Global Investing

Pricing ‘new brooms’ at White House and Fed

With less than two weeks left to the U.S. presidential elections and all three televised debates done and dusted, investors are at last squaring up to the detailed financial market impact of the event itself and the column inches in newsprint and research reports lengthen by the day.

Barclays interest rate strategists are one of the first to stick hard numbers on likely market outcomes in a report late Tuesday that dug deep into both the well-documented “fiscal cliff” but also into the less discussed uncertainty surrounding the medium-term direction of the Federal Reserve and its leadership.

With news reports suggesting Fed chief Ben Bernanke will not now choose to stand again for a third term at the helm of the U.S. central bank in 2014, some may argue Fed risk from the election has been neutered. But with monetary policy still the only game in town policy-wise for many asset managers – at least on the stimulus side — then even the slightest risk to the Fed’s mandate remains a significant market factor.

Even though it figured almost nowhere in the big public debates, Republican challenger Mitt Romney has vowed that if elected he would not renominate Bernanke to a third term.  Romney’s running mate Paul Ryan is an even harsher critic of the Fed, backing legislation that would open up the Fed’s monetary-policy decisions to congressional scrutiny and strip the central bank of its mission to seek full employment. Given that the longevity of the Fed’s third and current round of asset purchases is tied explicitly to cutting the jobless rate, that’s a particularly controversial stance going forward.

The Barlcays strategists, as a result, reckon that if Romney were elected, a more hawkish Fed over time would be more likely than under a re-elected administration of Democrat Barack Obama.  And they said it’s possible that Fed funds futures market could see implied Fed interest rates for the end of 2015 jump by as much as 50bp in a knee-jerk reaction to a Romney win and drop 20bp on an Obama victory. (According to Reuters data, September 2015 Fed funds futures are currently implying a rate of 0.60% — compared to the current target of 0-0.25% range — and that has risen about 10bp since the first presidential debate on Oct 3 saw Romney’s opinion poll ratings rise to match and in some cases nudge ahead of Obama’s.)

Put down and Fed up

Given almost biblical gloom about the world economy at the moment, you really have to do a double take looking at Wall Street’s so-called “Fear Index”. The ViX , which is essentially the cost of options on S&P500 equities, acts as a geiger counter for both U.S. and global financial markets.  Measuring implied volatility in the market, the index surges when the demand for options protection against sharp moves in stock prices is high and falls back when investors are sufficiently comfortable with prevailing trends to feel little need to hedge portfolios. In practice — at least over the past 10 years — high volatility typically means sharp market falls and so the ViX goes up when the market is falling and vice versa. And because it’s used in risk models the world over as a proxy for global financial risk, a rising ViX tends to shoo investors away from risky assets while a falling ViX pulls them in — feeding the metronomic risk on/risk off behaviour in world markets and, arguably, exaggerating dangerously pro-cyclical trading and investment strategies.

Well, the “Fear Index” last night hit its lowest level since the global credit crisis erupted five-years ago to the month.  Can that picture of an anxiety-free investment world really be accurate? It’s easy to dismiss it and blame a thousand “technical factors” for its recent precipitous decline.  On the other hand,  it’s also easy to forget the performance of the underlying market has been remarkable too. Year-to-date gains on Wall St this year have been the second best since 1998. And while the U.S. and world economies hit another rough patch over the second quarter, the incoming U.S. economic data is far from universally poor and many economists see activity stabilising again.

But is all that enough for the lowest level of “fear” since the fateful August of 2007? The answer is likely rooted in another sort of “put” outside the options market — the policy “put”, essentially the implied insurance the Fed has offered investors by saying it will act again to print money and buy bonds in a third round of quantitative easing (QE3) if the economy or financial market conditions deteriorate sharply again. Reflecting this “best of both worlds” thinking, the latest monthly survey of fund managers by Bank of America Merrill Lynch says a net 15% more respondents expect the world economy to improve by the end of the year than those who expect it to deteriorate but almost 50 percent still believe the Fed will deliver QE3 before 2012 is out.  In other words, things will likely improve gradually in the months ahead and if they don’t the Fed will be there to catch us.

Addicted to Credit

The Federal Reserve’s expansionist monetary policies are the equivalent of giving an alcoholic another drink or the heroin addict another fix, according to Dr Marc Faber, also known as Dr Doom, and a fierce critic of Alan Greenspan and Ben Bernanke.

“This is not solving the problem – it is just treating the symptoms,” he said, speaking at the CFA Institute’s European Investment Conference in Frankfurt on Thursday.

Faber blames Greenspan’s decision to hold interest rates at artificially low levels for precipitating the housing bubble and sees Bernanke repeating the mistake in the current crisis. “The Fed seems to ignore the fact that one of the causes of this crisis was the amount of leverage in the system. This is a credit-addicted economy.”