and inflation is in serious decline.
In that sense, QE3 is coming without a doubt. And I’m not the only one who can see that. In late September 2008, Warren Buffet bought $5 billion of preferred stock in a decimated Goldman Sachs. Two moths later, QE1 began. Although it took a significant boost to the asset purchases in March the following year to turn the equity market around, Buffet ultimately cashed in handsomely.
Now its Bank of America and Buffet is at again. One way or another, history is set to repeat.
