The Fed delivered more or less what the market expected: “expanding its holding of securities” by “reinvesting principal payments” and “purchase a further $600 billion of long-term treasury securities by the end of 2011” (taken together this actions will lead to a total $900 billion of purchase). The amounts announced and the time schedule came as no surprise. Based on a very poor description of the state of the economy (“disappoingly slow”), the expected economic impact remains unclear.
The economic rationale and impact of QE2:
The chart below is drawn from the Statement Regarding Purchases of Treasury Securities.
It shows that 70% of the total amount purchased will be concentrated on the medium tern (1/7 year) tenor of the yield curve. This monetary policy skew explains the ongoing steepening of the 5-30 segment of the yield curve.
This is surprising as some upward pressure on long term mortgage rates would have a negative impact on mortgage refinancing and overall deleveraging.
The Fed may be expecting to “promote a stronger pace of economic recovery” through asset prices, expecting this forthcoming liquidity to prop up asset prices and foster consumer confidence. Yet, as the chart below shows there may be a missing link between equity prices and consumer confidence.
QE2 and our financial forecasts:
Are we all “Hoenigian” now? Thomas M. Hoenig vote against QE2, putting forward the “risk of future financial imbalances’. Even though we share this view we consider that QE2 will have a rather positive impact on risky asset prices in the medium run.
1. All against USD? We have shown that over the last few weeks the correlation between almost every asset was strong and significant against USD (here DXY). Mid-term elections’ relative shift of power and the “mild”/’expected” Fed easing will not trigger any correlation break.
The transparency and publicly known pace of asset purchase will probably avoid a free fall of the USD. Rather we see the USD drifting lower. Yet, structural weakness is likely to prevail as most of the liquidity created will be poured into emerging market. 2. Liquidity driven capital inflows in emerging markets. Both charts below show the strong relationship between USD and the outperformance of US stocks against Emerging markets. This trend should continue albeit at a slightly lower pace.
Yet, 1. Inflation is looming as shown for instance by the 6th interest rate hike by the RBI this year (wholesale price up 8.6% in September) and the latest Turkey figures. Food inflation pays a role but the price dynamic may spread quickly in many sectors.
2. Reserve accumulation is still tremendous. As most of it is not sterilized, in many countries, real rates are negative or only slightly positive domestic credit growth is accelerating, triggering a further risk of domestic inflation. In addition, in many countries, real rates are negative or only slightly positive. The risk for many central banks is to spur further capital inflows through monetary policy tightening. Some countries are trying to cope with capital taxes / controls, some went the other way round such as China and India, liberalizing further capital inflows.
The risk of emergingflation comes backs and makes the situation looks like the post crisis era. Yet, with the changing nature of emerging market capital flows (more bond oriented) the sensitivity of foreign investors to inflation may have risen significantly. This remains yet a medium run rather a short term risk, but it will no doubt be part of 2011 financial equation.
3. Liquidity overhang and stock/bond relationship. The medium run target of the Fed suggests that long term interest rates will stay low but will probably not go back to their late summer level – barring a strong risk aversion shock. The major impact of the QE has been the disappearance of stock/bond arbitrage as the chart below shows.
In relative terms, the excess liquidity created by QE2 will probably favor stocks against bonds, hence a further divergence of both lines on the chart above.
4. FX implications. The dollar will be weak across the board but some pairs are more at risk than others. Countries that continue to normalize their monetary policies (Australia for instance) will continue to see currency appreciation. Even though many emerging countries are facing a risk of inflation and 2006/07-like macro imbalances, capital inflows will continue to drive asset prices. As far as there is no macro shock, the ongoing momentum should go on… Note for instance that momentum strategies have been the best performers over the last few months.
Not to say that there will be no mean reversion but it could take time, hence our prudence regarding for instance the relative AUD and CAD overvaluation a and undervaluation respectively (charts below).
The main risk should thus pertain to the Eurozone once again. The EUR/USD has benefited from the credibility of the ECB and its monetary orthodoxy. Ad hoc factors that used to help explaining the EUR/USD no longer help instead of the recent Irish crisis (see below of composite “cohesion countries” CDS index and its divergence with the euro: we are far from the 1.15 suggested…).
This would suggest a further EUR appreciation as long as investors disregard country risk. Yet the pace of appreciation should slow: 1/ US capital outflows will go to EM markets 2/ as the charts below show,,even though, in relative terms, the EUR/USD level is inconsistent with the relative performance of the DJ Eurostoxx 50 against the SP 500, it nevertheless tracks closely the DJ Eurostoxx 50.
Our positive bias on stocks but relative underperformance vis a vis emerging market stocks, would thus favor a positive bias (even though the EUR/USD is close to the upper bound of our fair value model see November Natixis Exchange Rate).
5. commodity prices: at first sight a dollar bear view would favor some long positioning on gold. Among commodities (metals notably), we favor those present strong fundamentals (supply shortage for instance) such as copper.
Oil prices are widely expected to increase up to 90 dollars. Yet we’ve got Brent at $80/bbl for year-end, before sinking to $73.80 for Q1 next year.
Cyclically driven asset prices? Don’t fight the Fed
Now that liquidity will remain abundant, the focus of investors may shift towards fundamental drivers of asset prices. 12-months forward PER remains really attractive and global PMIs are recovering which suggests that the last months of the year will not be those of the double dip.
2011 Pullback most likely
Your year-end forecast for asset classes prices are mostly driven by a liquidity based and “don’t fight the Fed” momentum. As the double dips turns into a soft patch globally, there might also be some impetuous coming from the news flow.
Yet, 2011 should start with some really disappointing GDP prospects (fiscal tightening, doubt on the French-German commitment on post-2013 bailout scheme…) and a significant correction should not be ruled out.
Disclosure: no position