We are believers in the power of monetary policy. We are even bigger believers in the power of the tape. Yet they are both limited, and reading the FOMC minutes -- which we have been reading for more years than we care to admit -- left us with an uneasy feeling. The impression for the market may have been the ever-tradable lure of more liquidity, but for us it was one of people slowly running out of options.
Here is the magic language from the minutes that pushed a declining market back into the green:
Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.
In other words, buy stocks because either the economy goes up or the Fed prints more money. In other words, the Bernanke put is on.
We were generally supportive of TARP and past quantitative easing (neither perfect, but nothing ever is) as having bought time for the economy and providing support to the financial system while structural adjustments proceeded. Without easier monetary conditions, banks would still be in the dumpster, along with credit, housing, the bond market and the financial sector.
As bad as lending conditions still are for housing, for the last 50 years banks have been behaving the same way -- turning a profitable sector into a credit fad and then drowning it in the name of market share, management bonuses, takeover avoidance, or whatever. Once they blow a sector up, nobody wants to hear about lending to it again for another generation of CEO management, which runs for about five to 10 years (the last thing that managers brought in to replace disgraced managers want to do is more of what got their predecessors sacked). Banks finally got around to blowing up housing, so now we have a generation of bank executives in place whose unifying feature is the determination to avoid a housing bust that won't happen again for another 70 years or so. The Fed can't do anything about it.
The good news is that most necessary structural adjustments have either largely taken place or are underway; the U.S. is actually fairly well-placed relative to the rest of the developed world. The drawback is that monetary policy really doesn't have much left to contribute at this point. One of the only two real positives we can see at this point from further Fed easing is a continued depreciation of the dollar, which has benefited exports and sparked a favorable shift in the cost of production to U.S. employment, in particular manufacturing.
Currency adjustments are both necessary and desirable to restoring trade equilibrium. We would even argue that the slowness in adjustment brought about by those exporting countries that resist currency appreciation has had a beneficial effect on the U.S. financial system. Stretching out the pace of depreciation assists an orderly transition, regardless of the motivations of the exporters (before you explode, we would also add that Chinese currency manipulation has been excessive and the West has been too timid in confronting it, to its own detriment).
However, as the past decade has amply demonstrated, there are real dangers to too much of a good thing. Downward currency spirals are treacherous once started. We don't see that as an imminent danger, except under the one circumstance that worries us in connection with more Fed easing.
The other remaining positive that we believe monetary policy has in reserve is to provide a cushion after the European dust-up that may or may not happen. We have no doubt that the much-rumored Draghi bazooka could give financial asset prices another three-to-six month boost, provided it was impressive enough (the current market favorite is quasi-unlimited sovereign bond-buying by the ECB, under the guise of improving policy transmission). We also have no doubt that it would do little else if unaccompanied by important structural changes.
The euro is in an awkward place right now -- too expensive for high-cost countries like Greece, Italy and France, too cheap for the country that has built itself on having a lower-cost export-oriented economy (i.e., Germany). Ideally the euro should depreciate, or allow Germany to leave and have its own currency, since the latter would be dead set against depreciation. Such solutions are so counter to entrenched political positions, though, that they could only happen in extremis.
Europe cannot cut its way to prosperity. No business can. One needs some growth to prosper. Germany has money to give, but only in exchange for austerity and extra-national veto power over budgets that aren't possible to the domestic politics of their allies. Even the Netherlands is getting fed up. Currency depreciation is a partial solution for higher-cost production frameworks in countries like France and Italy, but cannot happen with Germany in the eurozone, while countries such as Spain, Portugal and Greece need debt write-offs and currency depreciation on a scale much greater than the other high-cost euro countries would want to contemplate.
Mr. Draghi and the ECB could ease short-term funding problems for the two euro-Godzillas, Spain and Italy, thereby preventing them from immediately tearing up the eurozone countryside. The subsequent rise in asset prices would have numerous knock-on effects, though.
The Germans rightly fear that necessary structural reforms would be put off by the lack of budgetary pressure. The bond-buying program would raise asset prices well out of proportion to the small real effect it would have on the crumbling European economies, leaving markets vulnerable to an eventual crash and the ruling European elites more convinced than ever that the financial markets are run by shysters and promoters, not at all to be trusted as valid reflections of policy or enforcers of free-market discipline.
Then again, Germany might completely capitulate and agree to unlimited check-writing without budgetary input, currency depreciation, and the periphery governments could agree to write off their bad debts and let investors take the losses -- including the ECB. Such drastic reboots, however, only ever seem to happen in the wake of catastrophes such as war and/or financial collapse. It's realistically possible to envision such agreements happening in the near future through calm and rational discussion, but only so much as it's possible to envision interstellar space travel -- while the breakthrough could happen any day, it's not a betting favorite.
Looking at the realistic range of European outcomes, an intelligent wealth manager might want to avoid European securities like the plague. Looking at the likely consequences of a Draghi bazooka, though, he or she would do so at the risk of badly trailing the temporary explosion in asset prices and thereby losing most of the client base. The fund manager, whose choice is between being 95% invested and 98% invested, is left with the guessing game of which sectors to rotate into if Draghi pulls the trigger (financials, tech, ultra-high beta), or the ones if he doesn't and/or when the jig is up anyway (telecom, utilities, staples, ultra-low beta).
The hedge-fund manager is left with the choice of being event-sensible and significantly trailing the indices -- only 11% are ahead this year -- or crossing the fingers and drinking the Kool-Aid. The retail investor is left on the sideline wondering if anything in the world makes sense to own (if you answered bonds, be aware that that horse is nearly dead).
We think that Mr. Bernanke and the Fed need to keep one more decent reserve of dry powder against the day that Europe has its look into the abyss. If the former has already embarked upon accommodation as big as the market hopes for, one large enough to be called QE-3, then it would have little other option left in a eurozone crisis but the one of writing unlimited blank checks, the infamous throwing of money from helicopters come to life. That could be the seeds of a downward spiral, one that could get ugly when it came to decision time for the fiscal cliff.
It might not have to work out that way. In central bank paradise, Mr. Draghi's bazooka would ignite an explosion in European asset prices that dovetails with an American monetary push and sends markets to new heights. That finesses the FOMC around a re-election (Bernanke may be a Republican, but we don't think he wants any part of a Romney-Ryan reboot) and through an end-around of the fiscal cliff. A sensible compromise is reached, confidence is restored, and life goes on at a somewhat better pace, with plenty of time for sensible people to reach thoughtful, carefully constructed compromises.
Just because it's never happened before doesn't mean it can't happen this time. Just because the Fed has never launched widespread rounds of fresh accommodation with equities already up fifteen percent on the year doesn't meant it can't happen this time. Just because the ECB has only to hint at capping yields to effectively cap them doesn't mean they won't buy bonds in unlimited quantities. After all, this time is different. Isn't it?