OCTOBER 2014 INVESTMENT JOURNAL: QUITTING "QE"?
- IMF sets floor on interest rates
- US Fed to end quantitative easing program as US GDP surges in Q3
- Putin blasts the U.S. and calls for new world order
- Bank of Japan announces massive new easing program
October proved once again to be a very interesting month for investors. In the U.S., the S&P 500 Index finished the month back above its mid-September all-time high. This, however, does not tell the whole story. October was what Wall Street refers to as a whipsaw month for stocks. A sell-off coinciding with heavy media coverage on Ebola in the U.S. during the first half of the month saw many market participants panic and exit their equity holdings as the stock market fell -7.71% in just 11 trading days.
This sell-off was followed by one of the strongest rallies we've seen recently, with a 10.9% gain erasing all losses from the first half of October.
Elsewhere, developed international stock markets were slightly negative by October's end, and unlike the U.S., are not yet back to their June peaks. Emerging markets stocks showed positive returns in October, but peaked at the end of September and also have not returned to those higher price levels:
Over the last year, U.S. stocks have continued to lead all asset classes in returns. U.S. Bonds have provided stability this year for balanced and conservative investors, while international markets have been more challenging. Hard assets like gold and other commodities have continued to exhibit negative momentum that has now extended over several years:
While most investors were transfixed by the sharp stock market moves in October, the telling action was in the world of geopolitics and interest rates.
For quite some time, we have been pointing out how "official" interest rates have been converging globally towards zero or near zero (ZIRP, or zero interest rate policy). Japan started the party in 1999, joined later by the U.S. and Europe. (And, while Europe was the last major region to get there, they have now broken new ground by charging negative interest rates on deposits: NIRP, or negative interest rate policy).
This month, Sweden, which is not a part of the Eurozone currency union, joined the ZIRP club by lowering its official interest rate to zero (the rest of Scandinavia will probably follow suit shortly).
Late in the month, the International Monetary fund (IMF) refused to join the ZIRP club, as they announced a "floor" rate of .05% on its own form of global currency called "Special Drawing Rights" (SDR). The SDR rate is the base rate the IMF pays to its member lending nations for the use of their funds (a kind of a global "prime rate"). It then adds a margin, just like any other lender, to reflect the risk of a loan, and guarantee some sort of profitability (or "spread").
Since the rate is calculated as a weighted average of the three-month risk-free rates in euros, yen, dollars and sterling, and was threatening to go negative, the IMF made up a new policy. From the IMF executive board: "In view of the prevailing interest rates today, the SDR interest rate for the next weekly period starting Monday October 27, will be established at the floor of 0.05 per cent".
While the change will ensure lenders get a small positive return and fractionally raise costs to borrowers, it is yet another historic first in what continues to be a flood of activity in uncharted interest rate waters.
The IMF move is especially noteworthy since it underscores how fundamentally important it is to have at least some fractional positive return in place to keep the global financial fabric stitched together. Here's how the Financial Times put it: "The possibility of negative rates caused several problems, according to a senior IMF official. There is no legal basis in its articles of association for paying a negative rate; it would have created a perverse situation where creditors were paying to lend money to the Fund; and it would have frozen up the SDR market as no country would have any reason to participate. It would also have caused a breakdown in the IMF's "burden sharing" mechanism. Under that system, credit losses from countries that do not pay their IMF loans are shared between members, via a small deduction in the interest they receive." As we've been saying for some time, "the fundamentals are broken", and the IMF just verified it officially.
In the U.S., the Federal Reserve announced an end to its program of "Quantitative Easing". Here's how the FOMC stated it in their October 29 press release: "The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program. Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month."
We believe some of the recent stock market volatility was based on investors selling first and asking questions later, assuming that the Fed would indeed end QE and, by "turning off the spigot", cause prices to go down.
However, the Fed has been very clear that they will continue to monitor the economy, and stand ready to take any mid-course corrections necessary (this is the third, but perhaps not the last, QE we will see). In short, many investors seem to be jumping to the conclusion that the Fed is done easing, and is ready to start raising interest rates.
In fact, overlooked in all the hoopla surrounding the "End of QE" news was the Fed's commentary on their balance sheet: "The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions."
"Sizeable levels" means a $ 4 trillion plus balance sheet, which dwarfs the size of a $10 billion monthly QE purchase:
Until the Fed judges that the economy has reached "escape velocity", it is unlikely that the fed's balance sheet will start to shrink. In fact, they continue to caution investors to expect ultra-low rates for some time to come: "The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal." In case anyone missed it, here's the closing line: "The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."
The challenge for the Fed and other central banks globally is that a ZIRP/NIRP monetary policy hasn't cured the lack of demand. It's worth considering how the velocity of money has continued to plunge in the face of the cheapest loan rates of the modern era. In short, why aren't there any borrowers?
The Fed has blamed Congress for not addressing structural deficits (i.e. Social Security, Medicare, etc.). Others blame the growing and onerous regulatory burden on businesses. Some say our high tax rates retard growth. Whatever it is, this "lack of pep" is unprecedented. If zero interest rates can't do the trick, what can? (The answer is probably some combination of all of the above.)
In the good news category, U.S. third-quarter GDP expanded at a 3.5% rate, fuelled by a big boost in exports and increased government spending. Some noted that this pace was not sustainable in the face of the recent sharp rise in the dollar (hurting exports). What we didn't see a lot of focus on was this:
U.S. gas prices have fallen to the lowest point since 2010, and look set to stay down for quite some time, as domestic production gains from "fracking" continue to astonish. (Remember also that Czar Putin has "misbehaved", so the West is actively encouraging a lower price, probably with help from the Saudis).
For those Americans whose disposable income is not being eaten alive by private health insurance premium increases, it looks certain that household budgets are going to benefit from this development. (AAA has even coined a new term for it: "sticker delight"). It's a sleeper story that bears watching.
Speaking of Putin, it appears that he threw down the gauntlet to the West this month. Addressing an international intellectual forum in Sochi, he blamed the United States for undermining the post-Cold War order by re-shaping the world to suit its own needs and interests after the dissolution of the Soviet Union. He used the occasion to push for a new multi-polar system of global governance, warning of "a sharp increase in the likelihood of a whole set of violent conflicts with either direct or indirect participation by the world's major powers". No olive branches here.
Not coincidentally, several days after his speech, Russia conducted significant military maneuvers on the edge of the Baltics (NATO and European airspace). One if its spy planes violated NATO airspace for the first time since the Cold War. Many are already considering this speech the definitive foreign policy vision of Novorossiya ("New Russia"). While quite long, it's a well worth a read here (especially the Q&A that follows): http://eng.kremlin.ru/transcripts/23137
Finally, the biggest story for the month, and probably for all of this year, was the massive new, and unexpected, easing program announced by the Bank of Japan (BOJ) on the last day of October. Despite having the lowest interest rates of any developed country (their 10 year government bond yields .40% versus the U.S. ten year at 2.33%), they have not achieved their goal of producing a 2% inflation rate (i.e. some hint of DEMAND).
So, they will now unleash another massive wave of buying of government bonds ($700 billion) and, more importantly, stocks, both domestic and foreign. In addition, the Japan Government Pension Fund made significant changes in their asset allocation, reducing bonds and doubling their equity holdings, while also announcing a program of investing in alternative assets.
The NIKKEI 225 (their S&P 500) surged by 5%, followed by strong gains in other stock markets around the world. (Don't fight the BOJ?). Meanwhile, the yen was hammered, as was gold and oil.
It's hard to overstate how important this development is. Bear in mind that Japan has had near zero interest rates since 1998. Since that time, economic growth has stagnated and prices have fallen. This is their "all in" poker move, daring markets to ignore them. Effectively, they are devaluing their currency to boost exports and stimulate growth. Looking at the long term chart of the dollar / yen (the last 100 years), it becomes clear how the post WWII Japanese economic miracle rested on a more competitive currency. We may have just seen the gears shift into a long, slow reversal:
The main takeaway for investors is that the U.S. Dollar just got even more attractive, especially for foreigners. Higher yields and a strengthening currency are powerful forces when deciding how to allocate capital. And, make no mistake about it, capital is global and will seek the best returns. That should spell big time interest in U.S. bonds and stocks.
As we head into November, markets are adjusting to the U.S. Fed and BOJ's "new" policies. It's been a lively month, with more to come we're sure. Thanks for reading our Journal, and we'll check back in with you after Turkey Day.
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