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Thursday, September 19, 2013

The Fed’s ‘No-Taper’: Season 6 of ‘Breaking Ben’?



On September 18th, the Fed announced that it would continue its bond buying spree called ‘QE3’.  QE3, if you haven’t been listening to any financial press, is the Fed’s monetary policy after the respective QE1 and QE2 (‘QE’ means Quantitative Easing).  QE1 and QE2 didn’t get the economy started, so QE3 was invented.  With QE3, the Fed, since it can’t reduce short term rates any further (since they’re effectively zero), buys bonds or mortgage backed securities.  More purchases results in higher prices.  With bonds, higher prices lead to lower overall interest rates - stimulating the economy.  Or at least that’s how it is supposed to work according to the script.  
 
The Fed Chair, when he started QE3, indicated he was going to buy bonds until the economy got better, no matter what.  Later, he alluded to what constituted ‘better’ and indicated that ‘better’ meant unemployment below 7%.  Many times, the Chairman indicated that the Fed would only buy bonds as a stimulant to the economy, and once it started working, the economy would prosper on its own.

Pop back to July, and we see the Fed Chairman repeating his same speech, that QE3 would continue until the economy improved.  Then he gave an example of what ‘better’ meant, the market went crazy and bond yields almost doubled in a month.  Bonds plunged; even nice ‘safe’ short-term bonds.  Before the July speech the market was rocking, because no one, except apparently the Fed, wanted low-yielding bonds and instead sought stocks.  The market was behaving like drug addicts in Breaking Bad:  they wanted more stimulus, even if it wasn’t good for them. As we think about it:  the stock market was celebrating a weak economy.

Fast forward to September 18th, and we have the Fed Chairman restating his mantra:  we will keep buying bonds as long as the economy appears weak, and we still think it looks weak (of course, he said this in ‘fed-speak’).  In fact the Fed revised its estimate of GDP growth to 2-2.3%, versus 2.3-2.6% in June.  In his remarks, the Chairman said that higher interest rates could slow housing growth and the economy.  The concern is that this is a circular problem because the Fed’s recent decision not to taper was due in part to factors they created (i.e., higher interest rates caused by the expectation of tapering. These higher rates created a risk of a slower economy which is what the Fed doesn’t want).  Their failure to ease the Fed’s foot off the QE3 gas pedal on September 18th  extends the problem facing the Fed of when to reduce their unprecedented injection of liquidity.

Result of all of this gloomy news?  Bonds went up, stocks went up, gold went up.  The addicts would continue to get more meth from their dealer.  These ‘QE  addicts’  like easy monetary policy and the expectation is for that to continue, at least in the short term, which could extend further depending on the mindset of the next Fed Chair(wo)man. Investors need to be mindful of how to balance this short-term euphoria with the longer term consequences to our economy and our domestic financial future.

So now what?  There’s another little thing out there, and it’s right near the Fed: it’s called Capitol Hill.  Congress and the President are on a collision course over the budget and the debt ceiling.  In his speech on the 18th, the Chairman indicated his fear of a government shutdown and the failure to raise the debt limit.  The Chairman basically alluded to the fact that the Fed was doing all it could do, and Washington’s actions were independent.  In fact, his quote is pretty telling:
“That being said, you know, again, our ability to offset these shocks is very limited, particularly a debt limit shock, and I think it's extraordinarily important that Congress and the administration work together to find a way to make sure that the government is funded, public services are provided, that the government pays its bills, and that we avoid any kind of event like 2011, which had, at least for a time, a noticeable adverse effect on confidence on the economy."
So what does this mean to our portfolios?  It means that we see bonds potentially going up for a while, and the expectation of an ugly protracted fight in Washington as detrimental. It means that now is the time that we’re looking at the entire portfolio and setting a strategy.  Depending on the outcome of the debt/budget fight, and the outlook for the quarter, this could be a rocky time where headwinds are stronger than some of the current positive economic tailwinds. A government shutdown could slow the economy, slow retail sales and have a meaningful impact on unemployment. 

In the meantime, we don’t think bad news is good news.  Watch the next two months.  Maybe Washington will hold hands and sing ‘Kumbaya’.  Maybe the job situation will increase. And then the Fed will taper, and the Breaking Bad folks will just have to get by with a regular economy.  But like Breaking Bad, don’t count on knowing the ending of this show yet:  there may be some surprises.

Happy Fall,
Leon