We talk a lot about floors and ceilings these days – so much so that readers may be forgiven for thinking that we are carpenters. No – our floors and ceilings are of the electronic variety. Over the past several weeks we have seen the floor in action, with central bankers playing their now-customary role of shoring up support so as to prevent asset markets from falling further. First the ECB got its way when Germany’s constitutional court gave a thumbs-up to the European Stability Mechanism. Then the Fed chimed in with QE3, which could be more appropriately be called QE4ever. And in a “hey, what about me?” kind of way the Bank of Japan got into the act with its own new stimulus measures, as noted in last week’s Market Commentary.
This week we see the return of the ceiling, in a bit of tiresome déjà vu. Spanish bond yields are sharply up from their levels in recent weeks, Greeks are in the street protesting austerity, oil is dipping below $90 and stock markets are pulling back accordingly. Eagle eyes are trained on upcoming corporate earnings to see if the slow recovery is eating into the corporate bottom line. Gravity, in effect, is in full force.
The market’s inability to reach escape velocity and break through the ceiling is in no small part a recognition that the central bank policies put in place so far – including even Draghi’s perseverance in getting the ESM through Germany’s opposition – have not solved the problems. They have, to use a phrase we have often employed on these pages, just kicked the can down the road yet again.
But is there method in the madness? Is “kick the can” actually a strategy rather than a failure of vision? Maybe. Think about it this way: in its present floor-and-ceiling mode the stock market actually resembles a giant financial option. A basic call option has a floor, which is equal to the price you pay for that option. Your investment will never be less than that floor because the option has only two possible outcomes: to expire worthless; or to increase in value with the appreciation of the underlying asset.
The other thing about an option is that time is an ally. The longer time there is from today until the option expires the more value the option has, all else being equal. Why? Because the more time you give an asset to rise in price, the higher the probability that it will. If I buy an S&P 500 call option that expires next week then there are only a few trading days for the index to rise above the option’s strike price. But if the option expires two months from now than there are many more days in which that can happen. Statistically speaking my chances of winning are greater.
So it is for the synthetic floor the world’s central banks have put under the stock market. The floor may not be solving actual problems, but it is buying valuable time. Economic cycles come and go, and this anemic growth environment eventually will as well. If we have avoided another market meltdown by the time real growth kicks in again then the floor has been successful. Kick-the-can as a policy approach has worked.
That’s a big if, of course. There is already a growing body of doubt that any ongoing stimulus measures will accomplish anything. If investors believe there is no intrinsic value to the floor then the floor goes away and it’s watch out below. There are plenty of sharp curves ahead. But if nothing else, time is still probably on our side.
The aftermath since the Fed’s announcement of QE3 last week has been settled and somewhat unremarkable. As one would expect, investors have trimmed some of their equity positions after the initial rally following the announcement, but overall there has been no real drawback in risk asset markets. However, warnings related to future inflation expectations have surfaced among some observers, notably Richmond Fed Governor Jeff Lacker as the potentially unlimited expansion of the Fed’s balance sheet increases potential for future inflation.
Following the Fed’s announcement of QE3 last week and the European Central Bank’s (ECB) establishment of an open-ended sovereign debt buying program earlier this month, the Bank of Japan (BoJ) has thrown its hat into the ring with its own revamped monetary stimulus package.
Changes to the BoJ policy include an increase to the size of its asset-purchase program by purchasing about ¥10trillion ($126 Billion) in additional Short-Term Government Bills and Long-Term Government Notes (¥5trillion each), as well as extending its deadline by 6 months to the end of 2013. The hope of the BoJ is that the lower long-term interest rates resulting from these measures will weaken the appeal of the yen which tends to serve as a refuge in response to predicted economic turbulence around the world (though it should be noted that interest rates in Japan have been at extremely low levels for years as it is).
While a number of factors drive the persistently high value of the Yen – a perennial sore point for Japanese economic policy makers – the race for ever bigger quantitative easing measures exacerbates that tendency. The recent action by the BoJ, Fed and ECB have raised some concerns that central banks are engaging in “competitive easing” by pumping money into the home country’s (or region’s, in the case of the ECB) own economy despite whatever negative effects it could have elsewhere. These concerns are reinforced by this more aggressive policy by the BoJ, which comes as a surprise to many analysts who predicted that the more conservative BoJ Governor would delay any easing measures until late October.
The aftermath of QE3 also has an effect on the bond market but this is trickier to make sense of. Theoretically in a bond-buying exercise like QE one would expect to see bond yields fall as bond prices go up. Contrary to the theory, however, are the realities of present-day asset markets where QE induces interest rates to rise as investors sell out safe haven assets – this happened in both QE1 and QE2. However, QE3 has been something of a hybrid. Investors have – predictably – flowed into riskier assets, but there is no sustained upward trend in bond yields (as there was with QEs 1 &2). Yields on 10 Year Treasury Notes remain not far from historic lows and have not yet managed to surpass the already modest 1.97% yield seen at the beginning of 2012.
And so, the question remains that we posed last week: will QE3 work? And to follow that up with an even more ominous question: how bad will it be when interest rates really do start to rise, for real? We’ll be talking a lot about that in the weeks and months to come.
Note: Our Midweek Market Comment is actually an end of week comment this week, in order to focus on the Fed’s latest quantitative easing announcement made Thursday September 13.
The odds seemed to be on something happening, and the chorus of conventional wisdom grew louder as the week went on that it might be something big. But when it arrived, the news presented itself with a Zen-like simplicity: $40 billion every month. No cumbersome time estimates or sunset clauses. $40 billion for as long as it takes to produce results. Zero percent short term interest rates as far as the eye can see.
There are two key questions we have been focusing on in the run-up to and immediate aftermath of what the financial chattering class inevitably refers to as QE3. Those two key questions are: (1) was the Fed right to make the decision it made, and (2) having made the decision, is it likely to actually work?
Unsurprisingly that first question has been sucked into the venal vortex of partisan politics. It’s less than two months before a presidential election and the Fed – an organization independent of the three branches of Federal government – has opened the floodgates to rescue the economy (though technically the $40 billion mortgage backed buying program won’t start until after the election). Partisan reaction from both GOP and Democratic party flaks was in full view yesterday and will no doubt be woven into campaign narratives as the days go on. But that is absolutely the wrong way to look at the question of whether Bernanke’s call was the right call, which was very clearly not a political call.
The Fed has a dual organizational mandate: to undertake policies in support of full employment and price stability. That’s it. When the Fed makes its Open Market Committee decisions about whether to raise or lower or hold steady the Fed funds rate, or whether to inflate its balance sheet with more QE, it is with those two objectives in mind. Bernanke was very clear about this in his statements. The recovery continues to be anemic, unemployment is persistently high and shows no signs of budging, and is far above what any reasonable person would consider to be “full employment”. Meanwhile demand remains modest. Modest demand – reduced spending in other words – means that the threat of damaging inflation levels remains subdued. The Fed believes that a low inflation outlook gives it maneuvering room to try and stimulate the employment side of its mandate with QE. That’s what yesterday’s decision was about.
Which brings us to the second question: will it work? The task is daunting. Interest rates are already at historical lows. Credit has never been cheaper – but borrowing remains significantly below trend by both households and businesses. Is the purchase of $40 billion worth of bonds every month by the Fed going to be the act that moves the needle? It’s hard to make a compelling case – but it’s also hard to make a case for an alternative path to growth when there doesn’t seem to be one. Central banks are, sadly, the sole policymakers anywhere in the world with the ability to take remedial action to stimulate the global economy. Governments are gridlocked and political leadership is weak. It’s central bank action or nothing – and in a world where weak growth can fall back into recession in the blink of an eye, something is probably better than nothing. The markets seem to think so in the short term – but it’s the growth, consumer confidence and – yes – unemployment numbers that will provide the ultimate judgment.
After a somewhat lackluster first few days in September, global markets have rallied today on strong U.S economic reports and details on the ECB’s plans to help struggling European bond markets.
Although the August employment report will be reported on Friday (9/7), markets have reacted positively to the Private Sector jobs report, which reported numbers significantly higher than analysts’ estimates and is the largest gain in 5 months. Initial jobless claims were also lower than expected and the service-sector activity has increased from July to August, further fueling the positive market reaction. However, not all is hunky dory – despite the recent improvement in these data reports, unemployment has persistently hovered around 8%, hiring patterns have continued to be weak and US manufacturing contracted for a third straight month in August.
Tomorrow’s jobs report follows the end of the Democratic National Convention, and could potentially overshadow any warm-fuzzy feelings generated from President Obama’s bid for reelection tonight. Analysts are estimating a deceleration of 38,000 jobs from July to August and unemployment to remain at 8.3%, numbers that will likely not do the President any favors. On the flip side, should the numbers significantly outperform expectations we may see some amplification to any ‘Obamamentum’ coming out of the convention.
Meanwhile, across the pond ECB President Mario Draghi outlined a forthcoming Sovereign bond-buying program. Under the program, the ECB could potentially purchase an unlimited amount of Sovereign debt with maturities between one and three years. The program, dubbed “Outright Monetary Transactions”, is intended to provide a “fully effective backstop” against market volatility as well as reduce borrowing costs for struggling Eurozone countries.
Following Draghi’s announcement, Spain and Italy’s bond yields eased significantly and European stock markets rallied with the FTSE 100 increasing 2.04% and the DAX increasing 2.77% for the day. US stock markets have followed suit, and as of midday Thursday the S&P 500 gained 1.9% and the Dow isn’t far behind with a 1.8% increase. In contrast, Treasuries suffered with the yields on 10-year Treasury notes rising to 1.6675% by noon as the appeal of safe-haven assets diminished – as we would typically expect – in response to the positive economic data.
As of the writing of this post the major markets are all in 2%-plus territory for no particularly solid reason – in other words, business as usual for the tea leaves readers who are back in the saddle as the world of risk on / risk off solidifies its return to front and center of daily market forces. The rumor of the day has it that something of a plan may be forming around a bailout for the Spanish financial system that would forego some of the bitter-pill austerity the Continent’s policymakers have tried to feed down the throats of other ailing economies in the Eurozone crisis. As usual the details, such as they exist, are foggy and nothing is fundamentally different in terms of solving the root problems plaguing the troubled sovereigns. But no matter – we are back in the world of risk on / risk off that dominated for most of the second half of last year, and it is reasonable to take the view that this paradigm may continue to play itself out. Meanwhile noises have been wafting out of top US Fed members to the effect that a new round of quantitative easing is by no means off the table for ongoing central bank policy formation.
The willingness of investors to trade solely on the basis of speculative rumors that may or may not become actual news headlines, let alone clear and constructive policy decisions, may have something to do with a measure that has become more a talisman than a barometer. The S&P 500 is hovering a bit above its 200-day moving average, having briefly dipped below that average during the sell-off last week. Now there is nothing particularly special about the 200-day average – it is a simple rolling average calculation, nothing more. In normal times it can serve a role as one more useful data point for market observers who hold stock in momentum theories. But looking at the performance charts over the past twelve months it is kind of easy to see what may be driving investors to play a careful 200-day average game. During this time there have only been two decisive moves through the average. One was at the end of July last year when the markets plunged in the wake of the debt ceiling debacle. The other was right at the end of the year when the ECB began the first phase of its €1 trillion restructuring program to relieve banks of short term obligations coming due by deferring maturity for three years. That action confirmed the (response to policy-driven) uptrend that had started at the beginning of October.
When the S&P 500 dipped below the 200-day average last week you could almost hear the brakes squealing as investors paused to take stock of what might or might not precipitate another sustained fall through that support level. Much of the buying we have seen since then, particularly today’s strong moves, are probably attributable to short covering in fear of “announcement risk”. This would take the form of the latest incarnation of platitudes and paeans to unity and solidarity along with some broad-brush outlines of a plan – just enough to kick the can down the road one more time. You don’t want to be doubling down on your bet against the market if the policymakers successfully pull that one off one more time.
The big question we continue to monitor is when the specter of announcement risk ceases to cause fear and trembling. Remember, this has been going on for two solid years now. Everything starts to go pear-shaped, investors panic, the central banks come to the rescue with a mix of soothing platitudes and occasional policy actions – just enough to provide the reassurances that they will always be there as a buyer of last resort. The Greenspan Put of old is the Universal Central Bank Put of new. The problem is that apart from goosing up risk asset markets for awhile until the next bad thing comes along, these policy tools appear to have had a very minimal effect on the actual economy. With 10-year US Treasury notes yielding 1.5% and German Bunds at historical lows, exactly what kind of central bank stimulus can provide the incentive for companies to aggressively move to extend more credit? With Europe enduring what seems more and more like a repeat of its painful withdrawal from the gold standard in the first half of the 20th century, how much can piecemeal platitudes accomplish if not supported by realistic plans that get at the fundamental core of the region’s problems?
Investors are crowded around the S&P’s 200-day moving average wondering the same things, hesitant to be on the wrong side but ready to place their bets when they have enough directional confirmation. We can’t imagine this play can pull off too many more acts without something substantial changing that confirms whether today’s valuation levels are screaming “buy” or screaming “run for the hills”.