20 June 2013

The Fed has pencilled in a shift of QE policy - but can the markets bear it?

With the world watching, the FOMC did its best to say very little despite talking extensively.

Not so long ago, central bank policy meetings and announcements were about interest rates and their likely future evolution. In the brave new post-GFC world, the Fed has more or less forgotten about the interest rates they set and instead worry about keeping a lid on government bond yields that threaten to derail the US recovery. This was the Fed’s admitted goal back when quantitative easing measures were first announced back in 2008/9 – to keep long-term yields low especially those connected to mortgages.

Most G20 central banks have already reduced rates to record-low levels leaving only unconventional policy measures remaining. The Fed has been an avid user of such measures as a last resort to maintain the status-quo and prevent widespread defaults and bankruptcies.

With the whole of the investment and trading community on alert and focusing on the Fed this week, there was a clear danger of market instability should Ben Bernanke's comments be misunderstood or misinterpreted. Speculation about the size, timing and scope of tapering in addition to ambiguity as to what the Fed counts as a ‘sufficient recovery' to warrant an end to QE has been growing steadily since Bernanke hinted at a shift of Fed policy earlier this year. With so much uncertainty and speculation abound, Ben Bernanke had a tightrope to walk in front of a lot of spectators.

A sudden halt to monthly $85bn asset purchases would be a shock to the market now addicted to Fed easing and broad scale US government support. On the other hand, extension of asset purchases (or even just their continuation for a prolonged period of time) may also create problems in the form higher inflation expectations, progressive currency debasement and incentivising speculative leveraging eventually aiding the formation of asset bubbles.

With so much at stake, the FOMC did its best to say very little despite being asked to talk extensively.
In summary:
  • The Fed maintained its $85bn per month pace of purchasing Treasuries and Mortgage Backed Securities (MBS)
  • Kept rates at 0%-0.25% conditional on unemployment remaining above 6.5% and 1-2 year projected inflation remaining below 2.5%
  • 15 of 19 policy makers expected no increase in the federal funds rate before 2015. In March, 14 policy makers had that expectation

Official Statement

Two noteworthy comments from the official statement
"Downside risks to the labour market and economy have diminished since the fall" 
- this could be a telegraphed hint so further Fed member comments will be influential over the coming weeks prior to the next scheduled FOMC meeting on July 31st 2013.

"Inflation is running below the FOMC’s longer-run objective partly due to 'transitory influences"
- the reference to below-target inflation could be an indication that the Fed sees deflation as more of a threat to the US economy than inflation. Consequently, if US inflation does rise up to and beyond the 2% target, it would act as confirmation that a Japanese-style deflationary scenario has been avoided and pave the way for QE to be scaled back

The FOMC meeting had two dissenters - James Bullard, who said that the FOMC should "defend its inflation goal in light of recent low inflation readings" (dovish bias) and Esther George who maintained her hawkish bias and dissented for the fourth consecutive meeting, continuing to cite concern that keeping interest rates near zero risks creating "economic and financial imbalances" including asset price bubbles.


In his press conference, Bernanke stated:
"It may be appropriate to moderate the pace of purchases later this year assuming that the incoming data remains consistent with Fed forecasts"
"If the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year"

Bernanke also reinforced that the FOMC expects a “considerable period of time” between the end of asset purchases and the beginning of rate hikes. The forecasts set out by the Fed imply that the QE programme could come to an end by the middle of 2014. We see this as unlikely, and at this stage, highly optimistic.

The Fed’s June summary of economic projections for 2013 shows a decrease in GDP, inflation and unemployment outlook from previous its estimate in March.

Table showing June summary of FOMC economic projections
March estimateJune estimateChange
Unemployment Rate7.3%-7.5%7.2%-7.3%Lower
PCE Inflation1.3%-1.7%0.8%-1.2%
Core PCE Inflation1.5%-1.6%1.2%-1.3%

Market Response

The market’s response to the FOMC statement and subsequent press-conference was huge. We expected this because highly anticipated macro-data events have a tendency of inducing investor overreaction and market overshoots as a result of knee-jerk, speculative trading decisions.

  • The USD rallied significantly against all other G20 currencies with largest gains coming against AUD, NZD and CAD
  • Gold prices corrected lower by over $35 per ounce from $1,375 before the FOMC announcement to trade $1,340 post FOMC
  • US equity markets were sharply lower as the Dow Jones and S&P fell by over 160 points.
  • US Treasuries fell sharply, helping long-term 10yr yields to rise by over 10bp, breaking above 2010 lows (2.33%)
Source: Reuters & Zero Hedge

Conclusions and Outlook

The Fed has not begun to taper asset purchases but has only said that it plans to later this year or next year subject to macroeconomic factors making it possible to do so. Even when the Fed does decide to slow purchases, it will probably do so gradually and periodically meaning that asset purchases will continue for a considerable time but at diminishing levels e.g. $60bn per month for several months, then $40bn per month for several months and so on. When monthly purchases hit zero, the Fed will still have the unenvious task of removing the additional liquidity it has created (after a "considerable pause") – this is where a scaling down of QE only begins. By this point the Fed is likely to have a balance sheet in excess of $4 Trillion. At this stage, if long-term bond yields are elevated and rising, the US will have a huge funding problem that even the Fed may not be able to quantitatively fix.

All this leaves one, so far undiscussed, possibility – given the mammoth levels of debt owed by the US government, the US private sector, the Fed’s ballooning balance sheet and the complexities of modern day financial markets - the US economy may end up having ultra-low interest rates for decades while the Fed continues with asset purchases indefinitely. Interest rate policy meetings could become regular meetings to decide asset purchases and their scope/direction only; with future interest rate expectations permanently set to 0%-25% as financial markets enter a new paradigm of central bank reliance, cheap liquidity and market planning. State capitalism indeed.

The ‘too-big-to-fail’ mentality that was used to justify the bailouts of the largest (yet most indebted) coroporations can only flourish considering that we're seeing rising inequality and oligopolisation/monopolisation in most industries. In almost every sector, whether it is primary, secondary or tertiary, market share/power is consolidating into fewer hands and making all those 'too-big-to-fail' companies even bigger and failure immune. Policymakers were afraid to allow large banks/car manufacturers/insurance companies fail back in 2008 because of the possible knock-on effect it would have on the global financial system. Now those same companies are bigger, slightly less indebted due to government support but still likely to fail without further help.

Even in the best case scenario of Fed estimates actually being met and the US recovery accelerating, the Fed gradually reducing asset purchases through 2014, pausing, and then starting to offload assets from its balance sheet - we are unlikely to see higher US interest rates until at least 2016. The Fed is much more confident and optimistic about its outlook than most market participants, so it’s quite possible that the Fed undershoots its forecasts, delays tapering and is forced to postpone the rate hiking cycle further back to 2017/18.

As Ben Bernanke says:
"If you draw the conclusion that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion, because our purchases are tied to what happens in the economy. If the economy does not improve along the lines that we expect, we will provide additional support."

Additional support is on the table and will probably be required so expectations of Fed tapering should be seen for what they are – short-term and illusory. The reality is that dovish Fed policy will continue, intensifying proportionately depending on the nature of the macroeconomic shock that strikes the US next. We are in uncharted waters and the Fed is confident that it can navigate the US towards recovery - the only problems are convincing everyone that they have the ability to do so and hitting optimistic recovery targets that are largely outside of its control.

Commissioned by Think Forex