Waiting for Jackson Hole

Location Date: 
August 25, 2011

Will he or won’t he? The launching of QE3 by Big Ben is the hot debate this week and we will get our answer tomorrow. Given the improvement in industrial commodity prices, stock prices and a U.S. dollar at the low end of its trading range this week, it appears that investors and traders are tilting their bets to the “yes” side. Firms like Goldman Sachs have even built it into their base case scenario. However, since the end of QE2, equity markets have sold off sharply, leading to much debate as to whether this program accomplished anything good at all?

A quick review is in order. Virtually all are in agreement that QE1 was a success. The FED added liquidity into the system by expanding its balance sheet to purchase (leverage) treasury securities and low-rated obligations from the banks. Together with TARP, this provided much-needed stabilization and confidence in the banking sector.  It did not, however, cure the basic problem of excess debt in the system.

The success of QE2 is much less clear. While QE1 was about saving the system, QE2 was all about kick-starting growth and avoiding the kind of deflationary spiral experienced in Japan and during the Great Depression. The fundamental problem, as we and many others have noted, is the excessive level of debt in the system. It is hard to stimulate GDP growth given the consumers’ lack of desire to borrow (deleveraging) and the banks’ lack of desire to lend (given new standards, there are not enough credit-worthy people and companies). So enter the FED with round 2, targeted at boosting confidence in equity and credit markets (large issuances of high yield and lower quality debt outside of the banking industry). They created a wealth effect and lower rates for all borrowers.  The FED was able to do this until the end of QE2. Then stocks retraced a good deal of their gains and spreads have widened out. If the goal of QE2 was only to boost equities, then it was a success.  But as Karen Woods and Derek Holt of Scotia Capital correctly point out, one has to more broadly consider QE2’s “influences upon other market variables of great importance to main street households[i].” For example, as inflation expectations rose, commodity prices were positively impacted to perhaps too high a level given the excessive debt and toxic assets still in the system – but this, as noted by Scotia, was another “tax” via rising gas and food prices on consumers all around the world. 30-year mortgage rates also rose (not good for house prices and demand), although they have since fallen post-QE2. Many have also argued that the U.S. exported inflation to emerging markets, forcing EM governments (China, Brazil, and India more specifically) to raise rates to fight this inflation. Of course China’s managed currency has to shoulder some of the problem. Regardless, the verdict on QE2 is mixed at best given the rapid slowdown in economies around the world. It was a short-term shot in the arm, but the “heroin” (as Don Coxe puts it) has run dry. Now, many are hoping for another hit via QE3.

So what would QE3 look like if it was to be implemented?  Perhaps the best suggestion comes from David Rosenberg at Gluskin Sheff who suggested the FED could attempt a version of “Operation Twist” (done in 1961 to stem the outflow of gold from the U.S. when the gold standard was in place) whereby the FED buys 10-year treasuries up to a certain level to target a specific yield –then, they buy as much as it takes to keep the yield pinned there. This makes it a permanent rate upon which borrowers can take confidence in their long-term decision making. Of course, it may leverage and perhaps destroy the FED’s balance sheet - but you can’t have everything! There are plenty of other “options” including cutting the interest paid to banks on reserves parked at the FED, reinvesting pay-downs from its MBS portfolio into treasuries, direct lending to small business, etc...

At the end of the day, my gut feeling is that the public is getting tired of the tricks and interference in capital markets. Indeed, with three FED governors dissenting, it is not just the public that is grumpy. Forcing rates down artificially creates a large “tax” on anyone trying to save. In fact, this policy actually forces risk-averse savers into risky high-yielding equities and debt – in the past month or so, high yield spreads have widened from 400 bps to 690 bps – a nice capital loss!


Additionally, pension plans have been hurt from the perspective of their funding status. The rule of thumb is that every percentage point drop in bond yields boosts a plan’s liability by 15% [ii]. While plan sponsors have not lost all of the gains from the lows of 2008, falling yields and stock markets would jeopardize this situation.

In my humble opinion, I hope the FED says nothing much except that it is following the course.  QE3, if anything, will be a short-term bump in equities and commodities. Bernanke already has 10-year yields down to 2.25% without doing anything to impact the FED’s balance sheet. Refis are up substantially and the market has Bernanke’s strong signal that he “has their back” from a monetary perspective. It is actually high time the government stepped up and gave an honest and clear path forward on its debt issues. I am positioned neutrally into this rally and not committing much capital – buying back our gold positions, going long U.S. treasuries and maintaining longs in recession-proof companies (Walmart, Target. Altria, Heinz, Kraft, etc.) with little cyclicality and decent dividends. Boring, yes, but it is critical to live to trade another day – when it will be easier!


[i] Global Views, Scotiabank Group, June 24, 2011.

[ii] Pension Plans Suffering After Market Turmoil, The Globe And Mail, August 17, 2011.