Investment: The Fed flood slows to a trickle
By Richard Milne and Michael Mackenzie
Published: June 12 2011 22:52
Global markets for the past nine months have experienced their version of a sugar high. Assets from commodities to equities have been boosted and the US dollar pummelled by one of the biggest experiments in recent central bank history: the second round of so-called quantitative easing by the Federal Reserve, writes Richard Milne.
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QE2, as the policy of buying $600bn in US Treasury paper was dubbed, will draw to a close at the end of this month just as concern intensifies about the strength of the US and global economic recoveries.
How markets react will demonstrate whether the two-year rally in most asset classes following the financial crisis is on a stable footing or has been artificially doped by one of the biggest floods of money ever recorded.
“Asset price inflation really is a consequence of QE,” says Paul Marson of Lombard Odier, a Swiss private bank. A 90 per cent rebound in the S&P 500, the main US share index, since its low point in March 2009 has coincided with the Fed’s two QE programmes. Commodity prices, as shown by the Reuters Jefferies CRB index, are up 67 per cent over the same period, while the dollar has fallen 17 per cent.
QE was designed to help the US economy, in particular by staving off the threat of deflation, but some argue it could end up doing more harm than good with higher energy and food prices weighing on an already weak recovery.
With unemployment stubbornly high and growth stubbornly low, more than a few investors question whether the initiative had much real economic impact – or might instead just have encouraged speculation.
“It helps people in speculative assets, not the first-time [home] buyers,” says Andrew Parry, chief executive of Hermes Sourcecap, a UK equity investor. “The people who need it least get the most benefit.”The worry is that risky assets such as equities will not fare well once the Fed stops pumping money into the system. Steve Lear, deputy chief investment officer at JPMorgan Asset Management, argues that investors’ appetite for risk and the Fed-fuelled surge in liquidity are intimately linked.
Recent data certainly seem to support this concern. The S&P 500 has fallen in the six weeks since the start of May, its worst run since 2008. Safe-haven assets, however, have done well, with benchmark 10-year US bond yields slipping below 3 per cent, from a recent high of 3.6 per cent in April.
Those moves have taken place against a backdrop of weak macroeconomic data in the US, from sputtering growth in gross domestic product and an unemployment rate back above 9 per cent to the housing market entering a double-dip recession.
However some investors argue that the end of QE2 should have little impact on markets, because the Fed plans to keep official interest rates at zero for many months yet. “The end of QE2 is actually irrelevant. The key point of monetary policy is that real [inflation-adjusted] interest rates are so negative,” says Robert Parker of Credit Suisse.
Instead, the Achilles heel of QE2 for many has been the deep decline in the value of the dollar and the corresponding jump in commodity prices. Alan Ruskin, a Deutsche Bank strategist, says this rise in prices is “the sting in the tail” from QE2.
“Unfortunately, the attempts to reflate the housing market will also end up in reflating other assets like commodities.”
The jump in food and energy prices is blamed in part for the US economy expanding only at a lacklustre annualised rate of 1.8 per cent in the first quarter, with forecasts of about 2 per cent for the current three months. Inflation expectations and core inflation, the Fed’s preferred measure, are both rising, albeit from low bases.
This soft patch in growth has led to questions among investors as to whether another sugar high is needed: a QE3. Ben Bernanke, the Fed chairman, appeared to pour cold water on the idea last week.
That has not stopped investors from debating the concept however.
Some think the economy would have to take a dramatic turn for the worse. “I think the burden of proof for QE3 is pretty high,” says Peter Fisher, head of fixed income at BlackRock. But Willem Buiter, chief economist at Citi, argues that by focusing on measures such as core inflation that are currently low, the Fed could easily do more. “They are looking at indicators that are permissive. If the real economy disappoints for two more quarters we could be looking at QE3.”
QE will in any case carry on. The Fed will reinvest any maturing assets – about $20bn a month – into Treasuries, keeping its balance sheet stable at about $2,900bn.
What will end are any further purchases under QE2. That may have been flagged for a long time but investors are nervous about the outcome. Below, Financial Times writers analyse how the four main asset classes might fare in a “sugar-free” world.
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Bonds: Treasury holders are wrong-footed
Bonds are the one asset class in which the Federal Reserve has been active. The Fed has been the biggest buyer of US Treasury debt for the past eight months. But that activity has not made it easy for investors to predict the direction of interest rates. Many have been caught out at both the start and end of QE2, writes Michael Mackenzie.
A large number of investors thought the Fed’s hefty buying of Treasuries would keep government bond yields close to their historic lows reached in the aftermath of the 2008 collapse of Lehman Brothers. Instead, the start of QE2 in November 2010 prompted a vigorous bout of Treasury selling, sending yields sharply higher.
Now, as QE2 nears its conclusion, many investors have once more been wrong-footed, this time by a sharp drop in government bond yields that has gathered pace since late February.
Prominent investors, notably Bill Gross at Pimco, have long expected that the end of QE2 would result in higher rates, as the central bank would no longer be the main buyer of Treasury paper. But, having peaked at 3.77 per cent in February, the yield on benchmark 10-year notes is now back below 3 per cent, compared with 2.48 per cent before the start of QE2.
For all the talk of the Fed’s buying power driving the bond market, recent data showing a lacklustre US economy, weakening job creation and falling housing prices are driving down interest rates. Rick Klingman, managing director at BNP Paribas, says: “The rise in yields when QE2 began was due to stronger data, while for the past month and a half the data are now telling us that the economy has decelerated.”
One area where QE2 has amply rewarded investors is for those who sold Treasuries and bought riskier corporate debt, known as junk bonds because they are rated below investment grade. That reflects an implicit aim of QE2: pushing investors out of low-yielding cash and government debt into riskier assets such as corporate bonds and equities.
Since last November, the Barclays Capital Treasury index has gained 0.34 per cent, while the bank’s index of junk bonds is up 5.2 per cent. In May, the interest rate on junk bonds fell to a record low of 6.65 per cent, according to an index from Bank of America Merrill Lynch.
“The Fed announces QE2, there was a headlong rush out of US Treasury securities and into risk assets, forcing Treasury rates up, and my contention is that the QE2 sword cuts both ways,” says William O’Donnell, strategist at RBS Securities.
“There’s a risk that money flows that left Treasuries to go to risk assets could reverse after QE2.”
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Equities: Corporate profits will remain key
Equity markets offer perhaps the starkest debate over whether fundamentals or QE2 are behind the rise in asset prices. For bulls, the two-year rally in shares is above all due to the surprising strength of corporate earnings, writes Richard Milne.
“I won’t dismiss the idea that QE2 contributed to the bull run but earnings were far more important,” says Ed Yardeni, founder of Yardeni Research, an economic consultancy.
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But for many others, investing in equities is less about the attraction of owning shares and more about the lack of alternatives. “It is almost investing by default. I don't want to invest in money markets or bonds, because the returns are low. I don’t want to invest in commodities, because there is probably a bubble. So by default I want to be in the equity markets,” says Robert Parker, head of the investor council at the International Capital Market Association, an industry grouping.
Despite, or perhaps because of, the recent rally in government bonds and a small decline in equity markets, lots of investors still prefer shares to debt. “It is an asset allocation conundrum. I do think equities will do better than bonds. But I do think you won't get much of a return [from equities],” says Chris Johns, chief investment officer for fundamental equities at State Street Global Advisers.
But investors are also becoming more defensive. JPMorgan Asset Management is one of many fund managers to recommend a shift out of cyclical stocks – those that do well in times of strong growth – into defensive shares such as healthcare and utilities. The recent fall in global stock markets has been minimised by the strength of defensive stocks.
One interesting sign of the side-effects of QE2 can be seen in how different currencies affect the returns of the S&P 500, the main share index in the US. In dollar terms, the S&P is up 89 per cent since its post-crisis low in March 2009. But in euros it is only up 54 per cent, in Swiss francs 36 per cent and in Australian dollars the gain is a measly 12 per cent. That suggests dollar weakness has been a big boost to US equities.
Even optimists worry that the other prop for share prices – corporate earnings – cannot strengthen forever. Already well above their average of 6.5 per cent, margins for the S&P 500 are expected by analysts to be 9.2 per cent this year and 9.8 per cent next.
Mr Yardeni, who is still predicting a rise of about 16 per cent for the S&P from now until the end of the year, says: “Profit margins are probably getting close to a peak. And we are not going to get any help from the valuation side without QE2.”
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Currencies: Risk aversion may aid the dollar
For currency markets, the end of QE2 is all about whether the decline in the dollar will stop too, writes Peter Garnham.
The flood of dollar liquidity that has been poured into the market by the Federal Reserve has encouraged the growth of the so-called carry trade, in which currency investors sell the low-yielding US currency to invest in alternatives with higher interest rates such as the Australian dollar.
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This has pushed many emerging market currencies up to multi-year highs against the dollar, sparking talk of “currency wars” and prompting central banks in Asia and Latin America to intervene in order to shield their export sectors.
The dollar has also slid against free-floating commodity-linked currencies. The Australian dollar, which is seen as a proxy for Chinese economic activity, has surged to its highest level against the dollar since it was allowed to float freely in the 1980s.
Those investors who think the end of QE2 will benefit the dollar point to the potential for improving sentiment at Asian central banks, the world’s largest currency reserve holders.
Many Asian reserve managers feel that the Fed’s quantitative easing policy was a deliberate attempt to engineer the dollar lower, to the benefit of the US economy. Thus, the end of QE2 may prompt a reduction in their diversification away from the dollar.
Mansoor Mohi-uddin, managing director of FX strategy at UBS, says there is room for the dollar to rebound. Although the Fed’s balance sheet will remain at its current large size for a while, the fact that there will be no new purchases will stop the flow of additional dollar liquidity into financial markets.
It is this flow, he says, that has spurred the strong rally in risky assets and downward pressure on the dollar.
“Quantitative easing has led to portfolio reallocations by investors who have sold their bonds to the Fed and subsequently invested the proceeds in higher-yielding assets including foreign currencies,” says Mr Mohi-uddin.
“This flow will stop by the end of June, likely making asset markets more volatile and thus increasing investor risk aversion to the benefit of the dollar.”
Other analysts say that foreign demand for US assets is unlikely to increase markedly unless investors see a sustained improvement in the American economy.
“The end of QE2 may remove a source of downward pressure on the dollar, but it will not by itself trigger a sustained bullish dollar trend,” says Vassili Serebriakov, currency strategist at Wells Fargo Bank.
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Commodities: Demand can override all negatives
QE2 has not only boosted the economy of the US but has also driven up economic growth elsewhere. The gush of money pumped by the Federal Reserve has slowly filtered through the globe, accelerating the already red-hot growth rates of commodity-hungry nations such as China, India, Brazil and Saudi Arabia, writes Javier Blas.
The International Monetary Fund estimates that emerging markets, which over the past decade have become the main driver of demand growth for commodities from oil to iron ore and copper, expanded by 7.3 per cent last year. That is within the range witnessed in 2004-08, when the cost of raw materials also surged.
The strong growth of emerging markets surprised oil and mining companies, which had slowed down their projects to bring new capacity into the market in light of the financial crisis. Supply in natural resources markets was already slowing as companies had to turn to more marginal deposits, with the extra costs those entail.
The combination of QE2-inflated growth and slow supply response has driven the price of many commodities to record levels. Yet some analysts and traders say the main boost came instead from money being invested in futures markets. The amount of commodities contracts outstanding – or open interest – has surged to record levels in recent months, supporting the view that QE2 was inflating a speculative bubble in market places such as the New York Mercantile Exchange.
However, the speculation theory does not explain why the price of some commodities such as natural gas – with a vibrant speculative market – has remained largely stable, anchored by a sharp increase in supply. Nor does it shed light on why commodities in which financial speculators have little influence, such as iron ore, thermal coal or rare earths, have risen sharply over the past year and a half.
Supporters and detractors of the speculative theory agree, however, that the negative impact of QE2 on the dollar has boosted commodity prices. As most commodities are priced in US dollars, their cost usually increases when the dollar depreciates. A cheaper dollar offsets some of the price rise in local currencies, keeping demand growth high in spite of rising costs. But it increases extraction costs in those currencies for oil companies, miners and farmers. That is particularly true of developing nations such as Brazil.
While the industry is braced for weaker commodity prices, no one is anticipating a collapse. Supply and demand for most commodities remain tightly balanced, so prices are thought unlikely to drop sharply.
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Copyright The Financial Times Limited 2011
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