After an initial burst of euphoria, the market's response to the Fed's latest quantitative easing programme has been somewhat ambivalent. Equities and treasuries are almost exactly where they were beforehand, oil has fallen slightly, while metals have enjoyed a modest rally. The reaction looks about right; despite the aggressiveness of the Fed's open-ended MBS buying plan, it is far to early to say whether it will have much impact on what appears to be a weakening US economy. Strong markets during QE1, QE2 and Operation Twist coincided with improving economic data; if QE3 doesn't generate a pick-up in activity, it may not do much for markets either.
Data released since the FOMC meeting suggest Bernanke's concerns about the strength of the US recovery were justified. Second-quarter U.S. GDP growth was revised down to 1.3% from 1.7%, suggesting the economy is close to stall speed. Meanwhile, August's decline in durable goods orders suggests the slowdown in Europe and Asia and jitters about US spending cuts are hurting US industry. It may well be that Bernanke has taken out what he described at Jackson Hole as "insurance against the realization of downside risks" just in time.
Will it work?
If QE1 or 2 didn't fix the economy, why on earth should QE3 ? That may be a little simplistic, but Bernanke probably figured that if he was going to go for another round of asset purchases, it had to be something substantially different if it were to have any effect. And so the latest version comes with a pledge to carry on buying bonds until unemployment drops significantly.
Still, even in its new unlimited form, it's hard to see how additional QE will have more than a marginal impact on the real economy. The Fed is supporting the price of assets that are already much in demand, such as treasuries and highly-rated bonds. It may also manage to boost appetite for riskier assets. But it seems unlikely that cash rich American companies will hire more workers just because their borrowing costs fall even lower or that consumers will spend more aggressively if the S&P rises even higher.
If it is to work, QE3 will really only do so by boosting confidence and convincing markets that higher inflation is around the corner. After all, if the Fed's greatest fear is that the US is heading towards a Japanese-style deflationary trap - where spending is deferred and businesses avoid new investment - it needs to raise expectations of future inflation in order to bring forward activity. As this very good note from Alphaville explains, headlines about money printing and runaway inflation may be exactly what Bernanke wants. It's almost as if he is basing Fed policy on popular misunderstanding of the effects of its balance sheet expansions.
Bernanke acknowledged at Jackson Hole that unconventional monetary policies come with risks, the key ones being concerns about the Fed's exit abilities, the risks to its balance sheet from rising bond yields and the risks to financial stability.
His basic calculation seems to be that these risks only become threats if QE3 actually works. In other words, let's worry about overheating when we get a little warmer.
I think this is fair enough with regard to the first two points. If the US economy does rebound vigorously, I imagine the Fed would be able to lighten its securities portfolio without hurting markets. And while it would take losses in a rising yield environment, the US would be much better off if this coincided with lower unemployment and higher GDP.
However, he's naive in dismissing the risks to financial stability so lightly.
Firstly, financial stability is not only at risk from excessive risk-taking and leverage, as Bernanke suggests. The Fed's massive interventions in markets are also a source of significant instability.
The Fed has openly said it wants to drive investors into higher-yielding bonds and stocks. If these securities were distressed - as they were in early 2009 - that is understandable. But it is seems like reckless policy after a multi-year rally when they are fairly, if not fully, valued relative to the current state of the economy. If the US economy weakens further despite QE3, investors will find they have piled into risky assets at the worst possible time. Surely its healthier to allow markets to find a natural level - even if it doesn't inspire Americans to lever up and go shopping.
Secondly, Bernanke is tempting fate by telling us not to worry about bubbles. Yes, the Fed may have better tools for monitoring systemic risk than it did in 2000 or 2007, but spotting bubbles in real-time and doing anything about it is easier said than done. What if pockets of excess leverage develop in specific sectors but unemployment across the country as a whole has not come down enough to justify abandoning quantitative easing? How does the Fed respond?
The above leaves me relatively downbeat on US and global equities, as well as industrial commodities, over the next few months.
Thanks to the promise of central bank action, markets have proved remarkably resilient in the face of weak economic data over the last few months. Now that the Fed and the ECB have delivered, the data needs to improve if markets are to hold onto this year's gains. Otherwise, I suspect that recent resilience may come to a sudden end, as we saw in mid-2011.
If I had to remain exposed to equities, I would focus on classic defensive sectors, such as consumer staples and healthcare. While I wouldn't expect great short-term returns from these investments, I expect they will do well on a relative basis. As well as being less susceptible to concerns about an economic slowdown in the US, they also stand to benefit from the Fed's activity in the bond market, as more investors look for yield in "bond-like" equities.
I would be extremely cautious on cyclical sectors. In particular, I would use the recent rally in the resource sector as an opportunity to reduce exposure. Industrial metals and the companies that mine them, such as Rio Tinto (RIO) and FCX (FCX), have performed well in response to QE3 despite continued evidence that Chinese demand remains very weak. This disconnect creates the potential for a sharp correction in coming weeks.
Finally, I believe precious metals will continue to perform well. The asset class has shown a very strong correlation with the size of the Fed's balance sheet over the last few years. While we cannot be sure that QE3 will result in stronger growth, we at least know for sure that it will lead to a significant increase in the size of Fed's balance sheet.