Why More QE Isn't Coming
Markets were in the red for the majority of trading Wednesday, but bounced back and moved near positive territory later in the day.
The catalyst? The release of the minutes from the Federal Reserve's last open market committee meeting.
According to the minutes, many members of the Fed's FOMC were open to additional easing should the economy fail to pick up soon. At the very least, the FOMC's members appeared willing to change the language in the rate forecast, promising to keep rates exceptionally low past 2014.
Given the language in the minutes, market participants may be expecting the Fed to announce another easing program soon. The Fed's Chairman Ben Bernanke will give a speech in Jackson Hole, Wyoming at the end of the month. He used this opportunity two years ago to unveil what would ultimately become QE2.
PIMCO head Bill Gross tweeted that he thought the odds of QE3 were around 80 percent.
Still, despite the Fed's minutes and the opinion of Bill Gross, traders should remain skeptical that a new QE program is coming anytime soon.
To start, more QE really isn't needed. In the past, QE programs have been mostly effective at driving the markets higher. With the market back to pre-crisis levels, it is hard to argue that stocks really need a jolt.
Further, while QE does bring some positive benefits, it also carries consequences. Although Bernanke has stated that he doesn't believe QE directly affects the price of commodities, the correlation is uncanny: the price of oil and other industrial commodities has rallied strongly following the deployment of past QE programs.
Currently, WTI crude is pushing $100 per barrel and gasoline is near $4 a gallon. More QE might send these prices higher, weakening the economy as consumers are forced to reduce spending to offset higher fuel prices.
Of course, oil isn't the only commodity to worry about -- food prices remain elevated in the wake of the drought.
A higher grocery bill for a U.S. consumer is for the most part a nuisance. It could be a death sentence for those living in the third world. The “Arab Spring” that started in 2011 followed elevated food prices in the Middle East. China too experienced some brief unrest when food prices in the growing economy jumped some 40 percent in late 2010. More QE could have severe geopolitical consequences in a world that is already facing unrest in Syria and the possibility of a war between Iran and Israel.
Lastly, if the Fed intends to deploy more QE, it is likely in the Fed's best interest to wait.
Like many things in economics, QE faces the problem of diminishing returns. Interest rates on both government bonds and mortgages remain near record lows, so aiming to bring them down further will have little effect on the real economy. Likewise, the capital markets may see a bit of a boost but it would be unlikely to be as tremendous as the rally seen in the wake of QE1 and QE2.
The U.S. domestic economy is sluggish, but is undeniably stronger than it was in late 2008 and early 2009. Still, very real threats to the tepid recovery remain.
China's economy could be on the verge of a collapse -- many still see a “hard landing” for the emerging power, an idea which was bolstered Wednesday when China's flash PMI came in at its lowest level in nine months.
Europe also still poses a threat. Euro zone leaders have managed to muddle through thus far, but the continent's fundamental problems remain unsolved. Given Spain's persistently high unemployment, the yields on its bonds could quickly rally back to their previous record levels. Meanwhile, a Greek exit from the currency zone could still come at any time, with Citigroup recently placing the odds of such an event at 90 percent over the next 12-18 months.
In short, the U.S. economy isn't that bad but downside risks remain. Six months from now, things could be much worse -- does the Fed really want to use up its bullets now?
St. Louis Fed President James Bullard appeared on CNBC's Squawk Box Thursday morning. Bullard downplayed the Fed's minutes, characterizing them as “stale.”
Many traders dismissed Bullard's comments, suggesting that he was simply playing “bad cop” in an attempt to temper expectations for more easing.
But perhaps it is the traders who are being played. The Fed has been hinting at more QE since the last program ended. Commentators have long predicted that the “next meeting” would be the one where additional easing was unleashed, only to be disappointed time and time again.
August 2011 was a tumultuous month for the market, as the euro zone crisis raged and congress wrangled with the issue of raising the debt ceiling. Market commentators were certain that Jackson Hole 2011 was when QE3 would be announced. Yet despite all the problems in the world, the Fed limped by with a meager “operation twist.”
Earlier in 2012, June was the consensus pick for more QE. Most argued that September was unlikely, as it was too close to the election. So, Bernanke would opt for June, rolling out QE3 just far enough away from the election so as to avoid being accused of election engineering.
Yet, June came and went with no QE, and so expectations were pushed off until September.
Is this Jackson Hole finally the time for QE3? Perhaps, but it seems like a stretch. Traders who are convinced that more easing is coming may do well going long the precious metals. Those who are more skeptical might wish to hold cash, or even consider shorting the market.
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