Earlier this month, the Fed surprised markets by announcing a new open-ended QE program focused on Mortgage Backed Securities (MBS). The Fed’s balance sheet will start to grow again – to the tune of $40 billion per month – this new programme stated on the day of the announcement.
In targeting MBS, the new program looks more like QE1 than QE2. Clearly, the Fed is trying to provide whatever support it can to the US housing market and keep the refinance engine running. However, housing affordability is already quite elevated and refi activity continues to be restrained by capacity limitations (banks have tight capital levels) and credit issues (like unemployment)
The most important aspect of the Fed’s announcement last week was the open ended nature of the new program. The statement indicates that the purchases will continue as long as “the labor market does not improve substantially.”
We note that consensus forecasts show any meaningful improvement in labor market conditions over the next 12 months. Thus, it seems as if there will be a lot of Fed buying ahead.
QE1 was effective in saving the financial and economic system from collapse but failed to kick start the economy…. QE2 or operation twist failed miserably….
But Central banks have no other tools to use…so they have decided to continue to implement the same action until it works.
Likewise in Europe where Draghi adamantly declared that “the ECB is ready to do whatever it takes to preserve the euro“, and adding unequivocally, “And believe me, it will be enough”.
Draghi has signaled that the EURO & the EU will survive.
Both Central banks are adamant that GFC 2 will not occur on their watch….
The latest FOMC announcement probably helps to limit tail risks and provides some further impetus for an easing in financial conditions. All of this helps at the margin. But it seems awfully risky to link a policy instrument (in this case, the size of the balance sheet) to a macroeconomic objective when the relationship between the two has not been well established.
The bottom line is that we do not see this initiative as a fix-all to the overall arching problems of too much debt and not enough growth.
It is just possible that the Fed may wind up spinning its wheels in the mud on this one.
Equity market rally to continue?
Equity markets have closely tracked economic growth indicators in this cycle, but over the last few months this relationship has started to break down as equities have rallied substantially despite continued weak macro data. Much of this divergence is likely due to investors’ hopes for monetary policy intervention, which has duly been delivered by the Fed and European Central Bank (ECM).
The sustainability of rally depends on an improving economic growth outlook.
The timing of QE3 does not fit the historical precedent: Traditionally the Fed has increased monetary stimulus when equities have been falling, inflation expectations are low, and financial conditions are tight. QE3 has occurred after a period of sharply rising equity prices, relatively high inflation expectations and loose financial conditions.
Should we be suspicious of this move?
The immediate target of the FED’s effort is to add fuel to the tentatively rebounding housing sector, which presumably would juice up the overall economy and the jobs sector. But there were other likely prods as well. The rising cost of food, for one. The decline in business demand for capital goods, for another. A softening in two of the pillars of the recovery—exports and manufacturing, feeling the squeeze from global recession and somewhat listless domestic demand.
Then there’s the fiscal cliff, where up to $540bn of policies will come to an end (Payroll tax cuts, end to some unemployment benefits and Obamacare tax increases) all conspire to cut up to 3% off GDP.
Remember that GDP is currently growing at 1.5% to 2%…..so any fiscal drag is meaningful…. So could it be that Ben is worried about a recession in 2013/14?
What does this mean for asset allocation and portfolio selection?
Global financial risks have diminished further and while problems in the Eurozone and the US will persist for many years, these are well understood by financial markets and arguably well priced in.
Is there are case to revise our very defensive asset allocation?
Primarily, we retained a defensive asset allocation as protection against a disorderly unwinding of the Developed World credit binge of the last 20 year. The recent stop gap measures by the ECB and US Fed is designed to take the “dis” out of disorderly – i.e. kicking the can down the road.
In isolation, this would suggest that we increase our allocation to growth assets – as the Central banks are pleading us to do…
But growth looks as elusive as ever….and that means that caution is warranted.
While fixed interest markets are offering equity like returns in the current environment, we are reluctant to increase growth allocations.