Third time lucky? ‘Helicopter Ben’ kicks off QE3
City Index September 14, 2012 7:36 PM
<p>Last night the US Federal Reserve announced a third phase of quantitative easing, immediately triggering a strong bullish run in both equities and the price […]</p>
Last night the US Federal Reserve announced a third phase of quantitative easing, immediately triggering a strong bullish run in both equities and the price of spot gold.
The Fed said they would increase purchases of Mortgage Backed Securities to the tune of $40bn per month and that these purchases would be ‘open-ended’, meaning that there was no official end date. Even more so, the Fed indicated that even if the US labour market started to brighten – the Fed has a dual mandate of price stability and optimum employment – they would not stop their accommodative stance. Extremely low interest rates would endure throughout the next three years until at least 2015, an extension of previous guidance to 2014, whilst existing securities purchased through Operation Twist would be recycled to longer date securities past this year’s original Operation Twist expiry.
The Fed’s stance is impressive, aggressive and yet perhaps desperate all the same.
Ben Bernanke’s nickname in the markets is ‘Helicopter Ben’ because he is happy to parachute-drop bags of money into the markets and he lived up to his nickname yet again last night. This is the fifth major stimulus injection into the markets the Federal Reserve has made under the stewardship of Ben Bernanke as Chairman since November 2008. That’s five major stimulus injections in four years.
A look back at the timing of those injections (see chart below) shows that each time the markets mettle has been tested (see ‘?’ in below chart), Bernanke has acted. But when you also take a look at the US Unemployment rate chart vs the S&P 500, it is easy to see why the Fed acted with QE1 and QE2. The US unemployment rate was uncomfortably high. Yet this time around, there have been some extremely positive moves in the unemployment rate. The rate has progressively fallen from a high of 10% in October 2009 to 8.1% in August this year.
So why the need for QE3 now Ben?
Well let’s look at the dual mandate of the Federal Reserve. Unemployment remains uncomfortably high at above 8%. That’s far higher than the pre-crisis unemployment rate levels of around 4.5%. Bernanke has made countless admissions that the ‘employment situation remains a grave concern’.
See below S&P 500 vs US Unemployment Rate chart for a visual on the correlation between US jobs and equities.
So what exactly is the Fed’s target for unemployment? Bernanke said ‘there isn’t a specific number in mind but what we have seen over the last six months is not enough.’ There is a target of course – at least one would hope so – but understandably Bernanke does not want to admit what that is just yet. It plays into his other mandate of price stability to convince the market that the Fed stands ready to accommodate with aggression and sustainability in the long term. If Bernanke gave a target, the markets would see the end date visibly and yet this would also increase pressure on the Fed to act even more if its aims are not achieved. For example, if the target is a return to a 4.5% (I think this level is more likely to be around the 6% mark in truth) unemployment rate, then a move to anything above this is not enough and would keep the markets asking for more and more. Therein, however, lies another problem.
The more times you recycle similar tools, the less effective they become in the longer term. Imagine your favourite food for example. Have it too often and it could become less and less enjoyable.
Alternatively, perform the same gym routine each week and your body becomes used to it and by doing so, each repetition has less and less impact. Bernanke must know this yet perhaps he has been pushed into a corner on this occasion.
Of course we can add to this the weight of expectation in the markets that a lack of action from the Federal Reserve could have disappointed investors and triggered a stark sell off. I hate to think that the Fed acts merely to satisfy investors’ thirst for easing but then again, each time the market has suffered and investors cried out for action, Bernanke has stepped up to the plate.
I don’t believe the Fed needed to announce a third phase of stimulus yet. The US unemployment rate was edging lower and lower most months, stock indices were in a good place and the US economy is growing, albeit perhaps not at the vigour many people want but then again, the global economy in 2012 is far different from the global economy in 2007.
Factory activity is, however, a concern. US ISM Manufacturing dipped below the 50 growth level in June for the first time since July 2009, and whilst economic data is backward looking, it puts the Fed in a difficult position as to whether Fed policy is behind the curve or not. The last time US ISM Manufacturing dipped from growth into contraction territory was just before the start of the 2008 financial crisis. Exports remains weak at 47 whilst there has been a significant drop off in New Orders from May, which has stubbornly remained in contraction territory ever since. August marked a third consecutive month when factory activity had shrunk and the recent drop is being read as a shot across the bow of the Federal Reserve’s monetary policy.
There is a danger, however, of inflation. Bernanke seems to have turned a blind eye towards this but there is no coincidence that gold has rallied 14% since late June. Yesterday it rallied and now threatens to breach resistance levels of $1800. The Fed predicated that inflation will be between 1.6% to 2% in the next two years. The Fed’s target is 2%, the same as the Bank of England’s. US inflation rose stronger than expected in August to hit an annual pace of 1.7% from 1.4%. Inflation has quickly receded in the last year from 4% yet nevertheless, the warning signs are there even before last night’s decision with QE3 which is expected to increase inflationary pressures. Higher inflation will sap some of the positive effects on employment and ultimately consumer spending. Bernanke’s confidence on this front is admirable and mildly convincing. Let’s hope he is right.
Lets not forget the price of Nymex crude oil, which hit above $100 a barrel for the first time today since May. High oil process increases fundamental costs for companies and weighs on profit margins. High oil prices make growth even more difficult but if there is one element that might mitigate against this risk, it’s the fact that companies have striven over the past three years to cut costs as much as possible.
But let’s be honest, Quantitative Easing is not there to fix the US economy. Bernanke knows this. It breathes oxygen into the financial markets to buy the economy time to re-brick its foundations and move forward. To do that, governments also need to act and indeed this has been a pertinent message from both Mario Draghi and Ben Bernanke in recent months. QE is designed to help bring down the cost of borrowing, increase money flows into business, improve confidence and ultimately, boost hiring and spending. It is hoped that the money created at the top of the chain funnels its way down to the bottom. I am not convinced it happens as simple as that. What’s to stop banks hoarding the cash, for example, as has happened in previous rounds of QE? The markets of course love QE though as it has historically been shown to increase the flow of funds into the market in the shape of risk appetite, with stocks typically seeing the benefits.
So can this rally continue? I don’t see why not. The markets typically rally between September and the year end and the fact that we now have major Central Banks moving to inject stimulus into the markets is positive for risk appetite in both the liquidity it creates and the sentiment it improves. We have seen the Bank of England and Federal Reserve both act now to stimulate the markets. The ECB created Outright Monetary Transactions and the European Stability Mechanism is ready to provide emergency funds when needed. The last jigsaw in the puzzle is the People’s Bank of China (PBOC). Premier Wen Jiabao recently indicated that the PBOC stands ready to stimulate and could look to use the remaining 100bn yaun left in the fiscal stability fund to help speed Chinese growth and make sure GDP reaches 7.5% as a minimum for the year. All of this plays into the hands of the markets.
Momentum is also supportive for the bullish streak we have seen. Global stock indices have enjoyed strong gains since the lows of June, whilst the tagline ‘the trend is your friend’ remains the right hand man for bull traders at present. The S&P remains to a degree ‘Applefied’ whilst also hitting a fresh four-year high on the back of the Fed’s move’s last night. 1450-1460 remain the key levels to watch on that front. It would likely take a market shock to knock the winds from the sales of stock indices right now.
There could well be shocks to come in the shape of Europe of course. Investors are waiting to see whether Spain will request a fully fledged bailout and indeed what size that may take whilst we are still waiting on the Troika to file their full report on how much Greece has slipped behind their original commitments, which is delaying the next tranche of bailout funds to arrive in Athens. We must also not discount price corrections as investors lock in their gains, there is still the potential that investors will stay on their toes for buying opportunities.
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