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The Fed’s Double-Edged Sword
By: Martin Tillier
The Federal Reserve Board’s decision yesterday to continue asset purchases at the current rate should be a lesson to all market watchers of the dangers of “groupthink”. Ben Bernanke rightly pointed out when accused of misleading markets in the ensuing press conference that he had done no such thing.
He had never said that QE would be reduced this month; he had simply said that the board was considering the timing of a gradual exit, and that they, at that time, expected it before the end of the year. People made an assumption about what that meant, and the debate shifted from whether tapering would begin this month to how much the stimulus would be reduced. There were a few dissenting voices, most notably Bank of America Merrill Lynch (BAC), but the overall level of consensus was amazing.
I wish I could include myself among those who questioned the conventional wisdom, but in an article published yesterday, I started from the assumption that some reduction was imminent. I did point out that market positioning made an upward move in stocks the path of least resistance, but the actual decision came as a surprise.
The reaction, as you can see, was swift and violent.
Bearing in mind expectations and the market’s pre-positioning, that wasn’t too much of a surprise. What is a little more intriguing to me is that, following the initial jump there was no snap back. In fact, the upward move continued, throughout the afternoon, with hesitation only coming once all time highs were broached on both the S&P 500 and the Dow, and futures are indicating a higher opening again this morning.
Long term bonds also reacted positively in price terms to the news that the biggest buyer in the market was sticking around, as evidenced by the iShares Barclays 20 Year Treasury ETF (TLT) jumping around 2% on the announcement.
So, good news for investors all round, right? Well, maybe not so much.
The irrational depression about the short term trajectory of the stock market has, it seems, been replaced by a new irrational exuberance. It seems that the shock of no tapering has overwhelmed traders, and they have virtually ignored what Mr. Bernanke actually said.
The fact that he didn’t cut QE means that financial institutions will still be handed $85 Billion a month in freshly created money to play with, and, given my oft-repeated mantra that money must go somewhere, this is undoubtedly good for stocks. What is worrying however, is not the action (or inaction) itself, but the reasoning behind it.
The Committee charged with the decision, the FOMC, consists of some great economic minds and they have access to every piece of data out there. That they could analyze that data and decide that the US economy still needs help is a major concern.
Of course, it could be that they have got the whole thing wrong and are playing fast and loose with future inflation for some nefarious reason. Either it is designed to help their evil band of capitalist banking buddies or as a long term play to impose socialism on America, depending on your preferred brand of conspiracy theory. Call me naïve if you will, but I prefer to believe that they are fully aware of the potential consequences of their decision, but on balance decided it is the best thing for the economy.
This would suggest that they see trouble on the horizon. The rise in interest rates that was a result of speculation about the Fed’s actions was really no more than a move back towards normality. However, in the world of ultra-low interest rates that the Fed has created, even that move could quickly be seen to have negative effects.
Mortgage applications have stalled, suggesting that the fragile recovery in the real estate market may be in danger, so continuing to purchase mortgage securities looks like a prudent thing to do. As important as the real estate sector is, the more worrying signs are in the general economy. The last “Fed Beige Book” of regional opinions was reasonably positive, but there was anecdotal evidence of bank lending slowing from an already low level.
The Fed finds itself in an unenviable “Catch-22” situation. They have created an environment where low interest rates are the norm, and businesses hesitate to borrow at any normal, reasonable rate. This has a negative effect on growth and employment, creating a need for more stimulus and worsening the situation. Add to that that the large banks who are the main recipients of all that cash see better returns from trading than lending and you have an unenviable drag on economic activity. Eventually, the cycle must be broken and, when that time comes, disruption is inevitable.
Mr. Bernanke also mentioned caution as to the effects of upcoming political debates. I cannot help but feel that this is justified, as politicians have an uncanny knack of hurting economies, and if the last budget/debt limit shenanigans are any guide, that old truism will prove itself again this fall.
The fed’s decision is, without doubt, a double edged sword for investors. In the short term, the prospect of continued QE has caused a nice pop in the equity markets, but there is concern about some medium term pressures on the economy. It has been a great year for investors, and the rally following yesterday’s announcement may well signal a good time for prudent types who can see beyond the hype to take some profit.