The recent Organization for Economic Cooperation and Development’s composite leading indicators (CLIs), which were designed to anticipate turning points in economic activity relative to trend, pointed to mild losses of growth momentum in most of the major economies for April 2011.
The indicators signal a mild loss of growth momentum with one notable exception: the United States, which continues expanding, albeit more moderately than in the last month’s assessment. In the euro area, we see a mild loss of growth momentum.
The indicators of the BRIC countries (Brazil, Russia, India and China, which are all deemed to be at a similar stage of newly advanced economic development) point moderately lower with China indicating a possible moderation in its economic activity. There is a slowdown in Brazil and India, and we see the first signs of a loss of growth momentum in Russia.
It looks that the perceived slowing economic activity is really taking hold globally with, for now at least, the United States being the noteworthy exception. It looks like the BRICs won’t have the power that could reverse the ongoing slowdown.
Taking the indicators into account, it doesn’t look like the United States is headed for a double-dip recession, but rather it is experiencing a too-slow pace of economic activity.
As the end of the Federal Reserve’s large scale asset purchase, widely referred to as ‘QE2,’ nears at month’s end, many investors feel uncomfortable and fear there will be a destabilizing spike in Treasury yields.
Further complicating that issue is the recent price performance in U.S. Treasurys, which would appear counterintuitive.
Let’s look a little bit closer. We already know that he Fed will reinvest principal and interest and therefore its balance sheet will not shrink. In clear English, this means a continuation of a very accommodative monetary policy.
However, investors should not overlook the fact that the money supply is not increasing, so we can say that incremental stimulus has stopped.
This by itself carries the risk that the U.S. economy becomes more susceptible to “exogenous” shocks, such as the Middle East issues, or another big quake and tsunami in Japan or simply severe weather problems in the U.S.
The U.S. economy will now try to stand on its own. I personally still fear the pace of activity isn’t strong enough to lead to a typical self-sustaining recovery. I expect growth will continue to disappoint and remain below traditional post-recovery levels.
The size of the Fed’s holdings of Treasury securities, which is actually about 20 percent of the total marketable coupon debt outstanding, has resulted in a sizable lowering of Treasury yields. From the end of June, the Fed will continue to reinvest coupon payments and maturities and the market will “only” need to absorb the incremental debt less the principal and interest from the Fed’s mortgage portfolio reinvestment program.
Investors should take notice we now should see progressively the start of discounting the new supply/demand equilibrium prior to the expiration of the program. If yields do rise to reflect the exit of the Fed, it will most likely occur in June or shortly thereafter. No, the Fed’s exit from bond buying will not imply an immediate increase in interest rates.
Going forward, I think rates will be dictated more by fundamentals like growth and inflation and the behavior of risk assets once the Fed has officially ended QE2. Under today’s circumstances I still see the U.S. Treasury 10-year yields remaining in the range 3.00 percent to 3.75 percent after QE2. I only see a break of that range because of deteriorating growth or inflation issues.
Given the recent weakness in economic activity, and the fed-funds rate at 0 percent, Treasury yields should remain relatively well anchored.
In my opinion, there is no doubt that the end of QE2 will be less supportive of risk assets and mildly supportive of the U.S. dollar. To the extent that QE2 was responsible for an appreciation of equity and commodity prices, the completion of the program is likely to be negative for these asset classes, all be it at the margin.
For now it looks like this is actually discounted somewhat in advance.
On the inflation outlook, particularly inflation expectations, I think it will remain well-anchored as long as growth remains below trend.
Investors should take notice that such an environment is conducive to an accommodative Fed, which should ultimately support risk assets. Corporate bonds should do well as long as growth and inflation remain below trend.
Nevertheless, it is very likely we’ll see an increase in volatility which is, of course, a headwind to risk assets.
I think it’s also good to remember that several Fed members have expressed concern over the effectiveness of QE2 and the extent to which the program encouraged some speculative investing in commodities and other risk products.
Universally, the members have acknowledged a relatively high hurdle rate for incremental quantitative easing purchases. Last week, Fed Chairman Ben Bernanke said “monetary policy cannot be a panacea.”
In the absence of an exogenous shock that represents a systemic issue (EU sovereign/banking crisis, etc.) or a material and sustained retrenchment in private payroll gains, another quantitative easing program appears, for now, unlikely.
In addition, “deflation” now doesn’t seem to be in the cards. The Fed’s favored measure of inflation expectations (5-year forward 5-year breakeven inflation rate. [BEIR]) is significantly higher than it was in 2008 or 2010 when the Fed enacted its alternative monetary policy tools.
Of course, I can be wrong but I think the Fed will wait for a correction in commodity prices after all the criticism it has received globally about energy and food price increases.
When asked if QE2 could be partially responsible for the increase in commodity prices, Dallas Federal Reserve President Richard Fisher said on CNBC: “I have argued that it could be partially responsible.”
Under the current economic and political circumstances, I still think the likelihood of QE3 remains rather remote.
Nevertheless, it’s not off the table completely and there are some signposts that could signal investors an increasing the probability of QE3:
• 5-year forward 5-year breakeven inflation rates [BEIRs] below 2.25 percent;
• Negative private payroll growth for three straight months;
• Sudden equity sell-off greater than 15 percent;
• Oil prices below $85;
• A systemic shock.
It’s not only the end of QE2 that is at play for the moment. The actual economic soft patch as confirmed in the OECD’s composite leading indicators (CLIs) seem to have exacerbated the price action in risk assets at the time that QE2 is coming to an end.
I think risk assets could experience some form of correction associated with this soft global economic patch. Given the uncertain global economic growth scenario and tighter liquidity because of a less stimulative Fed, I remain “risk off” and therefore continue favoring the dollar, Swiss franc and gold.
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