Huey, Dewey, and QE
Guest post by Peter Tchir.
What do Donald Duck’s nephews have to do with QE? Nothing, but it is hard to find anything that rhymes with QE and doesn’t rely on quoting Hamlet.
But the biggest question facing every investor is
Can the market go down while the Fed is engaged in QE?
That is the question everyone is asking. The chart from Doug Short at Advisor Perspectives that I have seen in multiple places, is very good. It highlights what the market has done during QE1, QE2, and Operation Twist.
On a first glance, the obvious conclusion is that QE makes markets go higher, but I’m not so sure that is the entire story.
QE1 was launched in late 2008. Stock briefly popped around the time it was launched, but then resumed a sell-off and didn’t bottom for another 3 months. So we hit new lows during a period of QE. So it is possible to sell-off during QE, and QE was not the only program in place. The Fed, the Treasury, the FDIC, and the Government were all implementing programs designed to help the markets. There is no realistic way to say which program was most important.
I could argue that when Citadel held an open conference call for Ken Griffin to explain the basis trade they had on, that it marked the bottom of the corporate bond market. That from that point on, the basis market (the spread you could earn by owning corporate bonds and buying CDS against it) improved. That argument is less convincing than QE, but for that entire period, we had so many unprecedented events, that attributing the entire, or even majority of the stock market rally to QE, seems incorrect.
As a bear, you can take away the fact that in spite of QE1, the markets resumed their decline and actually hit a new bottom. Even while QE1 was in place, we never regained the pre-Lehman highs.
QE2, in many ways seems more powerful. From the moment of the Jackson Hole Speech, where it was unofficially launched, all the way through the final QE bond purchase, the stock market seemed to rise relentlessly. I remember reading on www.zerohedge.com that the stock market went up almost every day the NY Fed ran its POMO (Open Market Operations) to buy treasuries.
In late 2010 there was less going on domestically. There was nowhere near the same level of policy co-ordination as there had been during 2009, but to say there was nothing going on would be wrong as well. The Republicans had done very well in the elections. Many investors took that as a positive sign – remember the hope just 2 years ago that a message had been sent to Washington? How naïve we were. The government also extended the Bush tax cuts. That was viewed as a positive. Those are just two big domestic events that come off the top of my head, that both helped the market.
Employment data also improved following QE. The Fed would have you believe that QE2 led to the rise in employment, which led to the rise in stocks. Maybe it did, or maybe we were just bouncing back from a severe recession. Maybe the recovery has been in fits and starts and the bounce in employment had nothing to do with QE? The cause/effect relationship between QE and the improved job numbers is tenuous at best.
I would be remiss in my duties if I don’t mention that in the first part of 2010 there was actually discussion about when the Fed would hike rates, and what the exit strategy would be for their existing positions. Yes, there was serious analysis done on rate hikes and exit strategies in the first part of 2010. Comical in hindsight that we talked about a smaller Fed given what has gone on since then.
Then we have to look at the global situation. While many focus somewhat myopically on the U.S., there was a lot going on in Europe. The “flash crash”, largely caused by “algos” gone crazy, occurred at the height of the initial Greek crisis. Yes, Greece had issued bonds in March 2010, and was on the brink of default by May. I still think the world was better prepared to let Greece default then, than we are now, but Europe started the “bailout” mentality. By September, to coincide with QE2, the EFSF was formally launched. So Europe had created a €500 billion rescue fund. In reality it wasn’t that big, was poorly thought out, but nonetheless, it was launched with much fanfare, at least in Europe. I believe at the time that the ECB, under Trichet, embarked on the SMP program, buying Greek debt. In the end, the European plans failed miserably, but at the time, they added to the spark. They were new and investors wanted to believe.
So with QE2, it is hard to think of anything other than the daily march higher in stocks, and the case that QE2 was directly responsible is stronger than for QE1, but there were many other factors also influencing stocks, so giving full credit to QE2 is wrong. Also, pushing stocks up from 1,100 seems like an easier task than pushing them up from 1,450.
The operation twist period also shows stocks doing well, but the moves correlate much better with Europe than anything we were doing. The bounce from the November 2011 summit to end all summits (at least that’s how it was billed at the time), followed by LTRO1, Fiscal Compact, LTRO2 explains the run up as well as anything OT may have done. Then the Greek default, bad election results, and growing concern about Spain and Italy, followed by the “whatever it takes” speech, explains the moves more than anything else.
Failed Liquidity Attempts
During 2007, the Fed attempted to address the lack of “liquidity” in the mortgage market. They assumed the ever declining value of mortgage bonds (and corporate bonds eventually) were a function of no liquidity. But no matter how much liquidity they pumped in, the decline resumed, because the shortage of buyers had nothing to do with a short of available cash. It had everything to do with these being bad assets. Yes, the markets remained addicted to Fed intervention, and even hit a new high in October 2007, only to realize the Fed hadn’t stopped anything. Then we had the Bear Stearns is fixed rally, yet another time the market put too much faith in the ability of the Fed to support intervention.
The SMP program, and even, to a lesser extent, the LTRO programs have showed that liquidity and central bank buying doesn’t always work. The efforts helped, sometimes for months, sometimes for days, but those markets the ECB intervened in would eventually resume their declines, because investors weren’t buying because they had no money, they weren’t buying because they didn’t like the risk.
At some point, investors make decisions based on their evaluation of risk/reward. Liquidity can alter that perception at times, and with momentum traders piggybacking the central bank trades, it can seem even more effective, but time and again, we have seen liquidity fail to prop up markets when the real concern is about risk.
At the time of QE1 virtually every conversation I had with people was “wow, things seem so cheap, but there is nothing to stop them from getting cheaper”. There was dislocation after dislocation. Leveraged loans were often trading at similar yields to the unsecured bonds of the same company. But no one wanted to “step in front of that train” because there were so many stories of leveraged leverage loan bets unwinding. And bonds looked so cheap to CDS because everyone was worried there would be no money to buy bonds. They didn’t want to own bonds because of possible redemptions. And CDS, why own CDS if the banks won’t be there to pay you. A lot of people were pounding the table claiming assets were cheap, but were waiting for someone else to step in. Here the QE program was helpful. It was a liquidity problem, at least in part, so QE helped.
Right now, I don’t hear many “it’s so cheap” conversations. I hear a lot of, “well, what else can I do” or “how else do I get returns” sort of conversations. Investors are already in many cases, invested up to their eyeballs in assets they don’t even like at these levels, so how much more are they really likely to buy?
So maybe the question shouldn’t be “can a market go down while QE is in place?” but the questions should be “how much more will people invest in assets they already grudgingly own and struggle to see the value in?”
I’m not going full bear, but I am a little more comfortable with my bearish stance having seen that while QE has helped markets, the conclusion that QE makes markets go up is a long way from being obvious.