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In mid-December ("2013: The Year Of Printing Money"), I predicted that QE3 would prove to be highly bullish for the stock market. I wrote:

"Assuming that the Fed implements QE3 as announced on Wednesday, I expect to see the Dow around 15,000 next Christmas. This is because the Fed's balance sheet should grow by $1 trillion next year, a 36% increase over where it is now. By year-end, I expect nominal GDP growth to have accelerated from its current 4% to a level closer to 5%. I am therefore bullish about both economic growth and equity prices."

Since I wrote that statement, the Dow has risen by over 1,100 points, or 8.5%. Over the same time period, the Fed's balance sheet has grown by $240 billion or 9%*. As the Fed's balance sheet has grown since December, the stock market has steadily risen. I don't think this is mere happenstance; I think it is cause and effect. The stock market did not rise just because the Fed bought more bonds; it rose because the market has become convinced that the Fed intends to fulfill its statutory mandate by buying bonds until unemployment has declined to a normal level. In other words, the market has begun to believe that the Fed's promise of an employment target might be credible and not merely a nice gesture.

Last year, the employment target had little credibility because a number of FOMC members had expressed reservations about such a radical policy (unlimited open-ended bond buying). Some members expressed doubts about the unlimited horizon for the program, suggesting that it could be stopped at any time. If the new policy had been credible, the market would have reacted when it was announced in early September. In fact, it did not even react when the Fed began buying bonds after its announcement. It only reacted when the scale of bond buying became material and began to appear in the monetary base in January.

I think it is important to keep the scale of what is happening in perspective. The drive-by commentariat (on both the right and left) continue to believe that the Fed is buying bonds on a massive scale. They believe this because it would be too much trouble to dig up the actual data. Under the Fed's "reckless" and "inflationary" QE3, the monetary base has been growing in the single digits (after not growing at all for 18 months), and the money supply (M2) has been growing at the same moderate pace. The news is not that the Fed's balance sheet is growing rapidly; the news is that the Fed's balance sheet has finally begun to grow. Under five years of QE, the money supply has never grown faster than 11% and has averaged in the mid single digits. Under QE, core CPI has never exceeded 2.5% and has averaged substantially below the 2% target. And yet the TV economists are still debating whether "the economy is on crack" and "how we can get off of our addiction" to monetary stimulus.

One thing that puzzles me is the rather disingenuous way that Bernanke is trying to sell QE3 to Congress and the public. He says that he is buying bonds in order to lower long-term interest rates and support the mortgage market. This sounds plausible and sensible, but it just isn't true. Bernanke is buying bonds to raise inflation expectations and thus bond yields.

One need only consult Bernanke's own writings to know that the purpose of QE is to raise inflation expectations and bond yields. That is because the only way to lower real interest rates in an ultra-low rate environment is by raising inflation expectations. The Fed needs to convince the markets that it is sincerely committed to fulfilling its full employment mandate, even if it means exceeding its inflation target.

This is what Bernanke told the Japanese ten years ago, when he advocated price-level targeting for Japan:

"Inflation above zero will be needed if real interest rates in Japan are to be negative for a period, as many observers think is necessary for full recovery...

A period of reflation would provide a boost to profits and help to break the deflationary psychology among the public, which would be positive factors for asset prices as well...

Price-level targeting, as opposed to more conventional inflation targeting, requires a short-term inflation rate that is higher than the long-term inflation objective."

What Bernanke said ten years ago still applies: a successful reflation policy requires changing inflation expectations. If QE3 is to succeed, bond yields must rise to reflect the expectation that inflation will be higher than the level embedded in today's yields.

Unfortunately, we're not there yet. Reflation has not gained credibility in the bond market, as the 10-year rate remain stuck below 2%. The market does not believe that the new policy is for real. It believes that the minute unemployment ticks down, the money spigot will be turned off.

Bernanke is now struggling to convince the markets that he means what he says and that he has the votes on the FOMC to pursue QE3 until unemployment comes down to a significantly lower level. In my view, this will require an additional one percent of inflation. As the current pace of QE continues, we should start to see higher inflation by the end of Spring. Bad for bonds, but very bullish for equities.

In December, I predicted a 15,000 Dow by yearend. My current view is that we will get to 15,000 by mid-summer.

Note to bondholders:

If I am right and Bernanke succeeds in raising inflation expectations, you are about to be clobbered. You may believe that QE is your friend, but it isn't. As long as the monetary base grows, you will be fighting the Fed, and the Fed will win. Get out now while you still have your shirt on. You will never see rates this low again.

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*See data

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Stocks Will Go Higher As Reflation Gains Credibility