The analysis of current Fed policy has included the usual parade of mistaken pundits.
There is a legitimate debate about QE3, but it has been obscured by those with an agenda based upon their politics or their business models.
The result is an exceptional opportunity for the long-term investor.
Here are the four biggest mistakes:
- It's all about me. This is how the investment community views both the policy and every communication from the Fed. What a blunder. They look only at the effect on stocks. The Fed mentions stock market effects, but only as one of several indicators. They see the market as a confirmation that their moves either have helped the economy or are expected to do so.
- I don't understand the mechanism, so it must be wrong. The typical pundit asks questions like the following:
- Suppose a home-buyer does not qualify for a loan. How will this change that?
- Mr. Gundlach (or Gross or some other bond guy), How will this change your behavior?
- How can this create jobs? I don't see how to connect the dots.
- This is just printing money and monetizing the debt since the Fed is buying X% of new mortgages, etc.
- There is no exit strategy. When the time comes to reverse course, we will have a disaster.
And here are the correct answers, pretty obvious to anyone with any training in economics:
- The basic objective is to change behavior on the part of borrowers and lenders. The stock market is only one method for evaluating the impact and the "wealth" effect is only a minor transmission mechanism.
- The key to understanding QE3 is to think about marginal effects, not the all-or-nothing, "light-switch" thinking of those without economic education. If you lower the price of something, it has a marginal effect. Lower interest rates encourage more borrowers, qualify more borrowers, and increase the size of qualified loans. The price changes affect (marginally) the interest rates on all related bonds. The increased Fed balance sheet creates more excess reserves for banks and nudges them toward more lending. Lower rates make business investments slightly more attractive. This all takes place at the margin. This is the incentive for risk that Bernanke talks about. None of it has anything to do with pushing the average investor into risk assets, the popular pundit theme.
- The Fed is not monetizing debt if the purchases of securities are temporary. The concept of "printing money" should relate to an increase in the money supply -- M2 or MZM. These increases have been modest -- too low in fact. The hyper-inflationistas have been wrong for a decade or so, but that does not stop their chorus.
- Reversing course depends upon the demand for US debt, both Treasuries and Agency securities. Readers should note that those who have questioned this theme in the past, asking who will buy our debt at the end of prior QE's have been completely wrong. I do not understand why Bill Gross could be so mistaken, but he was. He does not seem to distinguish between the total volume of US Treasury trading and the net issuance. Or maybe he has his own agenda. Meanwhile, the average investor does not understand the total volume of Treasury trading. (See this piece for an illustration.)
Quantifying the Effects
There are some solid econometric efforts to quantify the QE3 effects. Here is a Bloomberg article that is helpful by sharing some results:
In a model-driven assessment based on the past impact of QE1 and QE2, Deutsche Bank Securities chief economist Peter Hooper says this is what the Federal Reserve printing another $800 billion - slightly less than the gross domestic product of Australia - will do:
1. Reduce the 10-year Treasury yield by 51 bps
2. Raise the level of real GDP by 0.64%
3. Lower the unemployment rate by 0.32 percentage points
4. Increase house prices by 1.82%
5. Boost the S&P 500 by 3.06%, and
6. Raise inflation expectations by 0.25%"
I am disappointed that the writer diminished his helpfulness by skewing in such a skeptical direction about these findings, falling into the basic current trap of catering to his audience.
The Deutsche Bank conclusion is correct. The general direction and order of magnitude of these effects makes sense given past QE policies.
A Deeper Look
In fact, I expect the current QE round to be more effective than the past versions. Why? The focus on changing expectations.
In the past, any good economic news was greeted with the notion that the Fed would step back. The current policy changes this. The Fed is committed to economic stimulation, even if it pushes inflation somewhat above the 2% target level.
For those who don't like the the Fed inflation measurement methods, you can just multiply by ten or apply whatever other silly adjustment you think is right. Meanwhile -- learn to live with it! This is the new policy.
The basic conclusion is that the business cycle is going to be extended significantly. We are in the third inning or so. It is a good time for tech stocks and deep cyclicals. (I like and own CAT, ITW, AAPL, ORCL, and INTC.)
Financial stocks will enjoy a nice yield spread. Europe will be helped. (Think GS, JPM, AFL.)
The timing is a bit different from past QE's. Since everyone is busy misinterpreting the policy, bashing the Fed, and politicizing the decision, the immediate market impact has been muted.
This time the real test will come via the actual economy, not the speculative commodity buying of the those with a simplistic view of Fed policy. The upside catalyst will come when we see some stronger economic reports, as we did with yesterday's ISM numbers.