On 13 September, Federal Reserve Chairman Ben Bernanke announced a new round of open ended Quantitative Easing (QE or QE3) and an expansion of purchases of Mortgage Backed Securities (MBS, CMBS, or RMBS). Given the mixed economic indicators leading into this announcement, this move, and the method of stimulus, were not entirely expected. Markets rallied heavily midday, then hit an interday high of 1474.51 on the S&P 500 on 14 September. This was the highest level of the S&P 500 since 19 May 2008, though still quite a bit below the 1 October 2007 peak of 1576.09, a time when economic conditions were far better. After the two day euphoria of QE3, markets quickly focused attention on Europe. In the first full week following the QE3 announcement, we saw markets mostly flat through the week, finishing slightly down on Friday 21 September 2012. Volume only increased on that Friday due to quadruple witching, the settlement and expiration of numerous futures and options contracts all on one day. Gold futures and S&P 500 futures finished down late in the day, on a rumor of increased margin requirements from the Chicago Mercantile Exchange; we will check next week to see if that margin increase proves true, which might remove some volatility. Greater margin requirements on gold futures would likely lead to a near term pullback in gold price levels.
As indicated previously, Fannie Mae and Freddie Mac were moving to increase guarantee fees on mortgages. While this change affecting the cost of creating and issuing MBS has not yet been formally announced, the recent move by the Federal Reserve to purchase MBS would go some way to nullify an increase in this fee. The two purposes of this fee, to offset lower 2013 tax revenues, and to provide cash flow to help wind down Fannie Mae and Freddie Mac, would effectively be monetized by the Federal Reserve. We can see some of the worry over future housing and mortgage markets in a great report from Reuters. After the failure of Fannie Mae and Freddie Mac, there has been a concerted effort to wind down these Government Sponsored Enterprises (GSEs). While the total loan portfolio has been reduced, and lending standards tightened, the private sector is moving slowly to replace the GSEs. Federal loan guarantees provided through these GSEs have been an important consideration for investors in MBS. Where Fannie and Freddie are stepping away, FHA has stepped forward, though with stricter standards. GSE interest rates compared to privately sourced loans moved closer recently, so we may see a test of loan markets as FHA reduces the guarantee limit from $729,750 to $625,500 at the end of 2013. When we consider all these factors, it appears that the Federal Reserve program of purchasing $40 billion of MBS each month should preempt any decline in the investor market for MBS. That may go some way towards explaining this new round of stimulus, but this appears to be targeted more at MBS investors.
As I watched Federal Reserve Chairman Ben Bernanke announce more Quantitative Easing, some interesting comments and wording emerged in his presentation, and in his responses to questions afterwards. Operation Twist, the buying of long term Treasuries, and selling of short term Treasuries, is intended to reduce short term borrowing rates, which in theory should increase borrowing demand from businesses. Bernanke mentioned that this is a “Balance Sheet Expansion”, meaning that the Money Supply (mostly M2) is increasing. Th3 latest Balance Sheet figures indicated M2 was near $2.8 Trillion, which is now expected to grow at the rate of about $85 Billion a month. Fed MBS purchases are $40B of that $85B a month. Chairman Bernanke stated that MBS purchases will continue unless sustained unemployment improvement is seen. The Fed does not want to withdraw stimulus too soon, nor too quickly. The Fed Chairman announced that the Fed Funds Rate of 0.00% to 0.25% will continue through 2015, which is an extension of nearly a year from announcements made earlier in 2012. Questions put to the Fed Chairman revealed more details on the policy announcement: 1. Federal Reserve stimulus is not like government spending, in that assets purchased are eventually sold; 2. interest bearing assets remaining at low levels are expected to help business and housing lending, though Bernanke admitted that this policy hurts savers; 3. inflation outlook is currently stable, with a target of 2%; 4. the primary objective of additional measures is to quicken economic recovery; 5. the Fed is unsure of specific indications that would signal removal of extraordinary measures; 6. Bernanke acknowledges that policy makers (i.e. Congressmen and Senators) must do their part to aid the economy; and 7. the Fed is not confident about offsetting fiscal cliffs, which is the goal of politicians. The Federal Reserve recently published their expectations for GDP growth and unemployment levels through 2015. The troubling aspects about that document are that projected GDP growth for 2014 would appear to indicate a bubble, and policy for 2016 and beyond seems to indicate a very large sudden change in the Fed Funds Rate. I don’t think we need to worry about inflation in 2013, though we may want to carefully watch indications in 2014 and 2015.
The lack of reaction from stock markets, beyond the immediate one day pop upwards, indicates that all eyes are still on Europe. ForexLive put together the interesting chart we see here. If the S&P 500 were priced in Euros, instead of in U.S. Dollars, then the 2007 market peak was already reached a few weeks ago. While that indicates how the problems in Europe are affecting the market, it may also be a near term indication that we may not see further gains without some solutions to the economic issues in Europe. The European Central Bank recently promised to buy peripheral country bonds with no “quantitative limit” in the near future. Europe is facing a prolonged recession, and borrowing costs in Spain and Italy have soared. The idea behind the open ended bond purchases is to control the rate of increase of borrowing costs. This is not unlike Operation Twist with the Federal Reserve, though the structure of the European Union means that implementing this idea is not easy, and is likely to face a great deal of opposition from Germany, Finland, Netherlands, and several other countries who do not face borrowing issues. The worry of some of these countries is that ECB bond purchases would delay much needed fiscal spending reforms. Quite often reforms have been unpopular, or prompted large protests and civil unrest. Politicians can risk implementing unpopular reforms, or push countries closer to unsolvable impasses, as we see Greece quickly marching towards. At this point Spain must ask for assistance from the European Central Bank, though the likely outcome might be the same as seen in Portugal and Ireland. Bond buying from the ECB would come with conditions for reform, and Spain is nearing elections on 21 October 2012. Rather than risk the wrath of voters, we may see no request from Spain prior to late October. Appeasing voters led to problems in Europe in the past, and could lead to further divisions and disagreements. Italy also faces some hurdles with a technocrat government empowered to clean up finances, but unpopular with the general public. We may see a deepening of the recession in Europe in the near term, before any real reforms and actions take place to turn the troubled economies around. As always, we continue to monitor the situation in Greece.
Unlike European Central Bank discussions, the Federal Reserve Announcement did have an immediate affect on 30 Year Mortgage Yields, which are now at record lows. Gold futures went the opposite direction after the Fed announcement, largely on the worry of inflation. The current market for agency (government) backed Mortgage Based Securities is about $5.2 Trillion. Current MBS holdings by the Federal Reserve are around $850 Billion, or around 16% of the total. Additional purchases at the rate of $40B a month over the next few years may lead to the Federal Reserve controlling nearly half of the MBS market by the end of 2015. The distortion in the markets for U.S. Treasuries has already been seen as the Fed increased their holdings through Operation Twist. At the current pace of MBS purchases, the Federal Reserve would hold about 28% of all MBS by the end of 2013. Given continued high unemployment, lower wage and earnings trends, and economic uncertainty, it remains to be seen whether Federal Reserve MBS purchases will cause a substantial increase in housing activity, either in new construction or resales. Current agency issuance of MBS was $122B in August, so the $40B Fed buying program may account for a third of all new MBS. Existing MBS bond holders and prospective new MBS investors may not like the lower yield on their investments, due to Fed distortion on the market, which could create a floor for mortgage rates in the near future, though I do not expect mortgage rates to increase much over the next few years.
While sales of homes are still near historical lows, the pace of increase in new construction, and the pace of resales, are outpacing the U.S. economy. When August housing starts figures are reported soon, the expectation is that housing starts will exceed 770K units, a rise above the 746k starts in June. Housing starts have increased more than 20% in the past 12 months. Since we now have many months of figures for 2012, it appears that 2011 may have been a record low in new home sales, since record keeping began in 1963. Loan standards remain tight, so we have yet to see lenders relax standards to make use of historically low mortgage rates. Despite the improvements in the housing market, 10 cities look unlikely to see a turn-around, mainly due to continued high unemployment levels. The employment boom in the past in many of these cities came through the housing and construction markets, which is still reversing. High rates of foreclosures have further depressed price levels in some areas. Investors who were behind the housing boom years ago may now be trying to re-enter some of these markets at perceived low points, though extreme caution is advised without a turn-around in employment.
As Federal Reserve Chairman Ben Bernanke indicated, the risk of a fiscal cliff is beyond the tools of the Federal Reserve. Congress in mid 2011 pushed until the last possible minute before passing the Budget Control Act. The risk at the time with the debt ceiling, was that the United States would willfully delay payment on previously issued Treasuries, or perhaps even fail to make payments, causing a default on U.S. debt. Markets sold off heavily into that risk, in order to protect against a severe financial shock. On 1 January 2013, unless Congress passes new legislation prior to then, there will be an automatic $100 billion of spending cuts, expiration of Bush era tax cuts, and expiration of the Obama era 2% payroll tax cut. Combine pulling $100B out of the economy with increased tax rates last seen in 2013, and the U.S. economy is very likely to quickly stall as consumers and businesses decide to constrain spending. Defense spending cuts would be near $55B of that $100B. Some economists and analysts think that the perception of a fiscal cliff approaching has already stalled the economy, as businesses hold off on investments and hiring until a clearer direction is indicated from politicians. While politicians are expected to meet to work on this after November elections, few people expect any action until the last possible minute.
It has been an odd flat week in markets, since the Federal Reserve announcement. The ruling at the German Constitutional Court was expected to lift markets in Europe. Since the court gave the go ahead to German politicians to fund the European Stability Mechanism, focus quickly shifted on the restriction of €190 billion (Euros) funding. At whatever point in time Spain may request additional funding through the ESM, it has been estimated that the amount would be between €60B and €100B. If Italy were to need funding, or Portugal and Ireland fell behind, the funding needs could quickly spiral beyond the capacity of the European Central Bank. The Bank of Japan announced an expansion of asset purchases of around ¥55 trillion (Yen), since their economy is slowing following the massive rebuilding efforts after the tsunami, earthquake and nuclear disasters. Japan recently warned of impending financial debt funding difficulties by November. Current gross debt is at 235.8% of GDP and net debt is 135.2% of GDP in Japan, which is far worse than Greece. Japan will need to move quickly to devalue the Yen in order to address debt in the near term, so we may expect to see a new Minister of Finance there soon. FT Alphaville put together the chart here, showing S&P 500 market volume on up days compared to down days. We have seen 95 days up movement and 83 days down movement in 2012, with most of those movements being less than a 1% daily change. Challenges facing many countries could see even greater volatility in global markets. Clearly these are difficult times for investors.
It is tempting to think that QE measures push money into the economy, or that this latest round of QE will lift markets as seen in the previous two stimulus rounds. Richard Fisher, the head of the Federal Reserve Bank of Dallas, recently spoke out about the latest measures from the Federal Reserve: “You elect these people, you pay for their campaigns, you put them in office. If they cannot straighten out the fiscal problems in this country, get some new ones. Do not turn to the central bank.” In a separate statement, Fisher indicated the Fed balance sheet from extraordinary measures is near $2.8 trillion, and that $1.6 trillion is sitting in excess reserves. This is additional stimulus money that has not made it’s way into the economy. As Fisher indicates: “trillions more are sitting on the sidelines in corporate coffers”. He indicated that nearly 90% of businesses either do not want to borrow, or have easy access to cheap credit already, and that a 0.25% decrease would not prompt more borrowing. On unemployment, Fisher states: “you cannot have consumption and growth in final demand without income growth; you cannot grow income without job creation; you cannot create jobs unless those who have the capacity to hire people – private sector employers – go out and hire.”
The President of the Deutsche Bundesbank (German Central Bank) Jens Weidmann, published an excellent paper on Money creation and responsibility. He points out the history of money, and that money is defined by it’s functions, originally tied to assets and commodities. Over the last several decades, paper money has not been backed by any real assets. The value of money is created in the mechanism of exchange. “Central banks create money by granting commercial banks credit against collateral or by buying assets such as bonds. The financial power of a central bank is unlimited in principle; it does not have to acquire beforehand the money it lends or uses for payments, but can basically create it out of thin air.” This is not a long paper, and part 4 has a great explanation of why having a central bank is important, and what central banks accomplish in an economy.
Marc Faber, of the Gloom, Boom and Doom Report, indicated six things to keep in mind about QE3. Of these, two points stand out. First is that consumption has never led an economy out of a recession, but that capital spending has done so. Second is that QE helps the investors at the top of financial markets, but does not flow to the man in the street. In another note to investors, Faber does point out two interesting strategies in these markets. One is to aggressively shift from one asset class to another. The other, and likely easier to follow strategy, is to have a more balanced approach with an investment portfolio with four equal components: precious metals, equities, real estate, and cash. If we see markets pull back 10% to 20% over the next few months, we may find opportunities in equities (stocks). Precious metals can be bought directly, through Electronically Traded Funds (ETFs), or indirectly through investments in the shares of mining companies. The cash position would allow for flexibility, though in the accounts I currently manage I hold 30% to 50% cash positions, instead of the 25% Faber indicates. Real estate appears to be the easiest market in which to directly invest, though purchases of MBS do not appear to be a good choice with low yields. Real estate investments would be better placed in physical assets, either existing properties, or undeveloped lands, though with a careful consideration of economic conditions in the investment location. In an era of money printing, we need to stay diverse, responsive, and flexible.
G. Moat
