When everyone is so very certain about what is going to happen, reality gets in the way and thumbs its collective nose at the public. So it seems with the effect of quantitative easing part II (QEII) on the financial markets. Investors got very comfortable with the fact the Fed was going to be the investor of last resort in the bond, equity and ultimately in the foreign markets, keeping all the assets afloat as the Fed bought back huge amounts of treasury securities.
Since the formal announcement bond prices have fallen, municipal bonds have tanked and the equity markets suffered their largest one day decline in over three months. Blaming the continued bailout of European countries (this time Ireland) for the decline, what may be missed by the financial markets is the effectiveness of the Fed’s actions. While the size of QEII is huge (who thought we’d be talking about this size two years ago?), it does not get at the heart of the problems in the US economy, lack of economic growth and still high debt levels. According to Fed Chief Bernanke, the goal of QEII is to lift asset prices to get investors/consumers feeling better about their overall wealth and begin to spend as a result of that new found wealth. While retail sales have picked up some over the past few months, they remain woefully below levels of a few years ago. This also ignores the large ticket item purchases of homes and autos; although up nicely in percentage terms from the recent lows are well behind “normal” levels or even levels that could clear excess inventories.
What the specter of QEII has done is to neuter economic data for the next few months, as it will take at least three months for the effects of the Fed’s actions to work its way into the broader economy: monetary policy works with a lag. What has been missing from this equation is fiscal policy to marry with monetary policy. Unfortunately, there still seems to be a fair amount of wrangling over Bush tax cut extensions, how to pay for ObamaCare, and how much “fat” can be cut from the Federal budget to get it back into balance without starving any nascent recovery. All of the above ignores what is going on globally, as our actions are not occurring in a vacuum. Countries in the Pacific Rim are spending time raising rates in response to inflationary pressures building in those countries as a result of our easier monetary policy.
So if foreign countries are trying to damp economic activity, yet they are supposed to be the savior for our economic ills, where does that leave us? As mentioned above, QEII has neutralized the economic data, however it still gets reported. The regional Fed reports have generally come in poor (Philly today looked OK), housing remains moribund, as housing starts fell to an 18th month low. Combined with still poor home building sentiment and now higher mortgage rates, purchase activity reported by the Mortgage Bankers Association fell in the latest week by 5% and also remains very need multi-year lows. Inflation reports remain a thorn in the Fed’s side as the PPI and CPI data show very low levels of inflation whether reported as headline/core or even median/trimmed CPI. Even some of the more esoteric data points, like architecture billings, port loadings and trucking data all show a still slow domestic economy. It will be many of these reports as well as comments from retailers in advance of the key holiday season that will provide the most color to the current state of affairs. Judging only by the recent retail sales figures, consumers remain relatively tight-fisted about spending coming into the holiday season.
While consumers/investors remain fairly uncertain about the overall economy, they remain very certain about stocks and the financial markets. Whether QEII will actually backstop the stock market remains to be seen, however investor sentiment reading for a variety of sectors (from individual to active money managers) are at or near multi-year highs. Alone, this does not bring the market to its knees, but the crowded trade is certainly for higher stock prices and what likely led to the spirited selling earlier in the week on strong volume. While the advance decline line remains very positive, the only fly in the ointment is volume patterns, where on-balance volume (OBV) has not made a new high as the advance decline line has done so.
Looking at the composite OBV chart above, volume was clearly supportive of the move from the March ’09 low into the April ’10 highs and reversed again as did the markets in September and are in jeopardy of breaking the modest uptrend line from those lows. Less clear is that pullbacks in OBV are getting increasingly larger, from the minor May/June ’09 period, larger still into the October ’09 bottom and the spring pullback this year. Based solely upon the above chart, investors are getting more skittish about buying and are much more willing sellers as news hits the markets.
In a more normal environment, the markets are supposed to act as an anticipatory mechanism – rising during the 80’s/90’s ahead of the booming economy, however that relationship seems to be broken since 2000, when the markets have failed to “see” issues ahead, getting way too bullish in ‘07/’08 and too bearish in early ’09. Many have argued that easy monetary policy has “papered over” many of the problems, creating this disconnect. QEII does nothing to provide assistance to clarify the situation and instead making it murkier and forcing investors into investments that may not be suitable, but are necessary for investment as “normal” alternatives no longer provide the income or historical safety as they have done in the past.
Earlier in the year, it was Greece, this week it is Ireland and the markets reacted in a similar fashion – selling off as news of default comes out, only to be reversed when a “bailout” is created and accepted. The deep rooted problems have not been solved, but merely papered over. In that vein, any guesses as to when QEIII will be announced?
