Heart, Head, Gut
Guest post by Peter Tchir.
I had a strong, even visceral, reaction to the Fed’s announcement Thursday. I was wrong in that I thought they would back down with stocks at highs, housing showing some signs of stability, high gas prices, some real potential ECB intervention in Europe, etc. I was wrong. I was also wrong when I thought the initial muted reaction was a sign that aggressive QE was priced in.
I’ve been wrong before and I’ll be wrong again but something about this really bothers me. I disagree so strongly with the Fed’s decision that I need to take that “anger” into account as I think about the markets and what to do next, so I’m going to try and separate my thoughts in “heart” or what I feel, “head” or what I think, and “gut” or that idea lurking below the surface that is what I should go with since “heart” is too emotional and angry, and “head” is overly compensating for that.
The QE3 Announcement
I disagree with the decision to announce QE. There seemed to be enough going okay that the Fed should have allowed the economy to continue to find its own footing. There is little evidence that QE has been helpful for the economy. QE1 helped a lot, QE2 I’m not so sure about, and what we don’t know, is what the economy would look like now had we not used the Fed’s balance sheet so aggressively. Would we be in better shape now? We just don’t know the answer to that. I can’t help but feel that this is Ben doggedly pursuing a policy he “knows” is right because he wrote the book on it and is very smart. Like a trader with a losing position, here is an academic who just can’t cut his losses. He knows he is right, and he is going to push for it. I think this is as much about personal vindication as anything else. He thinks he knows better than anyone else. He has all these equations that tell him it should work. His stubborn belief in the wealth effect is just wrong. Not only hasn’t it worked, but there are some pretty obvious reasons why it won’t work. Stocks are owned largely by a class who has savings, and isn’t increasing spending based on wealth effect. People are too smart to change business plans when they know the only support central bank policy. The narrow view of “wage inflation” is the only inflation also strikes me as wrong and is where ivory tower illusions cross with Marie Antoinette’s “let them eat cake”. I hate the decision and think it was unnecessary and potentially dangerous.
Ahhh, after that rant, let’s look at the decision more rationally. The Fed is trying to help the housing market through the purchase of mortgages. I don’t see that having much of a direct impact on housing, but it shouldn’t be a negative. Fannie and Freddie are supposed to reduce their on balance sheet holdings. The Fed conveniently steps up at a time to offset this alleged plan, so the timing makes sense. Regardless of the actions of the ECB, European banks are still generally in deleveraging mode, and many are under political pressure to exit the U.S., so the Fed getting involved in mortgages helps, even if indirectly by reducing supply of simple mortgages and creating demand for more complex RMBS and CMBS the banks have on their books. So I can see the desire to provide a deep pool of money to support the continued deleveraging. Ben is well aware that one of the biggest beneficiaries of his policies is the U.S. budget. By holding down rates he has indirectly helped the budget by at least $100 billion. By returning “profits” on the Fed balance sheet to the treasury he is quickly approaching $100 billion per annum in rebates. Adding more mortgages will help that. The 2015 language is largely throwaway as he will change it if necessary, and for anyone who has had doubts about the ability of the economy to turn around, you had to assume rates were staying at zero for a long time. Finally, the knee-jerk reaction to commodities to rise will tail off without final demand picking up. This is all about final demand and at this stage $3 gas with no jobs is worse than $5 gas with jobs. I don’t think we will get the jobs but at least the rationale makes sense.
In the end, I’m left with a gut decision that the plan is unlikely to do much for the economy but probably isn’t as evil as I first thought in terms of what it does or why it was implemented. Companies aren’t going to change their plans for this. The risk remains that with capital so cheap, labor continues to lose to capital. These policies seem to help the big existing companies at the expense of new company formation, but that problem is hard to see or measure in the short run, so we will ignore it until too late. With so many things going on and real risk that his time as head of the Fed is almost over, he pushed for one more round. He wants to create a legacy of being the Fed chairman who directly tied Fed policy to jobs. Not a megalomaniac narcissist, just a man who thinks he is right and wants to prove it.
Will Stocks Respond the Same Way as they did to QE2?
That’s the real question. Worrying about the long term consequences of the policy or the morality of turning the U.S. into a nation relying on the Fed balance sheet is interesting and will likely be a discussion point for months to come, but in the near term, this question is more important.
My first reaction is, wow, here we go again. The start of a relentless march higher in stocks no matter what economic or company specific news comes out. The NY fed will pump money into the system on days they buy mortgages and stocks will go up. Ugh. Ugh may not be the most professional word, but that’s how it feels. Ugh, nothing will matter and stocks will go up.
But as you think about it, there are many reasons we might not see a repeat. The obvious reason for stocks to go up is that the Fed will be sucking assets out of the market on an almost daily basis and investors will scramble to replace those assets, driving up all asset prices. The person who sells mortgages won’t buy stocks, but they might buy CMBS, and the person who sold CMBS, might reach down a buy a REIT, which in turn causes someone to buy an index. The money is likely to trickle down into risky assets. That is the lesson we learned from QE2. On the other hand, we have a stock market that is 350 points higher than when QE2 started. When things seem “cheap” money will flow into risky assets, but if stocks aren’t cheap, maybe more will wind up sitting in cash this time around? If European banks really are shrinking their U.S. business and Fannie and Freddie are reducing their on balance sheet exposure, maybe QE3 is more replacement than new? The post QE2 rally was a surprise to many. We have now been conditioned to rally on the back of QE3, so is it possible no one is underestimating the impact now? Is it possible that while QE2 played a role in the stock market strength in late 2010, that there were also other factors at work that we overlook because it is simpler to say QE = good stocks, and not look at deeper causality?
So what I’m left with, is the gut decision that QE3 will be generally favorable for stocks, and will reduce the threat of a big downward move, but is largely priced in for the near term, and the next big moves in the market will come from China and Europe. Will China stimulate? Chinese assets have underperformed, so is that the next re-coupling? Europe has created a theoretical framework to help Spain and Italy, but it needs to get implemented. Actual implementation will cause another spike in risk assets, failure to implement would cause another round of global risk-off, dragging U.S. markets down in spite of QE. Economic data or company specific news that is weak, will be largely ignored, since it will be “pre QE” so I just don’t see how that can be a driver, particularly to the downside. The final answer is meh. I’ve now resorted to ugh and meh but that best describes how I’m settling out on this QE program.
On September 3rd the long bond was at 101.50. Today it is at 93.375. In “simpler” terms, TLT went from 127.32 to 118.30 during the same period. In terms of price action, that gives the Spanish and Italian markets a run for their money. Friday’s 3 point move in the long bond is a real story. Don’t forget this move happened and the Fed owns 33% of longer dated bonds and they weren’t selling. Trying to figure out what the move was and what it might mean may be the key to understanding the longer term ramifications of the QE announcement.
The evil cynical side of me wants to jump up and down and say that the treasury move is because Ben put the final nail in the coffin of the U.S. dollar being the reserve currency. Foreigners just watched our Fed chairman debase the dollar by launching an aggressive money printing campaign at a time when the economy doesn’t seem that bad and will not want to keep treasuries. Yeah, take that!
The calmer, more rational side wonders if this part of a natural rotation out of bonds and into stocks. That people have assessed the support the Fed is giving and have decided it is time to take on more risk. I can come up with the intellectual arguments, but here I have to say, the heart might have it right. There are reasons for foreigners to become concerned about our commitment to a strong dollar. Egan Jones downgraded the U.S. debt, but they really downgraded the currency. We will not lose reserve currency status and China isn’t about to dump all of its treasuries, but thinking about the “you earn it” commercial and respect, I think we did do some damage to our reputation with this move.
My gut is that this story deserves more attention. That we are seeing the first signs of unintended consequences of Fed policy. The Fed holds so much of our debt, that rates can’t move much, but that will just cause speculators to go after other targets. While some amount of the move was likely good asset rotation, and some was a function of stop losses, there is an element of, what is this guy willing to do and why do I want to be in the USD if I can help it. The repercussions could be big. Is it possible we see mortgages trade tighter than treasuries? Doubtful, but that would send an alarming signal to the world that our economy is manipulated. You wouldn’t be able to pretend that the Fed balance sheet isn’t the primary driver. As investors have moved into treasures, corporate bonds, and long dated munis at record pace, what happens to them? 4 of the top ten holdings of LQD are bonds with maturities of at least 25 years. Deep down, something is happening, and it isn’t good, and could possibly be very bad.
My first instinct was to call town and ask for a permit to build an oil storage facility on my yard! That we are going to see inflation skyrocket as the dollar tanks and the fed prints money. Yeah, get my own oil storage facility, that’s the trade. My heart isn’t rational.
So you look to gold and decide that might be a better option. Easier to store than oil, but the reality is all commodities should do well, so build out a diversified portfolio of commodities with energy and minerals as the core holdings. But again, without final demand, how much can these really appreciate in the near term? The people who think Ben’s plan will fail, are the ones most interested in buying gold because of the inflation. In some ways that doesn’t make sense. The logical side sees too much evidence that the trade has been hyped up too much and won’t work.
So in the end, avoid a big rush into commodities, there will be better opportunities. If Ben’s plan is correct, many of the commodity producing stocks seem to offer better value than the commodities themselves. Look to companies that are heavily involved in U.S. natural gas. In a world where countries are retreating from globalization, something that has long term strategic value, will likely get government support, and is within our borders might be a better way to play it. Commodities are important, but can’t shake the vibe that next move is for some weakness.
Going to zero! Dead! There will be no volatility as the Fed has crushed it! That is what my heart says.
My head largely agrees.
Deep down though, while we likely see reduced volatility, it is setting up for the “big one”. The move where there are no shorts left in the market. The move where something happens and we have all become so complacent about central bank support. So while my head and heart say volatility is going to zero, my gut tells me to nibble at it a little every day. Start looking for some downside protection while no one else is. It doesn’t have to be done in a rush and in the end will do better than commodities.
I’m cautious. Focus like a hawk on what is going on with treasuries and the dollar. If that is start of something bigger, we may be headed for something that doesn’t look at all like QE2. I’m not expecting any big sell-off in near term, but after a few days of reflection, think too much is priced in with U.S. stocks and that whether QE3 is a disappointment or not, the market reaction will be in the near term. Avoid the commodity craze, exist yield based investments, focus on spread based credit opportunities, and start adding some downside protection because if we get another wave, there won’t be many shorts and the Fed will have shown their tools don’t work.