Fed minutes suggest strongly that QE3 is coming in September

HSBC reports that its August flash PMI reading for Chinese manufacturing came in at 47.8, well below July’s 49.3 and the weakest reading for 9 months. The “official” PMI data is released on 1st September – July’s PMI came in marginally in expansion territory at 50.1. With much weaker exports and a soft (to say the least) economy, the Chinese will have no choice but to introduce a stimulus programme and ease monetary policy further, though I must admit they have been very cautious (slow) so far;

Chinese steel prices have collapsed to their lowest levels since 2009, though mills continue to churn out product. Chinese steel output rose by +1.1% in August to just under 2.0mn tonnes, according to the China Iron and Steel Association. Last month the association reported that steelmakers profits collapsed by 96%, yep that’s 96%, turning the industry into a “disaster zone”. Reuters reports that Chinese steel mills have either defaulted or deferred shipments of up to 4mn tonnes of Iron ore this month due to declining prices. (Source FT). I must say, I had thought that the Chinese authorities would ramp up their fiscal stimulus, including greater fixed asset spending – indeed, I still believe it. However, clearly unemployment needs to rise in the 1st instance. To date it has not. However, these companies cannot keep churning out product, suggesting that job losses are coming. A build up of inventories will take time to clear – does not sound good for the miners. BHP yesterday announced the cancellation of their Olympic dam project;

US CBO forecasts recession in 2013 if no deal on “fiscal cliff”. Not really new news, but just highlights the serious problem. Will the increasing lack of cooperation between the main US parties cause a serious problem. Some kind of deal is likely, but……;

The FED’s particularly dovish minutes suggests strongly that QE3 is coming in September. “Many members (sounds like a majority) judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery”. This is a particularly clear statement and the bar not to act has been set pretty high, which can only lead one to the conclusion that QE3 is effectively a done deal. Economic data to be released ahead of the FED decision in September is unlikely to indicate “a substantial and sustainable strengthening in the pace of the economic recovery”. The minutes suggested that the FED would be buying longer term debt, I suppose mainly MBS’s and possibly without predetermined limits – the minutes state that its members (many) suggested that any new programme should be “sufficiently flexible to allow adjustments”. Cutting the deposit rate paid to banks was considered, as was extending its forecast for keeping interest rates low.

Outlook

I must admit that I did not think that the FED would introduce QE3 in September, but the minutes released yesterday suggest (particularly strongly) otherwise. Amazingly, US equity markets, whilst recouping their losses, did not rise materially – cannot understand – personally the minutes could not be clearer in my view. The FED will introduce QE3 in September and, indeed, there was some suggestion that it could be an open ended programme. Indeed, if the FED did not ease in September, it would come as a major surprise (which is very unlike the FED), resulting in a material sell off of equity markets.

The FED’s statement is particularly bullish and I will have to reconsider my cautious policy towards equities – indeed reverse it, most likely, though I remain extremely wary of the ruling by the German Constitutional Court..

The currency and bond markets agreed with the likelihood of QE3 in September, with the Euro rising well above US$1.25 and 10 year Treasury yields declining to 1.70%. Gold has risen to US$1663.

With the FED to announce QE3 in September and Draghi to announce details of his bond buying programme for the peripheral EZ countries (very likely positive, as well), the major threat to markets remains a negative and/or restrictive conditional approval by the German Constitutional Court on the ESM. I must say that the particularly dovish FED minutes has surprised me and markets I would have thought US equity markets would have reacted far more positively yesterday. All we now need is for some similar move by the Chinese, which I certainly expect, (in particular, given the weaker economic data, including today’s sharp decline in the HSBC PMI reading), but the Chinese are being even more inscrutable than normal. However, coordinated action by Central Banks (quite possible) is even more positive.

Asian stocks rose on the prospect of QE3 in the US and further stimulus/monetary easing in China. European futures indicate a higher open.

Traveling, so short note today.

Kiron Sarkar

23rd August