James Saft, Reuters Columnist
Minutes from the Fed’s March meeting released on Tuesday showed a more constructive tone about the economy and, crucially, revealed that only two members of the policy-setting open market committee saw the case for more monetary stimulus. That’s a sharp change from the month before when ’a number’ of members believed current conditions could justify additional easing. That slight chill breeze you felt was from the door slamming on any move in that direction at the Fed’s April meeting, implying that only a relapse in the economy will bring more help.
Risk markets, such as equities, have duly sold off since the news, as investors made new calculations about how much, exactly, they trust the strength of the economic recovery.
“Equities have been in a temporary sweet spot where investors have been factoring in a self-sustaining U.S. economic recovery while also anticipating the imminent institution of QE3. This is a contradiction. If the economy were indeed as strong as they say, we wouldn’t need QE3,” Charlie Minter of fund manager Comstock Partners wrote in a note to clients.
We are clearly past that sweet spot.
There are two significant questions for markets if in fact the Federal Reserve is not going to be lending any more aid.
The first, about the strength of the economy, is significant but in some ways self-limiting. If the recovery disappoints, the Fed will be that much more likely to twist the yield curve or buy more bonds. This is what is known as a put option, and it is firmly in place. Equity holders invest at least in part based on faith that the Fed had decided not to let them lose (too much) money.
The implications of this mind-set for how capital is allocated are troubling. Just look at Groupon, which was able to pull off a massive IPO despite a fragile business plan and, as has later been shown, inadequate corporate controls. That kind of thing happens far more often when people think they are playing with backing from the house.
Strengths and weaknesses
The second issue is how well equity markets will be able to get along in the absence of Fed support? What happens if we simply inch along, suffering low growth while households and governments slowly repair their balance sheets?
In the absence of further Federal Reserve easing you have to ask yourself: do I want to buy equities at an all-time peak of earnings as a share of GDP? Really a similar question can be asked of all riskier corporate assets. It is unclear how earnings will be sustained given poor wage growth and the need to save. Data last week showed that U.S. consumer spending rose a better-than-expected 0.8 percent in February even as earnings only increased by 0.2 percent. Consumers found the money by cutting back on a luxury: savings, which fell to 3.7 percent, the lowest level in 30 months. If your milk cow is producing more in milk than she consumes in nutrition you have a sustainability problem, although one which seems pleasant as long as it lasts.
Market reliance on the promise of accommodative policy is both a measure of the success of the Fed’s policy and an illustration of its inherent, and central, weakness. The Fed has helped the economy by floating asset prices higher on a sea of liquidity. That’s made people feel better and spend more. It has also transferred some money from savers, who lose out on interest, to borrowers, who are probably more likely to circulate the extra cash then are their lenders.
The weakness, sadly, is that the accommodation so often produces more of the kinds of mal-investment that makes the booms almost equally as destructive, on a long-term view, as the busts. If the Fed didn’t ease after the Long-term Capital Management debacle the dotcom bubble wouldn’t have been as bad, and if it hadn’t eased as much after the dotcom bust then the housing bubble wouldn’t have grown so distended.
And, as just the removal of the promise of more Fed aid has walloped the market, imagine what might happen if they actually began to liquidate their portfolio? The market and the Fed may have cornered each other, leaving neither party an obvious route of escape.