After Jackson Hole, Clear Road Ahead?

In terms of forward guidance I think the Fed Chairman's speech provided little direction, but Friday's precious metal price action into the close and the various sell side notes that I have seen suggest that this, at least initially, is too bearish a conclusion. The following excerpt from the speech, in particular, was taken as clear evidence of more and aggressive easing in the pipeline. 

As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.

Great emphasis has been attached to the chairman's use of the word "grave" as a clear tell-tell sign of more easing to come. I find this quite interesting since it is one of the first instances of such "new speak" interpretation of the Fed's statements akin to the good old days of Trichet and the utterance of (strong) vigilance. Needless to say, next week's jobs market report has suddenly been propelled to a key market event and every single US data point will now be watched with caution. On that note, the next ISM reading as well as consumption figures will be equally important to watch. 

I think Tim Duy’s interpretation is the right one then (hat tip Calculated Risk) with my emphasis.

On net, Bernanke's speech leads me to believe the odds of additional easing at the next FOMC meeting are somewhat higher (and above 50%) than I had previously believed. His defense of nontraditional action to date and focus on unemployment points in that direction. This is the bandwagon the financial press will jump on. Still, the backward looking nature of the speech and the obvious concern that the Fed has limited ability to offset the factors currently holding back more rapid improvement in labor markets, however, leave me wary that Bernanke remains hesitant to take additional action at this juncture. This suggests to me that additional easing is not a no-brainer, but perhaps that is just my internal bias talking.

On balance the main point for me is that the recent change in economic data clearly merits policy change on the basis of the Fed's reaction function. 

The unemployment rate in the US is sticky and the Fed has been persistently concerned about this which is indeed a strong signal to the policy bias especially as inflation expectations are well behaved. Inflation has come down significantly in the US running at 1.4% YoY and the Taylor Rule rate is now declining (though still in level terms way above 0 but that has more to do with the inputs than anything else). We have had two consecutive months of sub-50 ISM readings and consumption growth appears to be rolling over. My interpretation of the forward looking indicators is that they look better than the consensus suggests, but the Fed lives in the here and now and will act accordingly.

Another interesting point here is that despite the visible and strong recovery in the growth rates of US housing market indicators, Bernanke mentions the level of the housing market and not the change which suggest that the despite a good run of data with respect to the change in housing market indicators the level is still seen as depressed. 

The bottom line is that some form of easing is coming but what I find highly uncertain is the timing and aggressiveness of such easing. The August minutes had already stipulated potential moves for the Fed in the form of an extension of the low interest rate commitment, lowering interest rates on excess reserves as well as an extension of Operation Twist or outright asset purchases (probably through MBS securities). But which of these measures will be employed and in what order?

One thing for example which I find very interesting is the glaring gap between Bernanke's discussion of the effectiveness of unconventional monetary policy and its effect on the real economy (i.e. labour market). In that sense, it seems quite clear to me that quantitative easing can have a strong effect in the context of imminent deflation risks and strong downward pressures in asset prices. In such an environment the portfolio effect and, indeed, outright price effect from aggressive central bank action can be very effective. 

However, whether quantitative easing can be effective in countering a structural and sticky unemployment rate (and indeed a structurally declining labour force participation rate) seems much more uncertain to me. Obviously, this goes back to the point that the Fed is the wrong tool for the job at hand, but it also raises the issue of what kind of easing the Fed is planning here.

Of the measures mentioned above one of the only things which would have an effect on the labour market (from a theoretical point of view) is an extension of the low interest rate commitment. This would be a signal to companies that their cost of capital would remain low and incentivise investment and thus, in theory, additional labour input. But such a process is slow and arguably a weak remedy in the context of structural labour market issues.

More generally, we must ask ourselves whether an extension of the low interest rate commitment be enough for the market Clearly not and in any case, an extension much beyond Bernanke’s term would be meaningless as the looming presidential election has created uncertainty as to how strong this commitment is, if for example Bernanke is faced with a Republican president.

What about an extension of Operation Twist then? If this is combined with an expansion of the balance sheet through purchases of MBS I think this could be an effective medicine (although in general I find it hard to see how it could meaningfully affect the labour market). However, the theoretical argument here is fair. By influencing long rates the Fed is likely to stand the greatest chance of supporting the ongoing recovery in the housing market and thus, by derivative, the US economy. 

Ultimately, I see two sources of uncertainty here. Firstly, it is not clear to me that the US economy is heading into a hole in the second half of 2012 to an extent that would allow very strong Fed action. Secondly, while the Fed clearly seems committed and perhaps even pre-committed to more easing the nature of such easing and its scope is still very uncertain to me. The upside risk attached to much stronger easing is clearly there (not least because we also have the ECB coming in with policy measures soon), but the spectre of grave disappointment has not been completely extinguished in my view. 

Random Shots - Fed Outgunned, EMU Outflanked

As I read the latest round-up of comments by Fed officials that they are certainly not ruling out another round of asset purchases I am wondering whether this signals another round of actual quantitative easing by the Fed or whether investors should change their mindset back to before the crisis where it wasn't the USD that acted as the global carry trade funder but rather the JPY (or maybe the GBP here?). 

Quote Bloomberg

Fed Vice Chairman Janet Yellen said yesterday that a third round of large-scale asset purchases “might become appropriate if evolving economic conditions called for significantly greater monetary accommodation.” A day before, Governor Daniel Tarullo said buying mortgage-backed securities “should move back up toward the top of the list of options.”

They join Charles Evans, president of the Chicago Fed, and Boston’s Eric Rosengren in calling for consideration of further stimulus to boost growth and bring down a jobless rate stuck around 9 percent or higher for 30 months. A stock-market rally and gains in manufacturing and retail sales may convince the Federal Open Market Committee, which meets Nov. 1-2, to decide that it’s too soon for a third round of bond purchases.

You see, the recent initiative of the Fed in the form of Operation Twist is not quantitative easing since it does not involve an expansion of the balance sheet. In stead, it is what we refer to as qualitative easing as the bonds the Fed intends to buy on the long end (to move long rates down to help the mortgage market) will be paid for by proceeds of selling bonds on the short end. 

The biggest problem for the Fed here is not necessarily that Operation Twist is a bad idea. Indeed, to the extent that it fixes the effort squarely on halting the slide in the housing market and supporting volume and price in the primary and second market for mortgage securities I think it is an excellent idea. 

But we are forgetting the auxiliary objective of QE by the Fed; to weaken the USD. Make no mistake that this is an important objective for the Fed even if they have never declared this formally. And herein lies the rub.  Quite simply, with the recent announcement by the BOE of another round of QE worth £75 billion, with the ECB now willingly or unwillingly being forced into increased support of peripheral debt markets and with the BOJ also pledging more stimulus, the Fed is starting to look like the conservative central bank in the G4. [1].

In my opinion, this is very significant and also one of the reasons why Fed officials are busy ensuring markets that they have plenty of ammunition left should economic conditions merit it. But investors should not take anything at face value I think. Before the Fed actually starts to buy those MBS and/or moves to lower interest rates on excess reserves there is a real chance that especially the JPY will start to act more like the JPY of old, a.k.a global carry trade anchor of choice. Of course, this requires the BOJ to back up all the pledges with real action. For now though, the only thing we can say is that the Fed looks set to be outgunned by its peers in the G4. 

EMU Outflanked 

Is Europe now finally getting down to serious business or is it just another round of fudge from the fudge factory that investors have learned to respect for its ability to produce relief rallies out of nothing. Looking at the evidence I am thoroughly inclined to go for the latter even if each failed attempt to shore up market confidence brings Europe closer to full fiscal union. 

Even if Merkel and Sarkozy, and rightly so, appear most concerned with putting pressure on Italy, the most significant issue remains Greece. The country is now in default, a fact that was un-sanctimoniously confirmed by the leaked bailout document which has the Troika admitting that the medicine they were mandated to administer would only make the patient worse and not better.

Quote FT

Greece’s economy has deteriorated so severely in the last three months that international lenders would have to find €252bn in bail-out loans through the end of the decade unless Greek bondholders are forced to accept severe cuts in their debt repayments.The dire analysis, contained in a “strictly confidential” report by international lenders and obtained by the Financial Times, is more than double the €109bn in European Union and International Monetary Fund aid agreed just three months ago. 

The most recent estimate of haircut has now risen to 60% and this, mind you, would only reduce the debt to GDP to 110% and this without any consideration on how Greece is supposed to grow itself out of this level of debt while simultaneously dealing with the default. In addition and only adding to my disdain for the ECB, Reuters reports that the central bank opposed a 60% haircut on account that it  the private sector would refuse likely refuse this leading to a "fullscale" Greek default. 

I am continuingly amazed by the denial here. Ever since the first Private Sector Proposal (PSI) was put on the table, Greek has been in default and figuring out who would pay for recapitalising banks as a function of how large the final haircut ends up are merely steps in the actual default process. 

The second issue on the table is what to do with the increasingly freakishly looking EFSF. There has been no shortage of suggestions on how to increase the scope of the fund using the same guarantee by the same countries for the same amount of money (currently €440 in effective capital). The suggestion that might actually work came from France which has aired the suggestion that the EFSF be turned into a bank which would then allow it to access liquidity from the ECB. Both Germany and the ECB however have vehemently denied this which indicates that there is still notable reluctance to allow the ECB to wield the full arsenal of quantitative easing. 

The proposal which currently seems to have most traction is to turn the EFSF into a monoline insurer which would essentially use its capital to insure anything from 10% to 30% on any new issuance of sovereign debt by Italy and Spain. Crucially, the idea is that this "leverage" would bring calm to markets as this insurance could cover as much as 2 trillion worth of debt. 

I really struggle to find adequate words here. I think this is madness and if any Eurozone politician were afraid that an equivalent of AIG would certainly enter the scene, they now seem content on creating one. The first and most widely flagged issue is this would obviously create a two tier bond market. 

Quote Reuters 

This would create a division between insured and non-insured debt, that could split a country's investor base and suck liquidity out of the market unless new bonds were carefully constructed to allow them to trade on a par with existing debt."The issuer would have to create a new curve of insured debt, limiting the liquidity in both curves with risks that investors would dump the old non-insured bonds," said Commerzbank rate strategist Christoph Rieger.

Based on a 20 percent insurance model, JPMorgan estimates that insured bonds issued by Italy would trade at a yield around 100 basis points below existing debt with new, insured Spanish debt likely to be priced 80 bps lower than existing bonds.

I think this is significant, but we are missing the main point here. If this is set ut Spain and Italy will likely never be able to issue un-insured debt again and the contingent liability here is not only complex but will lock in future capital commitments to this aim of providing first loss insurance. For me, this is a horrible way to spend already scarce capital. 

Another issue is obviously that it assumes that it will make the Spanish and Italian problem go away which it clearly won't. However, much more fundamentally; while the idea is to ring fence Italy and Spain it almost guarantees painful haircuts in the case of Ireland, Portugal and Greece and once again, who will pay for those I might ask. 

The only silver lining I have seen in the latest reports is that it seems to me that while the imminent obejctive is to fiddle with the EFSF, there has also been serious talk about bringing forward the ESM which would have a much stronger mandate and essentially constitute a first step towards socialising of sovereign risk in the euro zone. Until that happens, the EMU and her politicians will be continuously outflanked by economic realities. 

---

[1] - I repeat that with the ECB not formally in ZIRP mode, the Fed still has the yield disadvantage here but do we really expect the ECB not to lower going forward? 

QE and the Wealth Effect in the US

Events in Japan and Libya do not seem to have derailed the ongoing positive sentiment in the market, but it might just have alerted various Masters of the Universe that black holes (or was that swans?) are both invisible and unpredictable until they occur. It is precisely because of this that such events are important even if I think that hedging against so-called "tail risks" by buying specially tailored financial products is probably as effective as buying an extra swim suit in anticipation of the next tsunami.

On that note and if there ever was a clearly signalled change in the daily state of the market it is the end of the Fed's QE2 and thus the end of unconventional monetary measures by the Fed. It would then seem to be a simple exercise of discounting information which is already incorporated into current market prices, but it is anything but. This is due to two things in particular;

• While it is certain that QE2 will end, it is considerably more uncertain whether QE itself will end and it seems as if the market is implicitly expecting a continuation in the form of QE3. But it is not clear cut. The macro picture is brightening in the US and Fed officials are getting more hawkish and what was certain a few months ago, may not be so certain today. In addition, if the perception changes into an expectation of an end to QE the path and pace of the Fed's exit strategy is also uncertain.

• There is considerable uncertainty (and disagreement) as to the exact effect of QE in the first place and this shows itself on two fronts. One is the discussion of whether QE has been a success or not and the second is the more technical (yet equally important) question of through which channels QE can be shown to work (if at all). Krugman recently suggested the exactly the stock market effect which this post is based on.

In order to get to grips with this I thought it would be apt to center my analysis on the horse's own mouth as it were and specifically the idea that the Fed is targeting stock prices. Obviously, if asked directly Bernanke and his colleagues would certainly point out that it is not all about stock prices but a much more complex issue of affecting rates on all maturities of the yield curve as well as to repair the the monetary policy transmission mechanism as well as the monetary multiplier.

Yet, given chairman Bernanke's comments that the success of QE2 is linked to rising stock prices I thought it would be interesting to have a look at the macroeconomic effect of rising stock prices and thus the idea of the wealth effect. This is to say, what is the effect of rising stock prices on personal consumption expenditures and thus, in some sense, growth?

In summary, my analysis gives the following hints to the wealth effect in the US

• The wealth effect from the stock market in the US is time variant but appear to be particularly strong in the period 1999 to 2010 which, in some sense, validates the Fed's focus on stock prices.

• The wealth effect also shows up in a negative relationship between changes in the SP500 and changes in the saving rate which suggest that rising asset prices may counteract deleveraging.

• The fiscal multiplier estimated here is also time variant and seems to change signs across periods.

• The marginal propensity to consume seems to have risen over time in the US.

Here, the two last bullet points are secondary to the main focus of this note but still worth thinking about.

(click on pictures for better viewing)*

At a first glance, it is difficult to see any meaningful correlation between the two, but look closer at the period from 2007 and onwards (as well as in 2001) and you will see a closer semblance. But this may also be a case of the infamous spurious correlation as stock prices and consumption are strongly correlated around recessions and thus also in the rebound.

Surely, the linear fit depicted above for the full period is not statistically significant which suggests that measured over the grand sweep of time there is no meaningful correlation between changes in stock prices and changes in consumption expenditures. Importantly, this would also seem to invalidate the Fed's link between QE2 and rising stock prices since such a link is empirically dubious at best. Yet, as the graph from the period 1999 to 2010 shows the link may have strengthened.

To that end I have conducted a small study fitting a linear model with the annual change in consumption expenditures as dependent variable to the change in the SP500 as well as government transfers and real disposable income to control for the marginal propensity to consume and the fiscal multiplier. I use monthly values to get 612 observations in the full sample regression (1960 -2010). Crucially, I split up the dataset in three periods; 1960-1980, 1981-1998, and 1999-2010.

In the full period, the estimation gives an MPC of 0.41 [1], a multiplier from government transfer worth of 0.09 and from the SP500 equal to 0.027 (all significant at 1%). This implies that a 1% annual return in the SP500 yields an increase the annual change of consumption expenditures of 0.027%, but the results also indicate that the "fiscal multiplier" is about three times larger. So, not exactly convincing results to support QE as an attempt to boost consumption through the stock wealth effect.

Splitting the period as noted above [2] does seem to add value to the analysis. For the period 1960-1980 the simple OLS estimate yields nothing and not even the estimate for the MPC is significant [3]. In the period from 1981 to 1998 the MPC is estimated to be 0.48, the multiplier from government transfers at 0.14 and lastly for the SP500 at 0.014 although this estimate is only significant at 10%. The period from 1981 to 1998 thus return a strong fiscal multiplier (at least in terms of significance) while a weak, at best, multiplier from the SP500.

In the final period however, something interesting happens. The MPC increases to 0.58 which squares well with the declining saving rate in the same period. More interestlingly however, the estimate for the fiscal multiplier changes signs while remaining significant at 1%. The estimate suggests that a 1% increase in government transfers will yield a -0.36% decrease in consumption expenditures. Surely, proponents of Ricardian Equivalence would be interested in testing more thoroughly for the validity of this estimate. Meanwhile, the estimate for the wealth effect from stocks is estimated at 0.035 and significant at 1% (and thus quite close to the wealth effect estimated in the full period).

Finally, and focusing on the period 1999-2010, I also fitted a linear model with the savings rate as dependent variable. The rationale here would be that the wealth effect from the stock market should materialise in a negative relationship and thus that a rising stock market would counteract deleveraging. Not surprisingly the coefficients for both changes in income and changes in government transfer are positive which suggests that higher income and transfers from the government leads to higher savings (that Ricardian Equivalence again?). The coefficient estimated for the SP500 is negative and much higher than the wealth effect to consumption. All estimates are significant at 1%.

The What, Why and Where of QE

As my readers would no doubt remind I have added nothing to the debate of whether QE affects stock prices in the first place and then has an effect on the real economy through the wealth effect. I have taken this as given on particular notice of Bernanke's explicit comments on the success of QE2 in relation to a rising stock market.

As it turns out, the story is a bit more complicated than that.

Take Morgan Stanley's Gerald Minack for example who recently came out strongly against the notion of QE as a driver of risky assets which invariably leads to a much more bullish and broad based recovery discourse;

I am pushing back against the view that QE – particularly the large-scale asset purchases – directly drives risk assets. The reason I am skeptical is that no one has to my satisfaction explained how – sentiment aside – QE has had a material effect on the demand for, or funding of, risk assets. It’s not even straightforward to isolate the effect of QE on the assets that the Fed purchased.

(...)

As I see it, QE2 was a $600bn placebo. If enough investors think it was good for risk assets, then perhaps it was good for risk assets. Stopping the placebo may have an effect, but my sense is the macro will remain the key driver of risk assets.

The first part of Minack's objection to the QE-Risk Asset synthesis is important and I have also found it difficult to replicate the idea that QE directly drives risky assets . But the link need not be that specific for the end of QE to have an adverse effect of the growth narrative. I think the underlying reason as to why the market may now be driven by the improving macro picture is exactly because QE is seen as an integral part of that improvement. It then stands to reason that if and when QE ends (without extension) it will have an impact. Another point relates to the idea that the commitment itself to QE is paramount and thus that the largest effect of QE is back loaded around the announcement [4]. I think it is an accurate way to frame the effect of QE but this also implies that a second layer of expectations may take hold in the form of the expectation of the announcement. In reality, it is difficult to see how many of these "announcements" the market has discounted I think.

An altogether more heavy analysis recently came from CSLA's Russel Napier simply noting that investors ought to sell US equities on the failure of QE2. Napier particularly makes the point that QE2 has materially failed to induce banks to increase credit.

Broad money has contracted since the launch of QEII in November 2010 and this suggests that rising growth and inflation are not likely. QEII is boosting unused bank reserves, but banks continue to shrink credit and it is having no direct positive economic impact beyond depressing Treasury yields. Equity-market valuations are close to bubble levels and need the prospect of higher inflation and negative real rates to continue higher: but M3 is contracting.

(...)

The failure of QEII will undermine investor faith in a monetary solution. With equities near bubble valuations, based on cyclically adjusted PE, a failure to reflate risks major downside. The Fed will try again with a new package, but investors would do best by waiting to see how it plays out.

This analysis then suggests a much more imminent and substantial effect of the alleged failure of QE2 and thus also the effect of a non-committal to QE3. Clearly, we are now in the situation where this illusive concept of the monetary transmission mechanism becomes important.

Thus, has QE2 succeeded because it has helped equity prices to rally or has it been a failure because of its inability to induce more than an increase in excess reserves?

I won't pretent to give full answer on this (Napier's analysis is difficult to disagree with) and I would like instead to yield the floor to John P. Hussman who recently had a very well written and balanced column on the end of QE2;

My intent is not to argue strongly that the economy cannot continue to expand as fiscal and monetary stimulus comes off, but instead to at least ask why this should be expected as a foregone conclusion. On the basis of leading indices of economic activity, we observe more indications of economic slowing worldwide than we observe growth. Moreover, strong periods of employment growth have historically been preceded by high, not low, real interest rates. This is far from a perfect relationship, but it is clear that historically, high real interest rates are far more indicative of strong demand for credit, new investment, and new employment than low real interest rates are.

I would file this under "I'd wish I said that". The big question then remains as to what kind of momentum the economy and risky assets will retain once stimulus comes off.

To summarize, I have been critical of the Fed's decision to tie its policies so close to the movements of the stock market and I still am. The idea to implicitly target stock prices is the ultimate form of hubris that a central banker can commit since it plays into the notion that the central bank can consistently fine tune financial markets. It can't. However, my analysis above gives some support to the idea that QE works, and works well, through its effect on stock prices. At least, I would note that the extent to which e.g. Krugman is right the apparent change in the wealth effect over time gives some credence to Bernanke's comments in 60 minutes even if I don't agree with the Fed's strategy on this point.

---

* The data used for my estimations are monthly data from the St. Louis Fed's database.

[1] - Clearly this is below traditional Keynesian estimates but remember that we have monthly data in changes and thus likely to have stationary time series (i.e. we have detrended series!).To be rigorous one would obviously have to properly test the unit root properties of the series in question.

[2] - I am considering writing this up as a small paper trying to quantify the structural breaks in the data as well as to fit a non-linear model.

[3] - Which points to the notion developed exactly by researchers (Friedman for one) using data for that period that consumers spend out of permanent income and not current income.

[4] - I believe Goldman Sachs made a top notch study on this.