Fed is Writing the Market a Put Option (via Easing)

On Friday, my lead theme was titled “Pushing on a String”, during which I shared the view that the risk-on trade was to a large degree predicated on the belief that the Fed is writing the market a Put option, by way of their plans to enact another round of QE if the economy should falter. Of course, there is the presumption that more QE by the Fed would have a positive outcome on the economy. This morning, CNBC came out with a survey of 67 economist, strategist and fund managers, as to their perception of the likelihood of more QE by the Fed, as well as their perception of the success of additional QE on the prospects for the economy. Here are some observations from this survey:


1>    70% believes the Fed will do more QE

2>    Most believe this will occur between November and January

3>    Most believe that the Feds QE activities will total half a trillion dollars

4>    50% said the Fed will be somewhat effective in lowering interest rates, while only 6% said they would be very effective, and 30% said the Fed would be mostly ineffective in lowering interest rates


The question which the CNBC did not ask, is whether lower interest rates will succeed in lifting the economy out of its malaise. My contention is with rates as low as they are, that lower rates will have almost no impact on a material improvement in the economy. 


A reader writes in and challenges me on that point that the Fed is limited in what it can do:


“The Fed has much more in its bag of tricks than you give it credit for. For instance, right now it pays 1/2% on the money banks leave in the Fed system over night. It could not pay or even charge for these deposits, forcing banks to evaluate whether or not they should actually lend the money from their overflowing balance sheets and make something rather than nothing or pay for the right to save the money. If more of these funds were in non dormant investments, the economy would be forced to move. The Fed is not pushing on a string yet. 


Does it make sense to complain about the Fed printing money on the one hand which should lower the value of the dollar, and then complain about the massive trade imbalance on the other? If you do not weaken the dollar you cannot address the trade imbalance. Weakening the dollar (printing money) has shown very little ill effects so far. It has stopped a panic, brought us out of a deep recession, slowed or stopped much of the deflation that was occurring and created marginal growth. Even though it is not apparent in the value of the dollar as compared to other currencies, we have effectively weakened the dollar because it would be much higher against other currencies if we had not printed the money. This means if we had not printed the money or printed less (and the economy still did not fall off a cliff) our trade imbalance would be higher.” (end of readers comment)


First off, the Fed is pretty much out of things it can do, except lower rates. If the Fed lowered the rate it pays on excess reserves held at the Fed to 0 (it is 0.25% now, not 0.5%), then the banks would be scrambling to invest in T-bills which would have a cap at 0, and likely to somewhat negative. I have written in the past about how the Fed can engender negative interest rates; it just might happen, and lowering the rate they pay banks on excess reserves is the way to do it. But what does that do? Will the banks opt to lend money to risky businesses at 4-6% because their return on excess deposits drops from 0.25% to zero? Perhaps if the Fed made banks pay them 1%, yes a negative 1% rate, then the entire complex of money market rates will go to zero, and then negative. Which will cause people to hold cash, and the question is whether banks can charge customers to hold their money? People would then withdraw their funds from banks, and M1 should explode. But does this mean people will start spending money, or will it just change the way in which people hold their money/savings?


In short, the topic of negative rates is a strange one, but apart from experimenting with negative interest rates, something which is not being contemplated by many, I do not see the Fed having much real impact.


As for the 1.3 trillion the Fed put into the banking system in 2008, and kept in the system via QE 1, this was needed to stem the liquidations of leveraged dollar assets held by banks, here and abroad. Since then, companies have increased the amount of cash they choose to hold, but on average, an expansion of the Fed balance sheet had little impact, except to divert a liquidity crisis at the time, and is now creating a scramble to put that money to work in the short term money markets.


Lastly, I am not making a value judgement on printing money.. I have never complained about it. I am just trying to sort out how to best orient strategies which will do well in such an environment.


Along the lines of my conversation from Friday, John Mauldin put out a piece this weekend, entitled, “Pushing on a String”, in which he quotes Morgan Stanley strategist, David Greenlaw. Greenlaw cites the ex-Fed governor Larry Meyer’s analysis on the impacts of more QE by the Fed:


“How much of an impact would $2 trillion in QE give us? Not much, according to former Fed governor Larry Meyer, who, according toMorgan Stanley, “…maintains a large-scale macro-econometric model of the US economy that is widely used in the private sector and in public policy-making circles. These types of models are good for running ‘what if?’ simulations. Meyer estimates that a $2 trillion asset purchase program would: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, Meyer admits that these may be ‘high-end estimate’s.”


In other words, $2 trillion of additional QE does not do allot for the economy, and sure puts allot of money into the system. Mauldin goes on to suggest that additional QE will serve to lower the value of the dollar, and that is something which I agree with as well. As Maudlin concludes:


“If everyone else wants to devalue their currency, should we play along? Can you say buy some more gold?”


I could not help but pass that quote on. If you want to read the whole article by Mauldin, it is a good read on this topic, and is at this link:


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* Trading points – Stocks – I am beginning to think that the October 10th, turning point date from Chris Carolan, who I have referenced in the past, may in fact turn out to be a stock market top, not a bottom as I had previously thought. Accordingly, this years template might follow that of 2007 when there was an August low, and then the market rallied into mid October. Based on my read of various technical analysts, the S&P must fall below 1120 to confirm a break of the uptrend, and the start of a down-trend. Until then, the trend is up for the time being.


* Bonds – I have turned bullish on longer dated treasuries, and it looks as if the entire complex of interest rates could be headed to lower yields than what we experienced in December of 2008, when 10 year treasury rates got as low as 2.05%. Part of this perspective comes from the divergence between the stock market and interest rates, which I pointed out in my blog of Sep 17th. To summarize the point I made then, rates have been not going up that much as stocks were rallying. In short, it seems as if theinverse relationship between stocks and interest rates might have been broken, at least for the time being. And with further talk of QE2, it seems as if the market is anticipating lower rates, driven by the biggest buyer on the planet, the Fed.