Published by WallStreetWeather.net
Stocks and commodities have risen while the dollar and bond yields have fallen since the September 21 FOMC meeting. The expectation is that the Federal Reserve will embark on a second round of quantitative easing (“QE2”) at its next meeting on November 3. Markets got a further dose of encouragement Tuesday after the Bank of Japan announced that as part of its easing strategy it might begin purchasing corporate bonds, REITs and ETFs. Could Fed Chairman Ben Bernanke be turning Japanese?
Are financial markets digesting all the evidence to reach this conclusion or are they just hearing what they want to hear? Despite all the rhetoric propounded by Bernanke and FRB presidents Dudley, Evans, Bullard and even Fed bureaucrat Brian Sack who heads the New York Fed’s open market operations, if investors carefully weighed all the information they might begin to realize why an additional round of QE2 might not occur. For every statement the Fed has made promoting the benefits of QE2, they have counterbalanced it with cautionary statements about the diminishing effects and costs of initiating a new program.
This is why it is my belief that all the rhetoric about deficient inflation and employment that cites the Fed’s dual mandate is simply to appease the doves on the FOMC, and to use the Fed’s bully pulpit to generate excitement for an inflationary/pro growth environment. Despite their rhetoric to the contrary, if the economy went into a double dip recession a substantial premature QE2 would truly leave the Fed with no more arrows to shoot.
Inflation requires an expansion of credit, and the money the Fed has pumped into QE is being sterilized through excess reserves held at the Fed. As the economy continues to de-lever, excess liquidity is also starting to form bubbles in unproductive asset classes such as gold. Companies are spending their excess cash on stock buybacks and M&A which reduces employment.
While the Fed can break inflation by tightening credit, it cannot expand credit if not enough people qualify, or there is a lack of demand for credit. Consumers and corporations who qualify to receive the lowest rate are more likely to be conservative in their expenditures, further retarding the economic effect of QE2.
The Fed is not concerned with inflation as an economic driver, but rather the ravages of the deflationary debt spiral. In a deflationary environment, falling prices and stagnant to falling wages means it’s more onerous to repay debt since the amount owed is constant while the dollars per hour worked declines. Therefore it will take more working hours to repay older debt in a deflationary environment. In an inflationary environment, rising wages means the borrower does not have to work as many hours to repay the debt. The Fed’s hope is that rising inflation will spur consumers and businesses to spend more on the expectation of getting less value for their dollars in the future.
But the problem as former Fed Chairman Paul Volcker has stated, is that just as a woman can’t be a little bit pregnant, the Fed cannot create a little bit of inflation without running the risk of inflation becoming out of control. Since Chairman Bernanke is already an expert on the Great Depression, a more appropriate study would be the stagflation of the 1970s that Volcker broke.
While the Fed’s rhetoric has been initially successful in driving up the price of debt, gold and other commodities, its overly accommodative monetary policy has had little success in recreating the “wealth effect” and the spending that accompanies it. By the Fed’s own admission it estimates that its $1.7 trillion in mortgage and Treasury bond purchases that ended in March only reduced long term interest rates between 0.3% and 1%. According to calculations made by the New York Fed and MF Global, the Fed would need to purchase an additional $2 trillion in Treasuries in order to push down yields on the 10 year note by just one percentage point.
It is estimated that the current size of the Fed’s balance sheet is the equivalent of 16% of GDP. Since over $1 trillion in excess reserves are already sitting at the Fed, how do they expect to get results from QE2 before the current excess reserves are moved out of the Fed and work their way through the economy? As Minneapolis FRB president Narayana Kocherlakota noted: “I do not see why they (banks) would suddenly start to use the new ones if they weren’t using the old ones.”
Philadelphia FRB president Charles Plosser commented that “It is difficult, in my view, to see how additional asset purchases by the Fed, even if they move interest rates on long term bonds down by 10 or 20 basis points, will have much impact on the near-term outlook for employment.”(1) And the effect of QE2 on lowering mortgage rates will have little economic effect at this point as those who qualify for refinancing have already done so, as have corporations that are stockpiling cash.
I previously wrote that additional policy accommodation would clog up the plumbing that interconnects the elements of the financial system together. While Fed policy has benefited investment banks such as Goldman Sachs (GS) and to a lesser degree Citibank (C) and JPMorgan Chase (JPM) as they have been able to issue debt at low interest rates, it raises the risk for other banks as they don’t need to borrow since they have more deposits than they can lend out.
Banks cannot lend long when they risk an increased cost of funding in the future. They cannot pay less than 0% for deposits, and the interest revenue from loans keeps going down which squeezes their interest rate margins (IRMs). Meanwhile bank regulators (which includes the Fed) are telling banks to watch the maturities because of the interest rate risk which further constrains banks from lending long. Banks are only willing to issue 30 year fixed rate mortgages if they are guaranteed by the federal government through Fannie Mae (FNM) and Freddie Mac (FRE) and can be sold.
Credit Suisse analyst Craig Siegenthaler estimates that Fed policy could cause IRMs at regional banks to decline from an average of about 3.54% in Q3 to around 3.44% in Q32011 vs. margins well above 4% before the financial crisis. (2) It is not outside of the realm of possibility that Fed policy could severely impair many of the large regional banks as well as put many smaller banks out of business.
Northern Trust (NTRS) said in its earnings call that near zero interest rates reduced 2Q earnings by about $70 million. According to Sanford Bernstein analyst Brad Hintz, asset trust banks such as Northern Trust and State Street (STT), firms with large asset management operations such as Bank of America (BAC) and Morgan Stanley (MS), together with brokers such as Ameritrade (AMTD) and Charles Schwab (SCHW) face lower returns on sweep accounts and money market funds that are not earning enough interest to cover their management fees. (2)
If the Fed emulated the Bank of Japan, it would have to buy futures contracts or broad-based ETFs based upon the S&P500 (SPY) and the Russell 1000 (IWB) which would make any money manager except for those firms managing the ETFs such as BlackRock (BLK) and State Street (STT) irrelevant. Investment bankers are becoming worried that nearly zero rates for an “extended period” could impact the financial services industry worse than FINREG.
Fed policy is also wreaking havoc with insurance companies, especially life insurers which have to match investment duration with expected payouts. Guaranteed income products such as annuities might not be feasible given customer reluctance to accept such low returns. Analysts at Keefe, Bruyette & Woods estimate U.S. life insurers’ earnings could be reduced by 2% in 2011 and double that in 2012 if yields do not rise. (2) Met Life (MET) announced last week that 2011 earnings could be reduced by $0.20 per share if the interest rate on the 10 year Treasury note remains at 2.50% through 2011.
Consistent with the insurance industry, public and private pension plans also have to match duration and income with expected payouts. Plans are allowed to estimate their return and calculate the discounted upfront payments to meet their obligations. The estimates commonly stated range from 6-8%, showing no reality to a prudent investment return which would be more likely closer to 3-5%. If pension plans would be forced to fund based upon the current rate of returns, government entities and corporations would have severely increased obligations that many would be unlikely to meet. This unmasks the likely bankrupt status of many pension plans. The longer interest rates remain this low, the more risk plans will have to take to avoid current funding obligations. An honest accounting for pension plans would place a severe drag on the economy, potentially offsetting the benefits of extraordinarily low interest rates.
The Fed has created what I call the reverse Robin Hood effect: consumers with the worst credit are subsidizing those with the best credit who can get money cheaply and they are paying an extremely high interest rate on their credit cards. Most consumers with top credit scores who qualify for extremely low rate loans have already done so. Many of these consumers are suffering from low interest income, especially retirees. A drastic cutback in interest income is pushing retirees to take more risk which is dangerous since time is not on their side to recover from investment losses. Low interest income has also greatly curtailed many retirees discretionary spending.
The Fed’s ultra accommodative policy and the prospect of more to come has fueled commodity speculation. The Fed’s continuous debasing of the dollar is not only wreaking havoc on our trading partners, but is also causing countries such as Brazil to institute capital controls.
Is Chairman Bernanke trying to convince the public that uncertainty has increased since the fall of Lehman Brothers in 2008? Are we to believe that circumstances now are even more “unusually uncertain” than during the height of the financial crisis? The answer is obviously no. And that is why the current Fed rhetoric is simply appeasement to the doves on the FOMC. Remember when the New York Fed said they would grant Bear Stearns a reprieve for “up to 28 days?” Most people mistakenly thought the Fed was giving Bear Stearns a 28 day lifeline, until then NY FRB president Timothy Geithner reminded everyone that “up to” did not mean 28 days.
Talk therapy is a whole lot cheaper than another $500 billion+ round of quantitative easing. The Fed appears to be stalling for time, hoping that economic conditions will have strengthened enough before the market realizes they’re bluffing.
(1) “Speeches show divisions at Fed on bond buys” by Steve Goldstein (MarketWatch)
(2) “Banks and Insurers Face the Killing Yields” by David Reilly (Wall Street Journal)