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Marcuard's Market update by GaveKal Research
The Federal Reserve made no policy changes on Wednesday—short rates remain near zero and quantitative easing continues at a fast clip of $85bn per month. The Fed did however adjust its economic projections, for the better—unemployment is expected to fall faster than previously thought, and inflation lower. Chairman Bernanke then spent an hour with reporters trying to clarify what this means for the future policy trajectory.
First, lower inflation expectations mean that the Fed’s hand is not being forced to tighten. That is good news. But IF, and since Bernanke only said it 50 times yesterday we will repeat, IF the Fed’s relatively optimistic view on growth is proved right (which would be a first in this recovery) then the Fed will start to gradually taper off its QE purchases later this year. And if the economic recovery persists (e.g., if unemployment drops to 7%) in the face of such tapering, then the Fed will wind down its purchases to zero, perhaps by mid 2014, and then hold the bloated balance sheet at that level for a while. Our reaction: What is not to like? The equity markets’ reaction: Oh the horror!
Of course, global equity markets did not like it at all, as they focused squarely on the prospect of less QE. And to be fair, the endings of previous QE programs have not been kind to equity markets. But the previous terminations took a very different form. They were pre-determined and abrupt. Moreover, their scheduled terminations unfortunately tended to arrive during mid-year soft patches in growth data—stoking fears that the stimulus was being removed just when growth was faltering. In other words, it would be like QE3 being scheduled to end abruptly this month, just after the manufacturing PMI dropped below 50. This is not the case. QE3 will remain until the growth data confirms an established recovery. The Fed has simply voiced its projection that this optimistic turn of events will come later this year. We should hope the Fed is correct.
What are the market implications of the Fed’s outlook and plan? First, US yields will continue to normalize. Bernanke’s words yesterday pushed 10 year treasury yields above 2.3%. We stand by our call that a normalization of yields could take 10 year treasury yields as high as 3% by the end of this year, and could rise to around 4% in the years following. If this is the result an improving growth outlook (not an inflation scare), then this is a good thing. This should be positive for the US dollar and for quality US companies that can capitalize on stronger growth. One does need to be wary of companies, and valuations, that depend more on easy money than solid growth.
Looking outside of the US, we see this as a boost for Europe and especially Japan. Recovering US demand supports global growth. And as UST yields rise relative to JGBs, bunds, etc… the dollar should rise and the euro and yen fall. This is exactly what many market participants have been hoping for. Obviously emerging markets are suffering as easy liquidity returns home to developed markets, and some are worried that the proverbial “whale” in the shape of a stressed financial institution will materialize in some cash-needy developing country. But at the same time, EM non-commodity exporters are top beneficiaries of a stronger US economy.
If the Fed is too optimistic about growth, then QE will continue at full steam. If the Fed is proved right to be so optimistic, then we will welcome a moderation, and eventual elimination, of QE purchases. After all, economies function best when they operate on appropriate price signals. Central bank manipulation of interest rates and exchange rates has been an unfortunate product of the recent crises. We are hoping for a normalization, and it is good to hear that Bernanke is as well.
Disclaimer: This information may not be construed as advice and in particular not as investment, legal or tax advice. Depending on your particular circumstances you must obtain advice from your respective professional advisors. Investment involves risk. The value of investments may go down as well as up. Past performance is no guarantee for future performance. Investments in foreign currencies are subject to exchange rate fluctuations. Marcuard Cyprus Ltd is regulated by the Cyprus Securities and Exchange Commission (CySec) under License no. 131/11.
