By
Calafia
Beach Pundit
:
I didn't think they would do it (QE3), but they did. It wasn't
necessary, but I presume that the FOMC was under tremendous
political pressure to "do something!" So the Fed will be buying $40
billion of MBS per month for the foreseeable future, and they will
also continue "Operation Twist." Their objective is to stimulate
the economy, primarily by artificially suppressing mortgage rates,
which in turn they hope will stimulate the housing market and thus
contribute to a stronger economy. Unfortunately, to judge by key
market-based indicators, all they have achieved so far is to
stimulate inflation expectations.
(click to enlarge)
The chart above shows 10-yr Treasury yields (the main reference
point for mortgage rates) in orange, and the yield on current
coupon Fannie Mae collateral (the benchmark yield for mortgage
rates) in white. In the past two months, Treasury yields have risen
while mortgage yields have not fallen. The spread has narrowed in
favor of mortgage rates, but the level of mortgage yields has not
changed. If inflation expectations continue to increase, Treasury
yields and mortgage rates will rise.
The Fed can't stimulate without causing Treasury yields to
rise
, and if they rise further, mortgage rates will have no choice but
to rise as well. Rising mortgage rates will be an excellent
indicator that the Fed has succeeded in stimulating the housing
market. Rates could rise by a lot before they became a burden on
the housing market.
(click to enlarge)
The chart above shows the market's forward-looking inflation
expectation (i.e., the expected average annual inflation rate over
the 5-yr period beginning five years from now). This has now
reached 2.85%, up from a low of 2.0% a year ago.
This same result (higher inflation expectations) can be observed
in the spread between 10-yr TIPS and 10-yr Treasuries. The average
annual expected rate of inflation over the next 10 years is now
2.48%. Not unusually high, but it's clear that the market is
figuring that QE3 increases the odds of higher inflation in the
future. Not dangerously higher inflation, but the risks of
deflation have now almost vanished, and that is presumably a good
thing.
(click to enlarge)
The gold market is also treating the Fed's move as a signal for
higher inflation.
How about the stock market-is it discounting stronger growth, or
higher inflation? That's a tough question to answer, but my reading
of the market tea leaves suggests that the stock market views QE3
as a sign of stronger nominal growth: businesses are more likely to
see improvement in their cash flows in coming years. Whether that
improvement comes from more inflation or more growth or both,
matters little at this point. Stronger nominal growth means less
likelihood of defaults, better profits on average (at least in
nominal terms), and less risk of a recession or depression. On
balance, the odds have shifted in favor of those who have a claim
on future corporate cash flows, so stocks look more attractive. I
don't think the market is yet discounting stronger real growth.
Let's get nominal growth up and then we'll worry about how much of
that increased nominal growth is real and how much is
inflation.
I worry more about the risk that the Fed has made an exit
strategy from QE more difficult, and thus I worry more about
inflation rising in the years ahead. But so far, those fears are
somewhat offset by a reduced risk of recession and/or deflation.
It's unfortunate the Fed had to come to this, but it's premature to
say it's the end of the world.
Regardless, inflation hedges just became more attractive. Seems
to me that the cheapest inflation hedge right now is real estate,
while the most expensive asset is Treasuries. So: buying real
estate using 30-yr fixed mortgage debt (equivalent to shorting
Treasuries) looks like an incredibly attractive proposition. With
the banking system set to accumulate even more excess reserves, it
seems inevitable that banks will want to increase their lending. At
the same time, the demand for inflation hedges like real estate
should be picking up, and with it the demand for more lending and
thus more monetary expansion. Whether this will be good for the
economy or just good for the real estate market and inflation
hedges in general is a question that will be answered in the next
year or two. For now, it looks like inflation hedges are the better
bet.
See also
Apple's Slide Gives An Option Investor A Fat Pitch
Down The Middle
on seekingalpha.com