Is QE2 Really Dead?
With Greece back in the headlines—and we’ve said quite enough on that subject--we thought we’d take the opportunity to talk a little about one of the other of the myriad concerns the US equity markets have been focused upon over the last two months—the coming end to QE2. Very few government actions have been so well telegraphed to the markets yet the equity, currency and bond markets have been roiling over the last two months as they fight to determine what, if anything, will be the exact effect of the end of the Federal Reserve’s program to support bond prices and keep interest rates and the dollar low with the purchase of US Treasuries.
QE2’s goal was to support asset prices through the purchase of $600 billion of US Government debt issues. The hope was that higher asset (equity, bond) prices would lead to the wealth effect among consumers and businesses alike, spurring spending and, eventually, production and hiring. Whether the program was a success or not remains to be seen. Of late we have received some fairly weak economic data from the US, including employment, which has called into doubt the efficacy of the program. Our thesis is that the effects of QE2 have a lag and that the full impact of higher asset prices and easy money has yet to kick in and be seen in US economic data. In the meantime, economic data, as it always is coming out of a recession, has been lumpy causing many to declare the program a failure. We choose to wait and see. In the meantime, while economists fret over the pending end to QE2 and the apparent lack of a successor, they ignore one very important artifact of the program from the outset—the Fed, now the largest owner of US Treasuries, is earning some decent interest rates on its purchases. In fact, the Fed’s balance sheet now stands at close to $2.9 trillion. With Fed Chairman Ben Bernanke declaring that it will be some time before the Federal Reserve begins to unload its considerable holdings in Treasuries, some pretty sizable interest payments will be hitting the Fed’s income statement. What will they do with all that money?
On June 22 the Fed concluded its monthly Open Market Committee meeting and Bernanke gave a rare press interview shortly thereafter. The takeaway for the markets, as we saw in equity price actions that day and the next, was that there would be no QE3, something many traders and economists alike were hoping for to continue to support asset prices. What was largely ignored, however, is that the Fed said on June 22 that it will continue to buy Treasuries with proceeds from the maturing debt it currently owns. Given the size of its balance sheet, that could mean purchases (reinvestment) of as much as $300 billion of government debt over the next 12 months without adding any additional money to the financial system. That means that the central bank will continue buying Treasuries to keep market rates down as the economy slows. And those purchases will continue to support demand at bond auctions while Obama and Republicans in Congress struggle to close the gap between federal spending and income by between $2 trillion and $4 trillion. So not only is the Fed maintaining its accommodative stance, it is, in effect, launching into an unofficial QE2.5—something the markets have yet to focus upon.
Of the Fed’s bond holdings, a total of $112.1 billion will mature in the next 12 months, 7 percent of the $1.59 trillion in Treasuries held in its system open market account. Just replacing those securities will require the Fed to buy an average of $9.4 billion of Treasuries a month through June 2012. The Fed also holds $914.4 billion of mortgage-backed debt and $118.4 billion of debentures, the debt of government sponsored enterprises Fannie Mae and Freddie Mac. Estimates are that $10 billion to $16 billion will mature each month, depending on the pace of prepayments. That is yet more liquidity that will be reinvested into the system if the Fed decides to keep its balance sheet size the same, as it has openly declared.
Helping the Fed with its low interest rate policy has been the flight to quality by investors in the face of European debt concerns. Treasury 10-year yields fell to the lowest since Dec. 1 last week, down from this year’s high of 3.77 percent on Feb. 9. On June 24, the two-year yield came within one basis point of the record low, set November 2010, reaching 0.32 percent. And so far there’s been no lack of demand for government securities even as US Treasury debt has grown to $9.26 trillion from $4.5 trillion at the start of the financial crisis in August 2007, and $5.75 trillion when Obama took office in January 2009.
Most economists don’t expect that the Fed will raise its zero to 0.25 percent interest target rate for overnight loans between banks until the first quarter of next year. At his June 22 conference, Bernanke declared that the inflationary pressures we saw earlier this year are abating, in his opinion, and yields on 10-year Treasury Inflation Protected Securities show bond traders project an average 2.2 percentage point inflation, up only modestly from the 1.5 percentage points the way back in August 2010, when Bernanke first indicated the central bank might resume debt purchases to fight deflation. That suggests the first interest rate hike may be well into next year—beyond Q1
Bottom line: the asset purchases the Fed must make, even if they occur on a smaller scale, over the next year still continues the strategy that the Fed was trying to accomplish in the first place. That means that even with the end of QE2, the liquidity flow and its fundamental impact will remain intact for some time to come. So even though the market is going through a correction in anticipation of QE2’s demise, we may very well see the resumption of the liquidity driven rally.
Monday, June 27, 2011
Monday, June 20, 2011
Ramblings of a Portfolio Manager
If Everyone is so Bearish, Who is Left to Sell?
The Dow managed to avoid 7 straight weeks of declines on Friday but just by the skin of its teeth. Rising 30bps, about the amount it needed to stay in the positive for the week, most of the “rally” came on hopes of a weekend bailout package for Greece—something similar to a European version of the Lehman weekend we all experienced back in October of 2008. Unfortunately, investors didn’t get their wish and the futures look ugly this morning.
Most readers know we aren’t big proponents of technical analysis and even less convinced Greece is meaningful but in a time where investors throw out fundamentals based on macro fears, we do concede that technicals have a role, if only for the reason that people do look at them. So we decided to take our own look at some of the more popular indicators to get an updated idea of sentiment and where it might be pointing in terms of where the markets might be heading over the next few months, regardless of what the fundamentals may be.
Ok, this is a lot of data and its’ not clear to the casual observer what to make of it. We have two takeaways. First, the trend is consistently down—i.e. negative. So anyone who tells you there is too much bullishness in this market is probably full of it himself. Secondly, the most reliable indicator we have back tested, the CBOE Equity Put/Call ratio, is getting close to its high from October of 2008 (extremely bearish), when the world was thought to be falling apart, and coincidentally, right now sits just atop of where it was on March 2009, the market’s bottom.
Reading this data, our sense is that we are getting close to a bottom on investor sentiment. Since 2008 we have had over 10 5% pullbacks, a record and one which is based on still fresh memories of 2008. Now, bottoming sentiment doesn’t necessarily mean that stocks will rebound but it’s a good clue that they probably will stop going down. Then, given the huge short interest ratio, if we are correct in our assumption that economic data will come in higher than expected in the third and fourth quarter and pairing it with the bottoms up fundamental data we keep hearing from our companies (beating estimates, raising forecasts) and valuations, we may have a recipe for a decent rally in stocks by year end.
We hope everyone had a great Father’s Day
The Dow managed to avoid 7 straight weeks of declines on Friday but just by the skin of its teeth. Rising 30bps, about the amount it needed to stay in the positive for the week, most of the “rally” came on hopes of a weekend bailout package for Greece—something similar to a European version of the Lehman weekend we all experienced back in October of 2008. Unfortunately, investors didn’t get their wish and the futures look ugly this morning.
Most readers know we aren’t big proponents of technical analysis and even less convinced Greece is meaningful but in a time where investors throw out fundamentals based on macro fears, we do concede that technicals have a role, if only for the reason that people do look at them. So we decided to take our own look at some of the more popular indicators to get an updated idea of sentiment and where it might be pointing in terms of where the markets might be heading over the next few months, regardless of what the fundamentals may be.
Ok, this is a lot of data and its’ not clear to the casual observer what to make of it. We have two takeaways. First, the trend is consistently down—i.e. negative. So anyone who tells you there is too much bullishness in this market is probably full of it himself. Secondly, the most reliable indicator we have back tested, the CBOE Equity Put/Call ratio, is getting close to its high from October of 2008 (extremely bearish), when the world was thought to be falling apart, and coincidentally, right now sits just atop of where it was on March 2009, the market’s bottom.
Reading this data, our sense is that we are getting close to a bottom on investor sentiment. Since 2008 we have had over 10 5% pullbacks, a record and one which is based on still fresh memories of 2008. Now, bottoming sentiment doesn’t necessarily mean that stocks will rebound but it’s a good clue that they probably will stop going down. Then, given the huge short interest ratio, if we are correct in our assumption that economic data will come in higher than expected in the third and fourth quarter and pairing it with the bottoms up fundamental data we keep hearing from our companies (beating estimates, raising forecasts) and valuations, we may have a recipe for a decent rally in stocks by year end.
We hope everyone had a great Father’s Day
Monday, June 6, 2011
Ramblings of a Portfolio Manager
Double Dip Talk Again?
How fickle the equity markets can be. One to two data points and the markets can change their tone on a dime. Case in point—not so long ago as mid-April many economists were talking hyper inflation, large interest rate hikes and a soaring dollar. Several weak data points later, including Friday’s miserable jobs report, and Treasury yields are back at nearly an all time low, the Euro is closing back in on $1.49 and those same pundits are now exploring a double dip recessionary scenario. The equity markets, of course, have followed in sync. With little political will for a QE3 so far, one must ask did we hit a soft patch or is the economy in Q1 or is the economy just in the process of transforming itself from stimulus-based growth to a self-sustaining engine? Just a reminder: economies NEVER move in a straight line.
A few encouraging points were missed last week. The Non-Manufacturing ISM, released on Friday as well, is still in expansion mode. Over the last 12 months the ISM non-manufacturing index has averaged 55.4 and May came in at 54.6 suggesting that this sector of the economy is still on track for an expansion. Continued gains here suggest continued gains in core retail sales and therefore consumer spending and the economy. That would mean no double-dip although it hardly suggests an accelerating economy. A few takeaways from the Non-Manufacturing ISM: Overall business activity rose in 14 industries, including real estate (interesting), construction, finance & insurance, healthcare and information. That these gains are so broad is reassuring as is the overall size of the gains. Orders were up in May with gains in 15 Industries and new orders came in at 56.8 in May compared to 52.7 in April. Among the 15 industries signaling growth were professional services, transportation, finance & insurance, healthcare and information. Since the current recover began, these sectors have exhibited job gains and an expansion in their sales. The current outlook of the US. Economy is for continued growth in these service sectors as the share of total consumer spending on services continues to grow over time. Another take away is that export orders grew in sectors such as art, entertainment & recreation, professional services, accommodation and
food services—all sectors where a strong, historical orientation to consumer service provides American suppliers with a comparative advantage.
Another oft talked about but seemingly ignored fact is prices paid, a measure of costs to the consumer. The ISM showed that prices paid increased in May again, but the index dropped to 69.6 from 70.1 in April. Seventeen industries reported an increase in prices paid, including real estate (a positive sign), accommodation & food (certainly no surprise), healthcare and professional services. Now, this may be a double-edged sword as rising prices paid suggest that many firms are getting squeezed at the bottom line in the short term and many retailers proved that it is likely that companies are having difficulty passing on input costs to their final customers given the problems faced by many consumers. However, though many commodities are up in price for non-manufacturing companies including airfares, copper, cotton, diesel fuel, gasoline and many oil derivative products these prices are expected to come down, particularly if our Chinese and Indian trading partners are successful in engineering soft landings in their respective economies (some economists are coming around to the view that these two countries are nearing the end of their tightening.. The market’s obvious fear, in the short term, is that these rising prices will crimp margins and thus earnings. However, we just came through earnings seasons for most industrial companies affected by rising input costs (retailers are still reporting) and few, if any industries, complained about their inability to pass on higher prices. True, retailers had difficulties but with a record cotton crop going into the ground the spring, that issue may also be alleviated in the fall. Gasoline is falling, which also benefits the consumer.
Of course, the Non Manufacturing ISM is but one data point but are not the markets reacting to every headline these days. Also overlooked is the fact that Greece finally, actually, really may have a resolution to their issues. That would put further downward pressure on the dollar, benefiting our exporters. Now, no country every devalued its way to prosperity, however, in the short-term, a continued weak dollar should help our exporters, bolster commodity prices and support the US markets. None of this suggests a double dip is on the horizon. And, while hope is never a good investment philosophy, there is little doubt that the Obama administration is running scared with the upcoming Presidential elections (anyone see him blame China and Europe for our woes last week? Incredible). So don’t discount some last ditch effort to create jobs (an effort that would have to begin soon to produce the desired effect by election time) as well as pressure for the Fed to keep all that liquidity in the markets for much longer than expected. So while QE3 remains off the table, liquidity will remain high and the recent sell-off on its demise seems quite overdone.
How fickle the equity markets can be. One to two data points and the markets can change their tone on a dime. Case in point—not so long ago as mid-April many economists were talking hyper inflation, large interest rate hikes and a soaring dollar. Several weak data points later, including Friday’s miserable jobs report, and Treasury yields are back at nearly an all time low, the Euro is closing back in on $1.49 and those same pundits are now exploring a double dip recessionary scenario. The equity markets, of course, have followed in sync. With little political will for a QE3 so far, one must ask did we hit a soft patch or is the economy in Q1 or is the economy just in the process of transforming itself from stimulus-based growth to a self-sustaining engine? Just a reminder: economies NEVER move in a straight line.
A few encouraging points were missed last week. The Non-Manufacturing ISM, released on Friday as well, is still in expansion mode. Over the last 12 months the ISM non-manufacturing index has averaged 55.4 and May came in at 54.6 suggesting that this sector of the economy is still on track for an expansion. Continued gains here suggest continued gains in core retail sales and therefore consumer spending and the economy. That would mean no double-dip although it hardly suggests an accelerating economy. A few takeaways from the Non-Manufacturing ISM: Overall business activity rose in 14 industries, including real estate (interesting), construction, finance & insurance, healthcare and information. That these gains are so broad is reassuring as is the overall size of the gains. Orders were up in May with gains in 15 Industries and new orders came in at 56.8 in May compared to 52.7 in April. Among the 15 industries signaling growth were professional services, transportation, finance & insurance, healthcare and information. Since the current recover began, these sectors have exhibited job gains and an expansion in their sales. The current outlook of the US. Economy is for continued growth in these service sectors as the share of total consumer spending on services continues to grow over time. Another take away is that export orders grew in sectors such as art, entertainment & recreation, professional services, accommodation and
food services—all sectors where a strong, historical orientation to consumer service provides American suppliers with a comparative advantage.
Another oft talked about but seemingly ignored fact is prices paid, a measure of costs to the consumer. The ISM showed that prices paid increased in May again, but the index dropped to 69.6 from 70.1 in April. Seventeen industries reported an increase in prices paid, including real estate (a positive sign), accommodation & food (certainly no surprise), healthcare and professional services. Now, this may be a double-edged sword as rising prices paid suggest that many firms are getting squeezed at the bottom line in the short term and many retailers proved that it is likely that companies are having difficulty passing on input costs to their final customers given the problems faced by many consumers. However, though many commodities are up in price for non-manufacturing companies including airfares, copper, cotton, diesel fuel, gasoline and many oil derivative products these prices are expected to come down, particularly if our Chinese and Indian trading partners are successful in engineering soft landings in their respective economies (some economists are coming around to the view that these two countries are nearing the end of their tightening.. The market’s obvious fear, in the short term, is that these rising prices will crimp margins and thus earnings. However, we just came through earnings seasons for most industrial companies affected by rising input costs (retailers are still reporting) and few, if any industries, complained about their inability to pass on higher prices. True, retailers had difficulties but with a record cotton crop going into the ground the spring, that issue may also be alleviated in the fall. Gasoline is falling, which also benefits the consumer.
Of course, the Non Manufacturing ISM is but one data point but are not the markets reacting to every headline these days. Also overlooked is the fact that Greece finally, actually, really may have a resolution to their issues. That would put further downward pressure on the dollar, benefiting our exporters. Now, no country every devalued its way to prosperity, however, in the short-term, a continued weak dollar should help our exporters, bolster commodity prices and support the US markets. None of this suggests a double dip is on the horizon. And, while hope is never a good investment philosophy, there is little doubt that the Obama administration is running scared with the upcoming Presidential elections (anyone see him blame China and Europe for our woes last week? Incredible). So don’t discount some last ditch effort to create jobs (an effort that would have to begin soon to produce the desired effect by election time) as well as pressure for the Fed to keep all that liquidity in the markets for much longer than expected. So while QE3 remains off the table, liquidity will remain high and the recent sell-off on its demise seems quite overdone.
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