A Hole in One?
As we all know, the Fed’s annual Jackson Hole soiree lays dead ahead and already the anticipation of yet another QE grows. You’ll remember that a few years back the Jackson Hole conclave was used as the verbal launching pad for QE2, followed directly by Fed sponsored POMOs (permanent open market operations) as an opening monetary expansion act to QE itself. Whether the Fed this year engages in more verbal QE magic remains to be seen. What I hope is helpful is a little pre-Jackson Hole compare and contrast.
On a very bottom line basis we know what the Fed and their entire global central banker cohorts wish most sincerely to prevent deflation. You can go all the way back to the now almost decade old Bernanke exhortation that “it can’t happen here”. In that well remembered soliloquy he did not mention an employment mandate. He did not mention some targeted level of economic growth. He focused directly on price deflation. I think this is what we need to keep in mind as a key bigger picture macro, despite the verbal monetary policymaker linkages to unemployment levels, etc. This is what we need to keep in mind as we approach the Jackson Hole “event” yet again.
Deflationary pressures come in many forms. A periphery European credit market meltdown can obviously be a deflationary transmission mechanism. For now this is a key highlight event, but we all know monetary expansion measures will be brought to bear in increasing fashion as the alternative to such measures is ultimately much more politically unpalatable. The slowing in the emerging economies very much in sympathy with Europe likewise transmits deflationary pressures into the global economy, primarily via reduced commodity and other import demand. In similar fashion, emerging economy authorities have been and will continue to respond. For shorter term traders it’s the rhythm of response that’s important. For longer term investors, it’s using short term price draw downs as longer term entry points that will be key to investment behavior. Both deflationary impacts from Europe and the emerging economies are more than well known.
Now let’s focus for a second again on the upcoming Jackson Hole gathering and anticipated message, as well as investor response. Without question, contracting or simply stagnant US domestic credit expansion can be deflationary. In fact, if you think back to QE2 in 2010, as the Jackson Hole event rolled around in August of that year, two important things were happening. First, banks were actually contracting their balance sheets as lending was in decline. Secondly, if we pull away the smoke and mirrors of student loans, consumer credit was likewise in continued contraction mode. Fast forward to pre-Jackson Hole 2012 and neither of these trends are visible, in fact just the opposite. It’s not gangbusters credit expansion, but reasonable. That was not the case pre-QE2. Would a Fed balance sheet asset expansion program at present be fighting dreaded perceptual deflationary tendencies domestically? Not really, at least not compared to these clear tendencies pre-QE2.
Although I’ll spare you the chart as I’ve presented many a time, the TIPS implied inflation breakeven rates remain higher today than was the case in QE1, QE2 and Twist. I think it’s very fair to say that the market itself is not pricing in meaningful deflationary tendencies at the moment. And so the Fed should? It can’t happen here. Well, for now it’s not happening here. I think the “facts” make a very strong case that Bernanke will not deliver any QE goods at Jackson Hole. There will be plenty of talk about vigilance and a heightened readiness to act if need be, but we’ve heard these words over and over all year long.
If the Fed does not initiate formal QE at Jackson Hole or at the follow on FOMC meeting, just how will investors react? Of course a lot depends on what happens in Europe, but in isolation will the Fed disappoint investors? And what could this mean for the symbiosis between the risk on and risk off mentality and behavior? Believe me, I wish I had the answers. The best I can wish for is to hopefully ask the right questions and focus on the correct data points.
Although global central bankers will never admit as much, they do not just wish to prevent deflation. Far from it. In a generational global deleveraging event, central bankers wish to proactively create inflation as opposed to just simply preventing deflation. Inflation that will act to mitigate the macro economic burden of balance sheet deleveraging itself. If Mr.Bernanke’s hands are a bit tied at the moment given the juxtaposition of US credit market conditions now versus the Jackson Hole of 2010, just what can we expect and what do we watch?
Although this seemed to receive very little attention, you may have seen that the Fed conducted two repo operations in the first two weeks of this month. Combined they totaled a little over $800 million, but it’s the act that may be important as opposed to the magnitude for now. Remember that pre QE2, the Fed did a consistent series of smaller magnitude POMOs. Notable is that these are the first two Fed repo operations since 2008. Why now? Could it be that the repos are a policy test pacifier to the asset markets? The Fed told us it was simply testing the repo mechanism itself, but this may indeed be the area to watch directly ahead, especially if Jackson Hole is a no-go for actual QE.
Before concluding, just a bit of bigger picture perspective to contemplate. We all know that in the prior QE’s that were asset purchase/balance sheet expansion based, the Fed bought bonds. There is little more they can do given their mandate. So, the success so far in the current cycle attributable to the Fed is that they have indeed gotten interest rates down. Although credit markets initially reacted to the QE2 announcement by selling off (an example being ten year Treasury yields), the ten year yield was lower a year later, on its way to carving out generational yield level lows. If anything, QE has worked in terms of interest rate suppression. But we all know that from here the supposedly beneficial influence of further attempts at rate suppression are suspect at best. Even Mr. B has admitted as much.
But where the Fed has come up short in terms of QE effectiveness is on the asset inflation side of the equation. For now, housing sure appears to be in the process of bottoming. But I think the key characterization is process as opposed to event. Yet even at what may be this bottom, we are light years from prior cycle peaks and have done little to alleviate upside down credit. Certainly the collective QE’s since 2009 have helped raise equity prices, but we remain below highs seen in 2007, to say nothing of 2000. At this point it sure seems what the Fed really needs is higher asset prices as opposed to lower interest rates.
In potentially walks the repo mechanism of the moment. One other relationship to at least consider in the bigger equation is that of banking system reserves. The Fed can work their QE magic through bond purchases that will influence interest rates, as they have. But it’s the level and trend of bank reserves that will hopefully provide the fire power for broader asset inflation given that the Fed does not directly buy homes or equities. Below is a quick look at US banking system reserves going back to 2008. Clearly the influence of each QE is apparent on reserve expansion. But it’s also clear when the Fed has stepped in. It has happened after a period of banking reserve decline or simply stagnation. Again, the key here is that asset prices must inflate. A decline in banking system reserves (just like a decline in the Fed balance sheet) is an absolute impediment to that goal. Just how would the Fed act to counteract this? Without detailed explanation of all interlinkages, they simply expand repo activities.
I know you can see the bottom line coming already. As we approach Jackson Hole in 2012, I think we need to watch Fed repo activity, especially if formal QE continues to remain elusive. The waters have been tested and asset markets reacted positively. Will the Fed perhaps help blunt any negative investor reaction (risk off) to lack of near term formal QE via an increased repo activity pacifier? Not quite a hole in one, but it could indeed keep the Fed on the green.
About Brian Pretti CFA
Brian Pretti CFA Archive
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