The sad necessity of Fed watching: James Saft

November 16, 2012

Nov 16 (Reuters) – Every investor, sadly, has to be a Fed
watcher given that U.S. asset markets are supported, if not
levitated, by quantitative easing.

Sadly because, and Ben Bernanke himself might agree with
this, we could all probably find more productive ways to spend
our time. Sad, too, because the Federal Reserve’s reach actually
seems to be diminishing amid doubts about how well QE is
working.

Perhaps never before has the market been this dependent on
the Fed and perhaps never before has there been as much doubt
over its eventual success.

That makes the latest Fed policy meeting minutes, released
on Wednesday, the markets’ most under-sung story of the week.

The minutes, which hinted at further accommodation in 2013,
showed that “a number” of Fed officials believe the U.S. central
bank will have to buy additional assets when its current
program, Operation Twist, wraps up at the end of the year. This
is counter-balanced, somewhat, by “several” others, including
Jeffrey Lacker of the Richmond Fed, who doubt this is needed.

Put your money with the easers, led most likely by Chairman
Bernanke.

Operation Twist, under which the Fed sells $45 billion a
month in short-term paper and uses the funds to buy longer dated
debt, is intended to drive down longer-term interest rates. It
is also a support for equities; when investors see pitiful
government debt rates, they are likely to throw up their hands
and buy dividend stocks and other risk assets.

What comes after Operation Twist may be, if anything,
slightly better for risk assets. Operation Twist keeps the size
of the Fed’s portfolio constant, as they sell a dollar of
short-term debt for every dollar of Treasuries they buy.

After Twist expires the Fed may well simply print money and
buy Treasuries, not only driving down yields but also creating
more money which can support equities. With the Fed already
spending $40 billion a month to buy mortgage bonds, we could see
about $85 billion of new money being pumped into the markets
every month in 2013.

WILL IT WORK?

What would happen if the Fed allowed Twist to end? While
interest rates might not spike higher, they would certainly
drift, and risk-asset investors would then face a poor outlook
for profits and the risk of a fiscal-cliff-induced recession.
The market would tumble. Since the Fed has tied its policy more
explicitly to unemployment, it is not going to allow that to
happen, so QE4, or, if you like, QE4ever here we come.

The inevitability of continued Fed easing is supported by
the discussion, in the minutes and recent speeches, of so-called
quantitative thresholds. Under such a threshold, the Fed
would commit itself to buying so many Treasuries until a
specific level of unemployment or nominal GDP growth were met.

That’s still controversial, both inside and outside the
central bank, but the very discussion is a fat signal that we
won’t see any passive tightening when Twist comes to an end.

The impact of additional QE is much harder to determine.

Thus far QE has shown mixed results. It’s been more a
supportive therapy than a cure, at least in terms of the
economy. And surely the experience in Japan, where QE has a long
track record and where they’ve gone as far as buying equities,
offers no assurances of success.

In market terms, however, QE has likely been
quite important. It has supported equities, particularly those
paying reasonable dividends, as well as other risk assets. It is
hard, though, to get very excited by the prospect of more
QE-induced gains.

Equities, even with support, face too many other hurdles:
the fiscal cliff, earnings, the euro zone and, of course, the
possibility that Fed support fails to work. If the United
States, even with massive QE, were to head into another steep
recession investors would quite rightly lose confidence in the
central bank. It is more a case of downside if they don’t than
upside if they do.

The counterbalance: An utter lack of attractive alternatives
to risky assets. Treasuries surely have much risk and little
reward and while corporate debt is well supported by clean
balance sheets, the corporations must sell to governments and
households with real balance-sheet problems.

The expiration next year of unlimited FDIC account insurance
may actually make things worse from a fixed income investor’s
point of view, driving huge amounts of cash out of bank deposits
and into government debt. This, in combination with proposed new
money market rules which will make them also more likely to hold
government debt, might actually lead to negative short-term
interest rates in the United States.

So there you may have it: pay the United States to lend its
money or take your chances with the Fed and equities.

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