Yesterday’s trade on Wall Street demonstrated there is still a good deal of bullish sentiment out there. Going against this is usually a sure-fire way to trading oblivion but, I am still sticking to my guns.
Given that the outlook for stocks is pretty much interlinked with the outlook for QE, the two day meeting of the Federal Open Markets Committee has the potential to be a crucial one.
I don’t expect any major fireworks until about 7pm tomorrow night, when the Committee’s statement is released and “Helicopter” Ben Bernanke gives his press conference. If you can face living through an hour or so of the world’s leading central banker fielding questions and answers, this could well be worth a watch (it is usually streamed live on http://www.bloomberg.com/tv/).
What will be interesting is how Mr Bernanke answers the inevitable questions concerning the Fed’s plans to unwind the latest bout of QE.
Making such an open ended commitment was always going to be extremely difficult to withdraw from. The original aim was to give markets confidence that the Fed would “do whatever it takes” (borrowing from Draghi’s famous statement about the ECB’s commitment). If anything can be judged from this year’s euphoric stock market environment then at least by that measure the Federal Reserve policy could be viewed as a success.
Although many of the long term structural problems remain in place and an ultimate reckoning has probably only been postponed, while markets are going up today, no-one really seems to care about the troubles of tomorrow…
Sticking with the current challenge for stock traders, a lot will depend on the data. The FOMC has explicitly stated its intention to maintain the Zero Interest Rate Policy (“ZIRP”) while the unemployment rate is above 6.5% and inflation projections remain below 2% for the next one to two years. However the case for the bond-buying programme is less clear.
In the last policy statement the FOMC stated;
“In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”
One such reading on financial developments surely has to be the 20-25% rise in stocks in recent months.
Whatever other criticisms may be thrown at the staff of the Federal Reserve, no one can claim they are stupid (editor interject – I certainly do and will claim that they are ‘stoopid’ and that Mr Bernanke is in fact almost as dangerous a man as Hitler was). These are highly intelligent people and they will be aware of the near term threat any bubble in asset prices will pose to their efforts. Bubbles always pop and crush confidence when they do. Such is the persistently fragile state of the economy that it is highly unlikely it could withstand such an event. The FOMC will hopefully currently be figuring out how to let a little steam out of this rapidly overheating market without bringing the kettle to the boil.
Hinting at a reduction in bond purchases is the obvious way the Fed could signal an end to QE and this generally seems to be expected. Mr Bernanke’s comments about any changes to interest rate policy could hold something of a surprise factor.
There are some early indications that the market is slowly starting to expect that ZIRP will come to an end at least a year earlier than originally expected. Current forecasts estimate that US unemployment will remain above 6.5% until mid-2015. However money markets have recently nudged higher, indicating an expectation that rates will go up within 12 months by 0.25%.
Now this may not seem like a huge amount, but if this happens it will signal a significant shift in policy. One unintended consequence of all this is that market participants might start to pay a lot more attention to the following chart. It summarises the explosion in reserves held at the Federal Reserve since the start of QE;
This chart poses a real headache for the Fed.
On the one hand it helps partially explains why inflation hasn’t rocketed in the face of the incredible money printing operation of the last four years. In very simple terms the Federal Reserve created the money to buy bonds, it bought the bonds from banks and the banks deposited the proceeds back with the Federal Reserve. In other words the money largely didn’t find its way into the real economy (hence the ongoing lending crisis).
The problem is that the Federal Reserve has to pay interest on these reserves. Each 0.25% increase in interest rates represents an additional $5billion in interest costs the Fed will have to find (on reserves of $2trillion). Perhaps there is something I am missing, but the notion that Wall Street banks stand to gain an extra $5billion a year on money created to save their failed businesses is extremely hard to stomach.
Leaving the moral issue to one side, the practical issues of reducing the reserves, without triggering massive inflation nor increasing the servicing costs, all the while trying to maintain growth and manage assets bubbles in certain areas and deflationary pressures in others, all mean that the Federal Reserve finds itself between a rock, a hard place, another hard place and another hard place.
With such incredibly tough choices in front of it, this is why I suggested yesterday that second guessing the Fed is probably a fool’s game. Even so it is the game we are all playing at the moment, so here’s my best guess.
Overall the Federal Reserve can’t do everything at once, but nor can they fail to act. I believe this meeting of the FOMC will be used to cool market expectations about the bond-purchasing programme while ZIRP will be left alone. Logically this should lead to a shift in expectations, which also should lead to a sell-off.
However I have to accept the market rarely conforms to these sorts of logical exercises. Fundamentally I am trading on my bearish outlook. That said, I am planning to manage my stops extremely tightly. If the market offers me an opportunity to short on a sharp spike tomorrow, I will grab it.