Ramblings of a Portfolio Manager

The QE2 is Setting Sail to New York. So Why Were All The Passengers Wearing Sombreros and Blowing Didgeridoos?

Ben Bernanke gave his much anticipated speech regarding the Fed’s propensity to reinitiate Quantitative Easing at an FOMC-sponsored Conference in Boston last Friday. The speech was intended to give insight into the probabilities of the FOMC announcing a resumption of Quantitative Easing (dubbed QE2) at its November meeting. In his remarks, Bernanke said inflation is currently too low and the unemployment rate is too high given the central bank’s dual mandate of maximum economic growth and price stability: He made a case for new Fed action to boost growth, saying inflation is running below the Fed's objective of 2% and that the economy is growing too slowly to reduce unemployment. But he also cautioned that there were costs associated with the policy as well as benefits and the Fed had much less experience in judging the economic effects of asset purchases, “which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public.” He went on to say that “These factors have dictated that the FOMC proceed with some caution in deciding whether to engage in further purchases of longer-term securities.” “Even though the conditions are in place for growth to pick up next year,” he said, “high unemployment and low inflation will probably linger.” “Given the FOMC’s objectives, there would appear -- all else being equal -- to be a case for further action.” Sometimes, around here, we miss the cryptic ramblings of Alan Greenspan. At least, under all that enigmatic Fed Speak, there was a definitive answer to the Fed’s next course of action. One just needed his Captain America decoder ring and a Cray XT-3 with language processing software and all was clear.

There was much economic data released on the day Bernanke spoke but the markets reacted almost solely to the Chairman’s words and the speech was greeted with little more than a yawn by the equity markets. Initially it gave a mild boost to equities and took some of the steam out of Gold. But Bernanke said very little that the markets were not already anticipating--since the Chairman outlined the potential second round of quantitative easing during an Aug. 27 speech in Jackson Hole, global equities have climbed 14.1% and commodities have gained 13.1%--and by the end of the day most equity markets were down and Gold had recovered some of its losses. The dollar, however, turned higher against the Euro and a basket of major currencies, but was still down broadly for the week. The interesting price action came in the 30-year Treasury bond where the bonds slumped, driving the yield up 18 basis points to just under 4.0% for the week. That’s a big jump in long rates from their September lows in the 3.5% range. Why the seemingly perverse reaction to an announcement by the Chairman of the FOMC that the Federal Reserve would begin a program of attempting to hold down long-term rates for a very long time?

We have been tracking street expectations for QE2 since the initial announcement in August. Since the markets began to digest that the Federal Reserve was serious in its plans, expectations for the timing and size of the operation have continually grown. By our analysis, there is now little market doubt that the FOMC will launch QE2 at the November meeting. Expectations range from $500 Billion to a $1 Trillion program, with some as high as $1.5 Trillion. Such a large disparity of viewpoints is a clear indication that the FOMC has done a poor job communicating its policies and managing market expectations. In fact, the way we see it, the FOMC has probably let expectations run too high and has created a situation where the current actions we have seen in financial markets are being driven almost entirely by QE2 expectations. The Fed, in essence, have painted themselves into a corner whereby there will be a negative reaction in equities, currencies and bonds if the markets’ expectations are not met.

So what will be the size of QE2 and will it work? Bernanke called the first purchases of $1.7 trillion in mostly housing-related assets successful. There are a range of opinions on the FOMC about the method of further asset purchases, and the details will be hashed out at the FOMC’s next meeting on Nov. 2-3. The market’s focus, however, will be “how much?” From our work it would appear anything short of $1.0 Trillion in QE2 would disappoint both equity and currency watchers.

But the markets’ trepidations go beyond the final amount of the QE2. The big fear, for many experienced investors, is whether the Fed will have an adequate exit strategy and will they time it properly—i.e. will their program work too well and ignite hyperinflation before they can shut it down. That’s why bonds sold off and the dollar strengthened on Bernanke’s speech, in our opinion. The Chairman’s response was that he is confident the Fed will be able to tighten policy when warranted, even if the balance sheet is larger than normal but he also pointed out that the FOMC might consider modifying the language of its policy statement to indicate that it will keep rates “low for longer than markets expect.” At the moment, the FOMC statement is that the exceptionally low levels of the federal funds rate are likely to be warranted “for an extended period.” Remember, the target is to get inflation higher and Ben Bernanke, student of the depression, will not be the Fed Chairman who presides over a US economy in depression and with deflation if he can avoid it. So in addition to preventing deflation, we believe QE2 is intended to boost equity prices and thus, net worth and the economy in general. The question is, will the Fed cave into market expectations and target the $1.0 Trillion number?

We expect the Fed to hit the $1 Trillion number but for the perverse reaction to QE2 to continue. That is, we expect long-term rates to rise and the dollar strengthen even as the Fed begins its purchases. Why? First of all, as we noted, the markets have already priced in a significant size of QE2; long treasuries are almost certainly discounting the $1.0 Trillion number so probably don’t have much more to rise. Secondly, as the Fed injects more liquidity into the capital markets stocks will most likely rise, adding to the wealth effect. This, combined with potential strengthening confidence in the economy post mid-terms, will serve to steepen the yield curve by raising the long end, even the face of Fed purchases (its almost impossible to steepen the curve by dropping short-term rates, which are essentially zero). Finally, most missed it but Bernanke raised the Fed’s expectations for US economic growth next year. If our scenario and theirs is correct, it all points to risk in holding US fixed income securities and a rosy future for US equities. We don’t know much about them but if you’re looking to invest in fixed income, you might look toward the countries nearing the end of their tightening cycles—Brazil and Australia. Happy sailing!