- While QE policy has evolved over the past five years, it has never been successful in achieving the Fed's mandate.
- QE3 was a turning point in the policy when Bernanke abandoned the lending channel and specifically targeted the stock market.
- Using the stock market as a catalyst for economic growth and job creation has been unsuccessful.
- The combination of QE with zero-interest-rate policy (ZIRP) over the past 5 years has led to tremendous leverage in risk assets.
- The tapering of QE3 combined with the end of ZIRP will lead to an unwinding of that leverage and realign risk assets with the economic fundamentals.
Last weekend I watched all 13 episodes of the second season of "House of Cards." I couldn't help myself. It was that good. I would say that Frank Underwood is one of a kind, but that wouldn't be accurate, since he epitomizes to some degree just about every kind of political representative or government official that we have in Washington today. He is an amalgam of everything the public has come to hate about politics, and Kevin Spacey does a riveting job of portraying the character. This is not to say that Frank, despite his relentless pursuit of power, isn't charming, witty and a very likeable guy. There are times I find myself rooting for him, before realizing that there is an ulterior motive to his every move. He speaks with such gravitas and sincerity that I'm nearly convinced he really means what he says, until he turns to the camera in the middle of a dialogue (my favorite part of the show) and tells you what he is really thinking. Frank's problem is that when things don't work out as planned, he begins digging holes for himself. He digs a lot of holes in pursuit of his ultimate goal, and he doesn't mind sacrificing a few people (literally) along the way, but despite eventually achieving this goal, those holes are still out there, and if not filled, they could undermine all that he has accomplished.
When I think about Frank Underwood's seemingly illustrious political career, I can't help but think of Ben Bernanke's last five years as chairman of the Federal Reserve. I am not suggesting that Bernanke is the kind of guy who would throw a hard-nosed journalist just doing her job in front an oncoming train absolutely not. Ben, like Frank, comes across as charming, well-spoken and likeable. He speaks with a sincerity and certainty that makes me want to believe what he says. Yet when I move past his avuncular persona, I see a slew of unsavory ulterior motives to the policy decisions he has made while in pursuit of his stated objective, and the Fed's mandate, of full employment and price stability. Both goals continue to elude the Fed to this day. Bernanke sacrificed countless individuals in the process, figuratively speaking of course, and dug one monstrous hole that simply can't be filled. My fear now is that the investing public that suffered the consequences of the Fed's previous blunders leading up to the last financial crisis will fall into that hole. I suspect that if Bernanke were to have turned to the camera in the middle of one of his televised testimonies over the past year to tell you what he was really thinking, it would be that he has absolutely no idea of how to climb out of it. Perhaps that's why he was encouraged to retire.
After implementing a zero-interest-rate-policy (ZIRP) in 2008, Bernanke's answer for everything was an endless campaign of bond purchases, otherwise known as quantitative easing (QE). The Fed's QE program has evolved since its inception. Despite this evolution, following its initial launch, each time it was reintroduced and amended under the same guise as a program that promotes the continuation of the economic recovery by creating jobs and fostering price stability. It is without question that QE accomplished a number things, some transparent, while others not so transparent, but it failed miserably in achieving the Fed's mandate.
The first stage (QE1) lasted more than a year (Nov 2008 - March 2010), during which the Fed bought approximately $1.7 trillion of agencies, mortgage-backed securities and Treasury bonds. The stated objective was to stave off the deflationary spiral that was snowballing due to the collapse in credit, with hopes of reigniting the engine of economic growth by adding liquidity to the financial system and lowering borrowing costs. QE1 was largely successful, with the help of the Recovery Act, in stemming the financial crisis. Yet QE1 was as much about bailing out the then defunct shadow banking system and Wall Street banks as it was an effort to "reduce the cost and increase the availability of credit for the purchase of houses," as the Fed indicated in November 2008. Nobody was buying houses at that time, but lots of leveraged financial institutions were looking to dump the lowest quality mortgage-related debt that they held, which was plunging in value. Socializing the losses of private institutions fell below the radar of our incurious mainstream media as the S&P 500 (NYSEARCA:SPY) rebounded approximately 50% from the bear market low of 666 during this period. Although once the program ended, as if ripping a life preserver from the hands of a drowning victim, the market sank nearly 9% over the five months that followed. That is until Bernanke's Jackson Hole speech in late August 2010.
Bernanke intimated during this speech that a second program (QE2) was on its way, and it was formally announced during the Fed's scheduled meeting that November. The Fed purchased an additional $600 billion of long-term Treasuries at a rate of $75 billion per month through June 2011. QE2 was intended to lower long-term interest rates, and by proxy mortgage rates and borrowing costs in general, to "promote a stronger pace of economic recovery" and "foster maximum employment and price stability." It was a complete failure. In fact, long-term interest rates (10-year Treasury yield) rose substantially during QE2, as can be seen below. Businesses and households were still in the process of deleveraging, and there was little demand to borrow with the exception of the federal government. A more plausible rationale for QE2 was to finance what was expected to be a $1.2 trillion federal deficit and to lower the government's borrowing costs. The only quantifiable result of QE2 was a substantial increase in reserve deposits on the balance sheets of primary dealer banks, and the removal of higher interest-bearing assets from the marketplace.
Additionally, and perhaps becoming more meaningful to the Fed, the S&P 500 surged approximately 22% from the day of Bernanke's Jackson Hole speech until the end of QE2, after which it immediately began to slump again (like the lifeless body of that drowning victim), falling approximately 10%. That is until Bernanke's Jackson Hole speech in late August 2011.
During this speech Bernanke intimated that a third program (Operation Twist) was in the offing, and it was formally announced at the FOMC meeting a month later. This time the Fed sold shorter-dated maturities of Treasuries (1-3 years) and used the proceeds to buy longer-dated maturities (6-30 years) totaling nearly $700 billion in another attempt to "lower borrowing costs and improve general financial conditions." Long-term interest rates did fall, but the decline was as much a result of the sovereign debt crisis in Europe and the decline in US nominal GDP as it was from Operation Twist. Despite a near 20% increase in the S&P 500 during the 12 months that followed his speech, the economy was moving in the opposite direction. Real economic growth had fallen to 1.3% in the second quarter of 2012, and there were glaring signs that the economy was on the cusp of another recession. Real personal income growth on a year-over-year basis had fallen to a level that was lower than it had been at the onset of each of the previous ten recessions. This led what would be a decline in operating earnings for the S&P 500 on a sequential and year-over-year basis in the third and fourth quarters of 2012. This was the most critical juncture in the evolution of the Fed's QE policy, because I believe it was the point at which Bernanke gave up on the traditional transmission mechanism of monetary policy-the lending channel. It is also the point at which he started to dig what has become a cavernous hole for investors.
In a free-market economy there is something called the business cycle. It is like a wheel with four spokes that goes round and round. We have the early stages of an economic expansion when growth accelerates, followed by the later stages of that expansion when the rate of growth peaks. Then we experience an economic slowdown as the rate of growth decelerates, followed finally by a recession, during which economic growth contracts. During this last period the excesses that have built up from the previous expansion are expelled, setting the stage for a new expansion. For this reason, recessions are necessary and healthy, but painful. We have had 47 of them over the past 200+ years. Politicians and central bankers fear them, because they serve as referendums on their policies. Therefore, they try to delay them indefinitely, allowing even greater excesses to build, which ultimately result in more severe contractions. In the fall of 2012, Bernanke stuck his QE monkey wrench into the spokes of the business cycle during an economic slowdown in order to avert recession and a referendum on his monetary policy.
Bernanke was obviously aware at this point of the extremely high correlation between the Fed's bond purchases (QE) and rising stock prices. He understood how sensitive the market had become to the slightest intimation of a change in policy by either Fed officials or the Fed's public relations man at the Wall Street Journal, Jon Hilsenrath, whom he used regularly to test the market's reaction to changes in the Fed's thinking about stimulus. With the lending channel largely shut down, due to continued deleveraging, Bernanke decided to focus the Fed's policy efforts primarily on inflating stock prices, confident that the market's Pavlovian response to previous bond-buying programs would continue. He would use the stock market as a catalyst to achieve his objective through the so-called wealth effect, rather than allow it to function naturally as the discounting mechanism it is, and had reverted to when QE1 and QE2 ended. The monkey wrench was QE3, which was announced at the September 2012 Fed meeting, and is still ongoing in its tapered form today.
The Fed would buy $40 billion per month of mortgage-backed bonds. A notable change in this program, which I believe was an effort to avert the slump in stock prices that had occurred when QE1 and QE2 ended, was that it would be open-ended. The Fed noted in its statement following the meeting that if "the outlook for the labor market does not improve substantially, the Committee will…undertake additional asset purchases." Three months wasn't a lot of time to determine if the labor market had improved as a result of QE3, but the S&P 500 had declined modestly over this period, so the Fed increased its purchases by another $45 billion per month in long-term Treasuries, stating that it was in an effort to reduce an "elevated" unemployment rate, as well as to offset the end of Operation Twist.
In a twist of another kind, the Fed also offered what it referred to as "forward guidance." This was the antithesis of the intentional ambiguity for which Alan Greenspan was known, otherwise called "Fed speak." Greenspan didn't want the stock market to react to his comments, but Bernanke was depending on it. The Fed would hold short-term interest rates close to zero, so long as the unemployment rate was above 6.5% and provided inflation was not projected to rise above 2.5%. The stock market responded on cue at the beginning of 2013 and never looked back, with what was $85 billion per month in additional liquidity and a guarantee that short-term interest rates would stay near zero (ZIRP) until we approached quantitative thresholds that Bernanke said "will give markets more information about how we are going to respond going forward." That forward guidance was nothing more than a license for leverage handed to large financial institutions that borrow short-term at these very low rates and invest long-term in higher risk assets. Now these institutions could further Bernanke's objective of pumping up stock and bond prices, uninhibited with the knowledge that a yellow light would flash at what seemed like a very distant point down the road, warning them about when their cost to borrow would increase. Frank Underwood would have been proud, for when things aren't going according to plan, you say or do whatever has to be said or done to accomplish your goal. Worry about adverse consequences later on, and keep on digging that hole! Frank would surely have reappointed Bernanke at the end of his term.
Bernanke's shift in focus from the lending channel to the wealth effect with QE3 was based on a false premise and a very short memory. A month prior to the launch of QE3, he stated that higher stock and home prices would provide further impetus to spending by businesses and households. First of all, a very small minority own the majority of stock market wealth, while the majority own little to no stock, so the wealth effect is muted. Secondly, healthy spending results from rising incomes rather than from higher stock and home prices, both of which can decline just as easily as they can go up in value. In fact, sustainable increases in stock and home values, as well as the economy's ability to grow, are the result of rising incomes. Your ability to purchase a home is a function of your income and not your wealth. You can't spend your home, at least not anymore. Nor do investors typically spend their stock portfolios, hence the term "investor." If stock prices rise, that leads to higher levels of investor confidence, but if it is not coincident with an improving economy and rising income, it does not translate into consumer confidence or sustainable increases in spending. Bernanke clearly forgot that it was business and household spending, based upon a false sense of confidence in the inflated value of stocks and homes, which led to the dramatic contractions in consumption from 2000-2003 and from 2009 to today.
In essence, Bernanke has put the cart in front of the horse, and both are about to fall off a cliff. We are realizing the fruits, in higher stock and home prices, of labor that never occurred, both literally and figuratively speaking. Literally, the headline improvements in labor are not as substantive when analyzing the quality of the jobs lost compared to the ones gained, and the absence of any improvement in wages is indicative of that fact. Figuratively, we have done very little work in terms of entitlement reform, financial regulation and economy policies that would build a foundation for sustainable growth. Instead, we have basked in the paper wealth of a monetary mirage that makes things look a lot better than they really are today. This financial wealth should be resultant from these developments, and not a pathway towards achieving them. To the contrary, in its effort to anesthetize the economy from any hint of recession, as it did in 2012, the Fed has simply delayed the need for us to do any of the heavy lifting that must be done to restore stability. History is repeating itself.
Now the taper is underway as the Fed takes credit for the meager progress in economic growth, job creation and price stability, each of which would have occurred on its own without the Fed's intervention. At the same time, the unemployment rate is rapidly approaching the 6.5% threshold that the Bernanke Fed used in its forward guidance a year ago to determine when it would consider raising short-term interest rates, but the Fed is not yet prepared to end its zero-interest-rate policy until the tapering of QE3 is complete. Rather conveniently, it has also acknowledged that the 6.5% rate of unemployment is not as accurate a measurement of economic health as it once thought. Therefore, the Fed adjusted its forward guidance from one that was quantitative to one that is qualitative by eliminating the unemployment rate as a threshold in its most recent meeting on Wednesday.
In a return to ambiguity, the Fed statement read that it "would rely on a wide range of measures in deciding when to raise interest rates." Janet Yellen, in her first press conference as the new chair of the Fed, provided more clarification of what that meant. In doing so, she gave us a glimpse at the size of the hole that the Bernanke Fed started digging back in 2012, and a preview of what I expect to happen on a much grander scale in the months ahead. Yellen said that interest rates would remain near zero for a "considerable period" after the conclusion of QE3. When asked what a considerable period would be, she responded that it would be "six months." The Dow Jones Industrials Average (NYSEARCA:DIA) plunged 160 points within eight minutes of those two words, in what was clearly a sharp, but brief, deleveraging response to a flashing yellow light that had not been anticipated. Now when Frank Underwood is at risk of falling into one of his own holes, his wife Claire comes to his aid with a temporary fix. I suspect that Janet Yellen will have to serve in that same capacity for Ben Bernanke, but her work is cut out for her at this point.
What is very clear from the past five years is that the stock market rises when the Fed buys bonds. The correlation is so tight that during the weeks when the Fed did not by bonds, the market declined, as can be seen below.
Due to the fact that markets respond to rates of change, rather than to absolute numbers, it appears that tapering is having the effect of simply levitating the market indices at levels where they began the year. If the pattern of the past five years persists, then we can only assume that stocks will decline when the bond purchases end later this year. The Fed is relying on an improvement in economic conditions, resultant from the increase in asset values to date, to break this pattern. Yellen stated that the Fed sees the weather as an excuse for the first quarter slump, but that is an excuse for the continued economic malaise. Consumer confidence and small business sentiment both still remain at very depressed levels, and the most recent NBC/WSJ poll found that 57% of Americans believe the US is still in recession. The Fed's forecast for an acceleration in economic growth to 3% this year is not going to materialize.
What concerns me is not the taper, but the end of ZIRP. If the market plunges on the suggestion that short-term interest rates will rise as soon as one year from now, it implies that there is a tremendous amount of leverage in the shadows on Wall Street and beyond. How much, no one knows, but we will find out. Dare I remind readers that our financial markets are still cesspools of unregulated speculation, as was proven in the $6.2 billion trading loss that JPMorgan suffered in 2012. I think we are at the beginning of a monumental game of musical chairs in which the leverage that has built up over the past five years on a steady stream of liquidity and zero interest rates must be unwound before rates rise. The institutions that play this game don't wait for the music to stop playing before deleveraging. Whether the deleveraging process results in a correction or a bear market depends on how much Fed-induced leverage there is in the financial system, and how far divorced the stock market has become from the economic fundamentals.
Bulls will counter that none of this matters, because corporate earnings have kept pace with the rally in stock prices, and that the stock market is fairly valued at worst. This view dismisses the fact that corporate earnings growth has been as much a byproduct of financial engineering in the wake of zero-interest-rate policy as it has economic growth. An estimated 216 companies in the S&P 500 have derived more of a boost in earnings over the past five years from reducing their share count through buybacks than from the growth in their underlying business. Huge quantities of corporate debt at historically low yields funded those share repurchases. This is a short-term strategy to boost profitability for most companies, which when coupled with the pace at which corporate insiders are selling their own stock, is a dubious development at best.
I hope that investors do not fall into the trap of viewing the stock market today as the discounting mechanism it used to be-it is not. The Bernanke Fed changed that. Wall Street refers to it as still being so in order to support its consistently bullish thesis. The depth of the hole that the Bernanke Fed dug with its policies can only be measured by how far the stock market indices have been divorced from the real economy. There are very insightful and experienced professionals with proven track records, like Jeremy Grantham, who believe that hole is approximately 750 points on the S&P 500, based on his fair value of 1100. That would be a 40% decline from current levels. The consensus target on Wall Street for the S&P 500 in 2014 is 1950. It obviously sees no hole at all. At some point during the process of tapering QE3 and ending the Fed's zero-interest-rate policy, the stock market will revert from a catalyst to a discounter, leverage will unwind and the house of cards that Chairman Bernanke built will fall.