Is the Fed Now Leaning Toward QE3?
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Fed May Be Rethinking QE3
2. Timing: This is a Big Political Year
3. ECB Bailout Loans Top Three Trillion Euros!
4. Greece Avoids Ugly Default – For Now
5. When Does the Debt Day of Reckoning Come?
Fed May Be Rethinking QE3
Even before the latest report showing that 4Q GDP rose a more than expected 3% (annual rate), there was a consensus that the Fed would not embark on a third round of quantitative easing, or QE3 this year. But upon further inspection, we find that the latest 4Q GDP report was higher than expected almost entirely due to inventory rebuilding, which has faded this year.
Analysts note that were it not for inventory rebuilding in the 4Q, the GDP number would have been only around 1%. This is leading forecasters to reduce their estimates of 1Q GDP growth. As I wrote last Tuesday, Wells Fargo expects 1Q GDP growth of only 1.5%. Morgan Stanley now expects only around 1%.
As a result of these lower GDP forecasts, the continued rise in oil and gasoline prices and continued high unemployment, the thinking is shifting regarding whether the Fed will undertake QE3 this year after all. In fact, if you look at the actual minutes from the last Fed Open Market Committee (FOMC) on January 24-25, you find that the subject was indeed discussed:
“The Committee also stated that it is prepared to adjust the size and composition of its securities holdings as appropriate to promote a stronger economic recovery in a context of price stability. A few members observed that, in their judgment, current and prospective economic conditions--including elevated unemployment and inflation at or below the Committee's objective--could warrant the initiation of additional securities purchases before long.” [Emphasis added.]
It is clear from the Fed minutes above that the FOMC is still concerned about deflation when they comment that if inflation falls below their target (of 2%), that could warrant more QE. So if the economy stalls, or if inflation starts to dip, or both, it seems obvious that the Fed would not hesitate to enact QE3.
The Fed knows that QE1 and QE2 were unpopular. No one wants to see the Fed’s bloated balance sheet of apprx. $2.9 trillion today soar to $3.5 trillion or more. One other option would be to expand and extend the so-called “Operation Twist” that the Fed launched last fall.
Operation Twist as you may recall is an exercise where the Fed sells short-term Treasuries such as T-Bills and purchases longer-term Treasuries such as T-Notes and T-Bonds. This operation is designed to put downward pressure on longer-term rates, without expanding the Fed’s huge balance sheet.
Timing: This is a Big Political Year
It remains to be seen whether the Fed feels compelled to enact another round of monetary manipulation. Likewise, if the Fed feels it needs to do more stimulus, it remains to be seen whether the FOMC decides to do QE3 or an extension of Operation Twist.
But when it comes to the issue of timing – assuming the Fed does something – we can narrow the window down fairly closely. Let me explain. First, since QE3 or Twist2 will be politically unpopular, it makes sense that the Fed would want to move sooner rather than later, given that this is a presidential election year – specifically, not in the last half of this year.
Such policy decisions are almost always made at FOMC meetings. The upcoming FOMC meetings are as follows: March 13 (today), April 24-25 and June 19-20. I would be surprised if the Fed votes to enact QE3 or Twist2 at today’s FOMC meeting; they need to allow a transition period. However, it would not surprise me if they announce another stimulus program at either the April 24-25 meeting or the June 19-20 meeting.
Perhaps the most likely scenario would play out as follows. For today’s one-day FOMC meeting, the Fed probably elects to keep all options open in its policy statement later today, just as it did in January, as discussed above. [Note: We won’t see the actual minutes from today’s FOMC meeting for about three weeks, when we will know what exactly was discussed today.]
Then at the April 24-25 FOMC meeting, they could begin to get more specific as to what they might be considering in the way of more stimulus.
Keep in mind that we will not get the first government estimate of 1Q GDP until the end of April. If the Fed is considering another round of stimulus (QE3 or Twist2), I would think they would want to see the official estimate of 1Q growth before they act. If the advance estimate of 1Q GDP growth is weak, then that could be the green light for the Fed.
So in this scenario, the most likely time for another round of QE3 or Twist2 might be at the June 19-20 FOMC meeting. That way, they get it out in the open in the first half of the year, with several months for the political negatives to die down well before the election. And, the Fed could then keep a low profile throughout the election season.
The Fed watchers at Morgan Stanley believe that if the FOMC decides to enact QE3, the amount will be $500-$700 billion, and would include not only Treasury purchases but also mortgage-backed securities. Or if the Fed elects to go with Twist2, Morgan Stanley expects that would be at least $400 billion. Obviously, these are just guesstimates.
Of course, no one knows for sure that the Fed will do anything just ahead. However, let’s assume that all (or most) members of the FOMC agree that it’s possible the economy could stall out in the next few months. If they also agree that they don’t want to make any unpopular moves after the middle of the year, they could decide to resort to QE3 or Twist2 just ahead – even if they prefer not to.
Richard Fisher, the outspoken President of the Federal Reserve Bank of Dallas, has made it no secret that he opposes quantitative easing by the Fed. Speaking to the Dallas Regional Chamber of Commerce last week, Fisher said:
“I would suggest to you that, if the [economic] data continue to improve, however gradually, the markets should begin preparing themselves for the good Dr. Fed to wean them from their dependency rather than administer further dosage… I am personally perplexed by the continued preoccupation, bordering upon fetish, that Wall Street exhibits regarding the potential for further monetary accommodation — the so-called QE3, or third round of quantitative easing.”
But as noted above, Fisher has opposed QE from the very beginning. I would also point out that Fisher is not a voting member of the FOMC this year, which explains why he can be so vocal.
My objective today is simply to make sure my clients and readers are not surprised if the Fed makes another major policy move just ahead. Now that the European Central Bank’s (ECB) balance sheet has soared above $3 trillion, maybe our Fed feels the need to top that number. I say this somewhat in jest, but you just never know.
I will update you on this situation when we get the minutes from today’s FOMC meeting in early April. Those minutes will tell us definitively whether QE3 or Twist 2 are still on the table and how concerned the FOMC members are in regard to the economy.
ECB Bailout Loans Top Three Trillion Euros!
The European Central Bank (ECB) has engaged in a massive bailout program of banks in the region over the last year. To put this shift into perspective, we have to remember that in 2010 the ECB was on a mission, or so it thought, to combat fears of rising inflation in Europe. It was intent on raising interest rates and reducing the size of the monetary base.
The ECB completely missed the deflationary implications of the global financial crisis. However, the ECB finally recognized that it was fighting the wrong battle just in time and reversed policy, but it was then playing a game of catch-up. And catch up it did!
The ECB did a dramatic 180 and implemented its own version of QE to the tune of 3 trillion euros (US$3.9 trillion) over the last year or so. The ECB eventually realized that the major European banks were essentially insolvent. Given that realization, the ECB reversed course and embarked on a massive program of printing money to save the banks.
The plan was to loan massive amounts of money to European banks to help them recapitalize and survive the financial crisis. The huge bailout was a series of three-year loans to the banks at an interest rate of near 1%. The major banks jumped on this opportunity.
In a statement released last Thursday, the ECB admitted that its latest round of loans to euro-area banks jumped 310.7 billion euros to 1.13 trillion euros in the week ended March 2. The ECB’s balance sheet has now swelled to 3.02 trillion euros, topping that of our own Fed at $2.9 trillion by more than one-third.
Klaus Baader, chief euro-area economist at Societe Generale in London, warned:
"With the dramatic expansion of its balance sheet… the ECB has become the most active central bank in the world. The ECB's measures are absolutely justified, but it has to be aware of the risks on its balance sheet and think of an exit strategy." [Emphasis added.]
While many have welcomed the ECB’s massive lending efforts, Baader and others worry that the central bank is taking too much risk. In particular, the ECB loosened the rules on the collateral it accepts against loans, increasing the risk that taxpayers would have to foot the bill if one or more banks default.
ECB council member Jens Weidmann, who heads Germany’s Bundesbank, said the unprecedented three-year loans are "at the limits" of the central bank’s mandate and warned of "substantial risks," Spiegel magazine reported on March 3.
The ECB relaxation on acceptable collateral mirrors what our own Fed has done in recent years. The question is – how and when will the Fed and the ECB ever unload these questionable assets the banks dumped on them without causing another potentially worse financial crisis? Yet no one asks publicly, as if we don’t want to really know.
Greece Avoids Ugly Default – For Now
The headlines tell us that Greece narrowly avoided a nasty default on its debt late last week. We are told that 83% of Greek bondholders agreed to swap apprx. €100 billion in old bonds for new, longer-dated bonds at a reported haircut of 53%. But if you look at where those new bonds are trading, the haircut is over 70%.
The Greek government put in place “Collective Action Clauses” late last week to force the remaining bondholders to accept the new bonds as a requirement to qualify for the pending bailout loan of €130 billion ($170 billion). Euro-area finance ministers are expected to approve the loan as soon as tomorrow.
The party line among euro finance ministers is that this second bailout loan of €130 billion will enable Greece to get its debt-to-GDP ratio, which is currently at 160%, down to near 120% by 2020. That will be next to impossible, and everyone knows Greece will need even more bailout money as soon as it burns through this latest loan.
Greece is in its fifth year of recession, with GDP contracting by a reported 6.9% in 2011, in large part due to the severe austerity measures forced upon the country. The unemployment rate is north of 20%, and the youth unemployment rate is above 50%.
The terms of the new bailout loan require Greece to make even more spending cuts, wage cuts and impose even higher taxes. This will ensure that the economy remains in a recession, or worse. Greece will hold national elections in late April or early May, and the mood of the electorate is livid.
While Greece may be off the front pages for now, it won’t be for long.
When Does the Debt Day of Reckoning Come?
At the end of the day, most of the developed nations of the world are accelerating their indebtedness at alarming rates. The US in recent years under President Obama has seen its national debt skyrocket, as I have warned repeatedly in these pages. This cannot continue indefinitely.
Currently, domestic and international investors remain content to purchase US Treasury securities at historically low rates of return. The US is still considered to be the safest borrower in the world, or so it would seem. Most of my respected sources believe that this alarming debt trend will continue for several more years at least, and the CBO deficit projections certainly bear this out.
Frankly, it is easy to embrace this view that a US debt crisis will not unfold until at least several years from now. After all, US interest rates across the board are at or near all-time lows. 10-year Treasury Notes are at 2% or below. 30-year Treasury bond rates are near 3%. Yet foreign demand for our Treasury securities is near all-time highs. So what’s to worry about?
Foreigners are still lining up to buy our debt despite the fact that our current President seems indifferent to trillion-dollar annual budget deficits or the fact that our national debt has recently surpassed our Gross Domestic Product for the first time in over 50 years.
But does anyone believe that the US can continue to ratchet up our national debt indefinitely without major financial consequences? I doubt that many, if any, of my clients and readers do. I certainly don’t. If we are correct, then we are simply counting the days until another potentially worse financial crisis unfolds.
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Gary D. Halbert
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.