Short Takes

We noted extreme levels of optimism earlier today. What could possibly trigger a correction in stocks and commodities? If the Fed fails to signal and/or announce another round of quantitative easing (QE), it would undoubtedly leave the markets disappointed.

The Fed uses the Wall Street Journal (WSJ) as a medium to communicate with the markets. It is possible someone at the Fed picked up the phone and said, “We need to temper short-term expectations for another round of QE. Can you help us out?” Friday’s WSJ has an article titled “Fed Holds Off For Now on Bond Buys”. Notice the word “may” is not included. Here is the first paragraph of the article:

Federal Reserve officials are waiting to see how the economy performs before deciding whether to launch another bond-buying program.

The statement above is very direct; it does not contain “expected to” or “analysts believe the Fed will”. While anything can happen next week, the WSJ is always worth monitoring prior to Fed meetings. Below are some more excerpts (WSJ 01/20/2012):

Some Fed officials are open to more bond buying if the economy doesn’t continue to improve, or if inflation falls much below their objective of about 2%, but they believe the outlook is too murky to move now, and views vary on the costs and benefits.

John Williams, president of the San Francisco Fed, for example, said in a recent interview that he would support such purchases if he was sure of his economic forecast for low inflation, but he doesn’t have great confidence in the forecast yet. “And also there are costs to taking greater policy action. There are always trade-offs that have to be weighed,” he added.

Some Fed officials oppose more bond buying, echoing outside critics who charge that it has done little to support the economic recovery and might be breeding inflation.

Right now, with unemployment at 8.5% in December, the Fed is missing the mark on joblessness. Inflation overshot its 2% goal for most of 2011 but shows signs of retreating. Some officials, including Mr. Williams, believe that if inflation falls below 2% and shows signs of staying there, more bond purchases would be justified. But if inflation lingers at or above 2%, or unemployment falls faster than expected, then the case for more bond buying will become harder to make.

We have expressed our frustration and concerns about over-the-top market intervention from central banks. While we do not like it, we must be prepared for more of it. The excerpts below from a recent Mohamed A. El-Erian article highlight just how far the central banks have pushed the envelope:

Central banks have recognized all of this for some time, prompting them to take enormous reputational and operational risks to slow the process. They have implemented a host of “unconventional policies” that previously would have been deemed unthinkable, even outrageous – and that can be seen in the enormous growth in their balance sheets.

In the last four years, the United States Federal Reserve’s balance sheet has more than tripled, from under $1 trillion to a mammoth $3 trillion. The growth relative to the size of the economy is even more stunning – from slightly more than 5% of GDP to 20%. The Bank of England’s balance sheet is also at 20% of GDP. And both seem to be itching to do even more.

The European Central Bank is often viewed as a laggard. No longer. Its balance sheet has now doubled, to a whopping 30% of GDP – and it, too, appears set to do even more. Mario Draghi, the ECB’s new president, recently said that he expects heavy take-up on the next three-year long-term refinancing operation, a powerful tool to pump cheap liquidity into the banks.

Unfortunately, the economic outcomes have come nowhere close to matching the intensity of these efforts. Effectively, the central banks have been unconventional bridges to nowhere, owing mainly to their imperfect tools and other government agencies’ inability or unwillingness to act. At some point – and we are nearing it – bridges to nowhere become a standalone risk: they can topple over.

We are keeping an open mind about further upside. Not to be outdone by the ECB, the Fed is expected to announce another mega money printing extravaganza soon. According to CNBC:

The Federal Reserve is likely to step in with $1 trillion worth of easing that could be announced as soon as this month, according to a growing consensus of economists who see the recent uptick in economic growth as unsustainable. With the Fed’s Open Market Committee set to meet next week, expectations are rising that the languishing housing market will drive the central bank to buy up mortgage-backed securities.

When the Fed buys mortgage bonds in the open market, it is known as quantitative easing or QE. QE tends to drive up asset prices, as explained in this series of videos. We are reviewing possible investment options to prepare for QE.

With last Friday’s downgrades of European debt, the pressure from leaders, such as French President Nicholas Sarkozy, on central banks to print more money will increase. The concept of free markets is coming into question as government intervention is increasing at an alarming rate.

Over the past five years, the primary driver of asset prices could arguably have been money printing, which should be concerning for investors, money managers, and taxpayers. In the video below, we outline several negative consequences of central bank intervention, which allows commercial bankers and politicians to continually avoid difficult decisions related to the proper allocation of resources. The video also describes an ongoing transfer of toxic assets from private to public sector balance sheets, leaving the taxpayers on the hook once again.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

The problems associated with the seemingly endless expansion of central bank balance sheets were touched on in a speech given by Jamie Caruana, the general manager of the Bank for International Settlements, given at the Bank of Thailand-BIS conference on December 12; below are some excerpts:

An increase in monetary liabilities – eg reserve money – will have implications for the liquidity of the banking sector in the short run, and this may undermine price stability in the medium term. But an increase in long-term liabilities could also crowd out lending to the private sector.
Taking into account these transmission channels, it is quite clear that large expansions of central bank balance sheets have implications for both the real and financial sectors of the economy. They do create risks – and we must watch these closely. In some historical episodes, central banks did expand their balance sheets too much in order to finance profligate government spending. This often had inflationary results. On other occasions, central banks were too slow in reversing expansionary policies when conditions improved.

This sustained expansion means that the central bank’s balance sheet becomes more exposed to market developments – a fall in the value of foreign assets or a rise in long-term interest rates could reduce the value of its assets while leaving the value of its liabilities intact. Today, I would like to consider whether balance sheets of the current size could create broader policy risks. Such risks could include: inflation; financial instability; distortions in financial markets; and conflicts with government debt managers.

We believe flexibility is required in the current event-driven markets, since it remains unclear whether inflationary or deflationary events will drive asset prices in the intermediate-term.

The United States Treasury auctioned off $13B in new 10-year Treasury bonds today. The Fed bought roughly 61% of the bonds…think about that… it shows the sad state of affairs. Somewhere down the road, the U.S. will face the same problems as Europe.

Some will tell you futures are higher this morning due to Alcoa’s earnings. Keep in mind, Alcoa was down in the after hours session following Monday’s earnings announcement. What is the primary driver of this morning’s pop in the S&P futures? You guessed it….hope for more stimulus (a.k.a. money printing). From Bloomberg:

Emerging-market stocks rose to a one-month high amid speculation China will loosen monetary policies to bolster economic growth.

The “good news” coming out of China was that import growth fell to a two-year low, which means its time to, once again, print more money.

As stated numerous times in recent weeks, it is still prudent to see how the S&P 500 acts between 1,285 and 1,343ish. Approximate levels to watch include 1,293, 1,305, 1,326, 1,313, 1,324, 1,334, and 1,343. We are open to better than expected outcomes over the coming months, but it will be difficult for the market to gain sustained traction with significant problems in Europe.

From CNN (01/05/2012):

The debate over whether the Federal Reserve would pull the trigger on QE3 started even before QE2 ended last summer.

Now, six months later, the verdict is still out, but most of the investment experts surveyed by CNNMoney largely agree on one thing: the U.S. economy will have to get worse before Fed chief Ben Bernanke will even consider launching yet another round of asset purchases, a policy known as quantitative easing or QE.

“The Fed is already using all of the tools at its disposal to stem the crisis,” said Doug Cote, chief market strategist at ING Investment Management. “QE3 or bond buying of both U.S. banks debt and European bank debt remains a powerful tool but will only be used as a last resort.”

As we mentioned in a recent video, 2011 was a difficult year, primarily based on the ever-increasing central planning (read market intervention) influence on asset prices. Robert Colby posted the following:

Hedge Funds suffered their second-worst year on record in 2011, according to an index maintained by Eurekahedge, an independent research firm that specializes in hedge fund data. Some of the world’s largest and best-known hedge funds suffered huge losses, down 20% to 50%.

Under “normal” market conditions, banks assist each other with short-term needs via overnight loans. When banks are concerned about the assets on the books of other banks (European debt), they avoid lending to each other. The European Central Bank (ECB), which is fast eclipsing the Fed as King of The Bank Bailouts, is happy to help “private” banks with their funding needs when trust between banks is low. Therefore, when the ECB is making a lot of overnight loans to banks, it shows (a) ongoing concern about balance sheets, (b) lack of trust, and (c) concerns about getting paid back (see MF Global). Banks borrowed 17.3 B euros from the ECB last Thursday, 14.8 B on Monday, and 15 B on Tuesday, which according to the Financial Times is “exceptionally high even by standards set during the turbulent past few months”.

The bias for the first few weeks of 2012 may be bullish due to seasonal factors and recent market intervention from central banks. The European Central Bank’s (ECB) balance sheet expanded at an unprecedented rate late in 2011, which impacts market dynamics. Serious fundamental problems remain in the form of debt and demographics.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.