A little more than a month after the Fed announced another installment of quantitative easing, the markets are giving Bernanke a message: this isn't going to work as planned.
While the QE announcement on September 13th came as no surprise, the size, scope, and duration of the asset purchases did raise eyebrows. Unlike previous incarnations of QE and "Operation Twist", the criticism this time has been more pointed and negative than ever.
The combination of the existing asset purchase programs and new ones amounts to $85 billion per month through the end of 2012. Starting next year, the old programs run out but the new program will continue at $40 billion per month (they reserve the right to step that up). If the Fed did nothing else except the $40 billion per month starting in 2013 through mid-2015, it would amount to almost $1.2 trillion in additional asset purchases over this time period.
The Fed's key guiding principle is the oft-discussed "dual mandate": to promote both "maximum employment" and "stable prices" though monetary policy. The debate over the efficacy of the Fed's actions boils down to the "transmission channels" - that is, how do these massive asset purchases work their way into our financial lives so things can get better? Much of the commentary has been focused on the impact of QE on housing, the stock market, the dollar, and inflation.
The issue is not whether QE will influence these things - we know it will (and existing programs already have influenced them). The problem is whether any of these will result in real demand and meaningful sustained economic growth.
By looking at each of the major transmission channels, we can start to understand why the Fed is in such a weak position.
Transmission Channel #1 - Housing
While the Fed doesn't explicitly state this, it considers housing a major transmission channel for economic recovery. Why? Housing is a large component of the net worth for most American homeowners. Existing home owners take out home equity lines of credit to pay for cars, appliances, etc. The rise in our home price makes us feel wealthier. We plan home improvements and remodeling based on our ability to sell our homes at higher prices. Buying a new home leads to all other kinds of purchases. New home building employs construction workers and purchase of heavy machinery. And so on.
Putting it all together, owning a home in a strong housing market makes us spend and generates demand in the economy. According to data recently compiled by JPMorgan for Q3, housing is only 2.3% of GDP, but homes account for 24% of total consumer assets. Furthermore, mortgages are 72% of total consumer liabilities. That means your house and what you pay for it is a huge part of your financial life.
"Operation Twist" and the purchase of agency MBS have been two of the main tools the Fed has deployed to kick-start and sustain growth in the housing market. These two programs are designed to deliver the one-two punch of lower mortgage rates and spurring lenders to create more mortgages. Arguably, "Operation Twist" has had a meaningful impact on mortgage rates. Last summer, prior to the first "Twist" announcement, 30-year fixed mortgage rates were in the neighborhood of 4.5%. Today, they are at historic lows around 3.4%. In theory, this should get new homeowners off the sidelines to purchase a home and get existing homeowners to refinance and put more money in their pockets.
The problem is that the Fed's actions are running uphill against a major trend: the de-leveraging of the American consumer. As the figures below illustrate, the household debt service ratio has declined and the personal savings rate has increased since the 2008 financial crisis. More importantly, neither of these trends show signs of reversing anytime soon. As long as economic uncertainty persists, consumer debt ratios will stabilize or decline further and savings rate will go up. Essentially, the savings resulting from reducing mortgage payments will not necessarily materialize into increased consumption - which is the key ingredient for GDP growth.
(Source: JP Morgan Guide to the Markets 2012-Q3)
Another issue is that many consumers who were burned by the housing crisis simply cannot afford to own a home. More specifically, their credit scores have taken a beating if their homes were foreclosed and/or they fell behind on other debt payments.
A recent FICO study found some interesting results. The percentage of consumers with credit scores between 700 - 749 was the lowest since 2005. The distribution of consumer credit scores is drifting away from this middle region, with people going higher and lower. In the low FICO range (500-699), the percentage of consumers is the highest since 2006. For these folks, getting a loan may simply be prohibitive, which means they won't be able to buy a house very easily (if at all). Eventually their scores will improve - but it will take time and will be dependent on consumers staying current with all of their outstanding debt payments.
At first, it may seem that an increase in the number of people with higher credit scores (800 - 850 range) bodes well. But this is likely due to people cutting down on their revolving debt (credit cards) and paying down balances on other debt. This is good for the consumer, but doesn't help consumption.
In 2009 lending standards became significantly tighter, with much greater scrutiny and verification of an applicant's financial data than before. Understandably, this was a reaction to the housing crash. Even with some improvement in economic conditions since then, very few banks have reported any change in these tight standards. For all practical purposes, it is just as hard to get a loan today as it was back in 2009.
There are some positive data points out there. For example, lower mortgage rates have spurred re-financing. While this puts some money back into consumer's pockets, they are not rushing out to spend it; instead are putting some of that to pay down other debt. Also, there has been a recovery in housing prices, with the oft-quoted Case-Schiller index ticking up in the past few months. Again - this doesn't automatically translate into money in the hands of the homeowner. Even if I have a home equity line of credit, it is fixed for my home until I re-finance. So any increase in my property value doesn't translate immediately into more credit available to buy other goods and increase consumption.
So any positive trends in the housing market are likely to be constrained by the financial health of the consumer and continuing tight lending standards.
For investors, this means being selective in the S&P sectors they pick for the near term (6 - 12 months). For example, we can expect continued strength in the homebuilders stocks -- a good, diversified investment this sector investment is through the SPDR S&P Homebuilders ETF (XHB) (which up over 50% this year already). The general de-leveraging that has been taking place is limiting the consumption that would normally occur when consumers have access to more credit. This means limiting exposure to consumer discretionary stocks and ETFs, such as the XLY. Indeed, investors relative feelings about housing vs. consumer spending is captured by the YTD performance of these two names: XHB is up over 50% while XLY is up approximately 19%.
Transmission Channel #2 - The Stock Market
If the Fed is eager to get you into a new home, they are equally eager to get you into the stock market. Returns on bonds and other fixed-income assets have dropped so much that, accounting for inflation, the real yields are negative (especially for shorter-term securities).
Many observers have pointed out that Ben Bernanke, unlike his predecessors, is much more mindful of the "wealth effect" and its impact on the economy. And if the value of your portfolio and retirement accounts improves, you're likely to spend more. He is also a believer in the theory that low interest rates across the yield curve will push investors into other assets, driving up their prices (the following reference has a good discussion on this topic).
While the yield on the S&P 500 is attractive relative to the 10-year Treasuries, that doesn't mean a mad rush into the stock market. First, there is the proverbial "wall of worry" that is scaring retail and professional investors: slowing earnings growth, European debt crisis, slowing of the Chinese economy, and the looming "fiscal cliff" to name a few. Each leg up in the market is met with increasing skepticism and the chatter grows louder that there is a correction around the corner.
Most retail investors are not skilled stock traders that can use the market deftly to earn income. Instead they tend to own stocks through mutual funds or retirement accounts. They hire money managers and financial planners to manage investments for the long term to build wealth. This takes time and discipline.
So the stock market is not a readily available ATM machine for households - a fact that is underscored by recent data from the Investment Company Institute (ICI). For example, in 2011 over 52 million households (about 44% of total) owned mutual funds. These holdings represented a significant portion of household financial holdings. A large fraction (over 2/3) of these holdings were in IRAs and direct-contribution accounts (such as 401k plans). As we know, there are strict rules for when money can be taken out of retirement plans. In the ICI survey, the reasons given for owning mutual funds included saving for retirement and/or education, reducing taxable income, and emergencies. Nowhere was disposable income mentioned. Furthermore, direct stock holdings by households has dropped significantly in the past decade, with households choosing mutual funds as a proxy to stock ownership.
So while households will benefit eventually from the stock market appreciation, it doesn't always translate directly to having more disposable income. And with every market crash, overall confidence in being able to generate wealth through equities becomes more suspect. The "wealth effect", which the Fed is counting on, becomes eroded.
Besides, the stock market gains due to QE appear to be reaching diminishing returns. The Wall Street Journal compiled a great interactive graphic showing the impact of QE on the stock market. QE1 and its extension had the most dramatic impact on the market. But with each successive round of QE and "Operation Twist", the DJIA and S&P 500 gains (as a percentage) have been lower.
Investors need to be very cautious of the prevailing wisdom that somehow the Fed has "put a floor" on stock market (i.e., the "Bernanke put"). As we have seen in the past (and especially this past week), when investors lose confidence in the market and earnings, markets can give up months of gains in a few days. It is true that you will get a better yield on the S&P 500 than in 10-year Treasuries. But that also means an investment in the S&P 500 (for example, with the popular SPY ETF) has to be made with a long-term horizon to realize significant dividend-adjusted advantages relative to fixed income.
Transmission Channel #3 - Currency Depreciation
One (potential) positive outcome of QE is to lower the value of the US dollar relative to other currencies. That would make our exports cheaper and drive GDP growth. It would encourage manufacturers to hire more aggressively in the US.
If our central bank was the only one engaged in this activity, the outcome would be as just described. The problem is that most of the largest economies in the world are engaged in some type of QE.
Since no country wants to be left "holding the bag" of an expensive currency that would threaten exports, what we've got now is a "race to debase" currencies.
European Central Bank (ECB) has been buying up bonds and will probably have to do a lot more of that, which debases the euro. China's currency is pegged to the US dollar, so we cannot get a significant advantage relative to the yuan. In mid-September, Japan's central bank also stepped up its bond purchasing program which will push the yen lower.
For example, the USD/Euro exchange rate has fluctuated in a range between 1.20 and 1.30 throughout 2012. The headlines coming out of Europe, which the Fed can't control, will be as much of an influence (if not more) on the Eurodollar exchange rate as QE will be.
The Fed's latest round of QE may not be enough to weaken the dollar if other central banks engage in even larger QE. Anyone looking to short the dollar (for example, through the FXE ETF) or buy up other currencies on the perceived dollar weakness needs to be cautious. The relative currency fluctuations are driven as much by traditional factors such as trade imbalances and GDP strength as they are by the central bankers fighting it out. On the latter, it is impossible to predict what move the bankers will make next.
Transmission Channel #4 - Inflation
You may be wondering why inflation is considered a transmission channel. Isn't that something we want to avoid? Well, yes and no.
Here's how the Fed's thinking goes. In the context of the dual mandate, the Fed will be comfortable with a certain amount of inflation. The FOMC is willing to tolerate slightly higher inflation in the short-run as a trade-off for the positive impact of their policies. This inflation will inflate some assets and positively impact some portfolio holdings, such as equities and gold. So if inflation is low, the Fed has some "breathing room" to implement QE and not risk runaway inflation.
Surprisingly, the Fed sees inflation under control and is not nearly as worried about it as everyone else. On the surface, the official statistics from the Bureau of Labor Statistics (BLS) back this up. The most widely reported figure is the Consumer Price Index (CPI) which is hovering around 2% (excluding the volatile food and energy components).
The problem is that 2% CPI is right at the threshold where the Fed feels comfortable within its mandate of price stability. So we are right at the crossing point of high inflation, and instead of pulling back, the Fed has doubled down. This is living dangerously -- even by the Fed's own standards.
If the inflation rate really marches higher than 2%, then the Fed's actions will hurt the very people needed to kick-start growth - i.e., the middle class. If inflation ramps higher, the Fed will be in a very difficult position. They will have to essentially undo much of what they have already done and risk tilting the economy back into a recession. For now they are (ironically) counting on subdued economic growth keeping a lid on prices.
The bond markets may not wait for the Fed to raise rates if they perceive that inflation is getting too high. We can expect investors to start selling bonds, especially the longer-dated maturities that are more sensitive to interest rate fluctuations. Investors are already keenly aware that short-term rates are near zero and longer-term rates are bottoming out. So there is a much higher risk that rates will increase rather than decrease in the 2 - 3 year time horizon (when the Fed's current programs start to expire).
One popular ETF to capture the long-dated Treasuries is the iShares Barclays 20+ Year Treasury Bond ETF (TLT). With all of the Fed's asset purchasing programs, it has been on steady march up and has gained 20% in the past two years (almost matching the performance of the S&P 500). Given the inflation risk, it is unlikely to deliver those kinds of returns going forward.
So where does all this leave us? We come back to the key item in the dual mandate: "maximum employment". Everything discussed above -- stronger housing, a rising stock market, lower currency, and low inflation -- is designed to give a big jolt to the economy. It is not always necessary that the economy has to improve before companies hire; just the perception that things are getting better will spur some to hire in anticipation of a recovery.
While the recent news on unemployment has been encouraging (with the rate dropping below 8%), it is way too early to call this a trend in the right direction. Even the Federal Reserve acknowledges that it can only do so much. After all, "maximum employment" has to do with the structure of the labor market and is determined by several non-monetary factors. With the GDP growing at less than 2%, how can we absorb all the people entering the workforce?
Ultimately, the Fed is in a much weaker position than it likes to admit.
Bernanke doesn't show all his cards at once. He has repeatedly referred to "other policy tools" that the Fed has and insists that they have not "run out of bullets." Ultimately, any policy tools they have are still going to have to fight an uphill battle against the de-leveraging and consumer confidence trends discussed above.
Give Chairman Bernanke some credit - he is trying as hard as he can. After all, he is a scholar of the Great Depression. Even some of his critics give him credit for preventing a second Great Depression in the US in the aftermath of the 2008 crisis. Bernanke has admitted that the Fed's misguided monetary policy actions in the early 1930s turned a routine recession into one of the worst economic periods in history - and he is determined not to let something similar happen on his watch.
Milton Friedman first advocated the notion that the Fed worsened economic conditions which led to the Great Depression in his seminal work, A Monetary History of the United States (co-written with Anna Schwartz). In November 2002, Bernanke (then a Fed governor) was invited to speak at a conference at the University of Chicago honoring Milton Friedman's 90th birthday. He lauded Friedman's work and insights in his speech and closed with the following:
"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, [the Fed] did it. We're very sorry. But thanks to you, we won't do it again."