The rather discredited Philips curve taught in Econ 101 classes relates the inverse trade-off of unemployment to inflation; the Fed seems to have decided that if lower unemployment can cause inflation, higher inflation expectations can create employment. Spain’s equity market is up 40% since the late July low, the S&P 500 technology and financial sectors are up 23% this year (with Bank of America up 70%), and the euro has rebounded above 1.30 versus the USD, while medium term US bond market implied inflation expectations have broken 3%, versus just 2% last autumn. Back in early June, the smartest brains in the investment world would have confidently bet against most if not all of those developments, as reflected in the underperformance of hedge funds since, with the benchmark Bloomberg index up just 0.7% last month and lag the MSCI World YTD by over seven percentage points on a total return basis. The Fed’s previous QE efforts were flawed in that they removed safe asset collateral from a financial system chronically short of them and left markets convinced that 2% was an inflation target ceiling. Last week, we got a clear signal that it won’t be.
The Fed was most always likely to act via the mortgage bond rather than Treasury market this time, but the open-ended nature and ‘acceptable’ employment target have raised the stakes considerably. The Fed hopes to generate more economic activity per dollar of balance sheet expansion because the program is open-ended, even though $40bn a month is smaller than QE1 or 2, via faster bank mortgage origination and hence boosting a promising early stage housing recovery. One reason banks have been hesitant to step up that origination capacity (which has been running at just $4bn a month net YTD) was that they didn’t believe the low-rate environment would last. As the policy wonks at the Fed might put it, the portfolio balance channel (i.e. goosing asset prices) works better when accompanied by use of the expectations channel (i.e. low rates indefinitely). As ever, things are likely to prove more complicated than those neat econometric models predict…
One risk with relentless monetary expansion via bond purchases is that a false market developing in US fixed income, such that the global risk-free benchmark rate is distorted. We are certainly in an unprecedented situation as regards price discovery because as well as MBS, it’s quite possible that the Fed will continue to purchase longer-term Treasuries ($10-15bn a month) simply to prevent the stock effect of its previous purchases leaking back to the market, but probably without the short-end Treasury sales that to this point have been neutralising the impact on the monetary base, as its supply of these Treasuries to sell will be close to exhausted. The Fed has become the dominant buyer of Treasuries, accounting for almost 50% of 7-year and over 60% of 10-year new issuance. Over the next few months, it will be the dominant buyer in the market for agency-backed mortgage securities, where gross issuance totals about $130bn per month but accounting for securities that reach maturity, the Fed’s purchases will actually shrink overall supply. Unsurprisingly, the yield on the commercial MBS index tumbled to a new low of 2.26% last week and MBS spreads over Treasuries fell to their lowest level in over 20 years.
Junk bond yields are already seeing a ‘displacement’ effect along the risk curve. All of this activity will take its balance sheet toward $4trn by 2014, but will also squeeze fixed income market liquidity even further. I’ve often noted that the essential investment implication of QE is to artificially suppress macro tail-risks and the Fed has been selling volatility into the markets to reduce term premiums and hence term interest rates. Buying mortgages results in a direct sale of volatility (prepayment risk). Economist Hyman Minsky’s brilliant insights into the impact of low volatility (ignored pre-crisis, and still only grudgingly accepted among policymakers) on speculative behaviour suggest we’re setting ourselves up for another ‘Ponzi finance’ bubble and the only question is where it will inflate this time (aside from bond markets). For China, even if its trade surplus has fallen sharply from 11% of GDP to say 3%, recycling even $300-400bn annually into Treasuries will be a nightmare competing with the Fed as buyer of first resort.
The slowdown overseas is beginning to cut into US corporate profits, which had benefited in the last few years from exports/foreign affiliate earnings outpacing domestic demand. Analysts expect earnings in the S&P 500 to decline 2.2% in Q3 y/y, according to Thomson Reuters, the first annual drop since Q3 2009; earnings are expected to be down 3% from Q2 while the Shiller CAPE is now almost 23x. Certainly, GEM equities have underperformed DM this summer as the BRIC slowdown hits earnings momentum and valuations look far less stretched that in the US and some euro zone markets. EM USD debt has surged further with the desperate global hunt for income, and focusing on stable cash flow, high dividend equities has been a successful investment strategy just about everywhere. That trend looks well supported by the latest Fed move, but having gone back to a long risk stance back in June, I’m weighing up the implications of these cross currents for this month’s Q4 portfolio strategy note. I’d suspect that the ‘washboard’ ride for markets isn’t over just yet.