Good Evening: After months of threats, the Fed finally pushed the monetization button. Federal Reserve Chairman Bernanke and the rest of the FOMC decided today to embark upon the one strategy central bankers have always considered the dreaded last option — Quantitative Easing. It’s one thing for the Fed to push the “Easy” button and lower rates or temporarily inject reserves into the banking system, but to push the “QE” button (creating currency out of thin air with which to purchase assets) is an action reserved for only the direst of circumstances. If such a device truly existed in the Board room of the Eccles building, it would be a red button under glass with a “Press Only in Case of Emergency” warning stenciled underneath. That market participants responded to this monetary jolt by buying stocks, bonds, and precious metals while thumping the dollar is not a surprise. How investors react over the longer term to these actions and the inevitable unintended consequences will be far less easy to predict.
Prior to the Fed’s announcement, most markets were fidgeting around not too far from unchanged. Stocks had digested this morning’s economic data (an uptick in both CPI and mortgage applications, plus a drop in the current account deficit) and managed to recover from early losses of 1% or more in the major averages. When the FOMC statement hit the wires (for the complete text, see below), the S&P 500 soared 3% and briefly topped resistance at the 800 level. For those keeping score at home, today’s high of 803 represents a gain of 20% over the 8 trading days since the low set on March 6. Feeling suddenly a bit winded, the major averages spent the final hour trying to consolidate the gains. By day’s end, the Dow’s 1.25% gain lagged behind, while the Russell 2000’s 3.5% advance led the pack.
The reaction to the Fed’s policy change in the other markets was much more volatile. Treasury notes and bonds saw furious short-covering and yields plunged by amounts not seen in 47 years (see below). Carry traders, mortgage duration hedgers, and liquidators of double short Treasury ETFs all jostled and elbowed each other to grab whatever Treasury coupons they could find. When the electronic dust inside the trading screens had settled, yields were down a staggering 22 bps (2 year) to 47 bps (10 year). In sympathy with Treasury yields, the dollar also precipitously fell. The prospect of hundreds of billions of newly minted dollars coursing through the global financial system caused currency traders to thrash the greenback by almost 3%. Gold, the currency no central bank can print, switched places with the buck in going from the outhouse to the penthouse. The yellow metal was down some 4% while the FOMC was meeting, but it closed with gains of nearly the same magnitude once it became clear the Fed was pushing the monetization button. The rest of the commodity complex was oddly out of step and went the other way. Despite the surge in metals both precious and base, the CRB index actually retreated by 1.2%.
Many months and a couple of thousand Dow points ago, I predicted that the credit crisis would eventually deepen to the point where the Fed would feel forced to step in and directly purchase a variety of assets instead of merely financing the assets held by others. I said a the time that “Helicopter Ben” Bernanke would live up to his nickname and live out the actions outlined during his famous 2002 speech about the options at the Fed’s disposal for fighting deflation once fed funds had already reached the zero barrier. Wall Street analysts had come to much the same conclusion prior to this week’s Fed gathering, but none (including this writer) foresaw the Bernanke Fed undertaking such broad and sweeping actions so soon. Most of us thought the FOMC would continue its recent pattern of gradual mission creep, incorrectly thinking that the Fed might announce some limited asset purchases (if any).
As Bank of America-Merrill Lynch economist, David Rosenberg, details below, however, today’s policy change is nothing short of Quantitative Easing (see below). The Fed is “now bringing out all the ammo in its arsenal”, according to Rosenberg. Treasury purchases ($300 billion), a huge expansion of MBS buying ($750 billion), a doubling of GSE debt purchases ($100 billion), and hints the TALF will buy distressed assets from banks will expand the Fed’s balance sheet by at least another 50%, says Mr. Rosenberg. He also points out that the Fed’s balance sheet will now grow to become 25% of GDP, an eye-popping level that should end all questions of whether or not we are like Japan during the decade just past. And, for those who think the time is ripe for upping their equity allocations, Mr. Rosenberg would like to remind them of what happened to buyers of the Nikkei 225 after Quantitative Easing was tried in Japan. Longs were treated to a 20% rally that lasted six weeks before stocks set new lows just four months later. Ultimately, predicts Rosenberg, QE helps bond buyers more than stock buyers.
Unlike Mr. Rosenberg and his prescription to unload stocks and buy Treasurys, I’m less certain about how all this will play out. With a low savings rate and high external debts, the U.S. of 2009 is very different from the savings rich Japan of the 1990’s. The key will be how the U.S. dollar reacts now that Mr. Bernanke has pushed the button. If the world’s creditors are willing to look the other way as the Fed buys every asset it can lay its hands upon, I can see how Mr. Bernanke’s latest policy moves could succeed in speeding up an eventual recovery for our economy. But since I doubt dollar holders will sit idly by as the paper they hold shrinks in value, I see a quick and happy resolution as being a low probability event. Then again, other central banks (the BOE & SNB) are engaging in the same currency-busting policies, so it’s not altogether clear whether the world’s fiat currency system can survive a war of attrition. I remain comfortable owning precious metals and shares of the companies that mine them because of this very uncertainty.
We’ve arrived at this unfortunate juncture in our nation’s financial history because of reckless behavior in both New York and Washington D.C. Interest rates were too often kept too low, lending standards were whittled away until they were non existent, and borrowing too much for one’s own good (both corporate and personal) reached the point where it carried no negative stigma. Our nation’s elected officials consistently spent far more than was collected in tax revenue and our nation’s regulators were so poor they wouldn’t have been able to cut it as mall cops.
We learned nothing from the foreshadowing events brought about by the reckless behavior on display at Long Term Capital, Enron, and WorldCom. Bill Fleckenstein neatly summed up the last 15 years in one his best-ever Raps back in January of this year. Anticipating today’s events, Bill wrote, “…initially, in the late 1990’s, we attempted to speculate our way to prosperity via the stock bubble. And then, when that didn’t work, we attempted to borrow our way to prosperity during the real estate bubble. Of course, those two ended the way they did, in an epic disaster, and now we’re trying to print our way to prosperity…” Well said, Bill. Let us all hope the U.S. experiment with pushing the button on Quantitative Easing is more successful for us than it was for the Japanese. But given all the behavior that brought us to this point, we will need to be both lucky and good from this point forward.
— Jack McHugh