These are updated comments from Schwab following the past few days market reaction. Not a lot positive here but it does provide more context to try to explain why the markets (at least the US markets) are not acting the way they normally do. RGW

 

On Strategy

The Fed Twists and the Market Turns

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
September 22, 2011

Key points

• The Federal Reserve announced "Operation Twist," which was largely expected, but did little to calm markets.
• The goal is to further reduce borrowing costs and push money via lending out into the real economy.
• Whether it will work is the big question … because high interest rates are not the economy's problem.

(The bulk of the article below was penned immediately after the Fed's announcement of "Operation Twist" on September 21, but the following 11 paragraphs add fresh perspective on the recent market action.)

Stocks, commodities and even gold prices tanked the day after the Federal Open Market Committee's latest policy meeting concluded, adding fuel to the notion that the confidence crisis is reaching new heights. Often the goal of a Fed that's easing monetary policy is to stir up animal spirits, but instead its move and more pessimistic outlook only added to the lack of confidence about the future health of the economy.

Adding to the woes is the continued meltdown in the eurozone, leading investors to exit all forms of risk and head to the safety of cash and US Treasuries. This has spurred a rally in the US dollar, which, given the recent inverse correlation between the dollar and stocks, has also exacerbated the market sell-off (in commodities, too). In short, the market is coming to the realization that there’s only so much the Fed can do.

Not helping matters were comments from Mohamed El-Erian of PIMCO, speaking at an event in Washington, DC today: He suggested that the world was on the eve of the next financial crisis with sovereign debt its epicenter, and that the European Central Bank hasn’t put in place a "circuit breaker" to contain the region’s debt crisis. This has been our concern for some time now as well, believing a default by Greece is inevitable. Michelle Gibley and I addressed the eurozone crisis in our report last week titled "The End of the Line."

Lending some credence to the view that the eurozone crisis has become the market's biggest driver is an analysis of daily trading activity. Based on a study by Birinyi Associates, for the first seven months of this year the primary focus of the US stock market appeared to be the domestic economy, but since August attention has shifted toward foreign concerns.

Through July, the first half hour of trading—when US markets are often reacting to overnight trading in foreign markets—had little effect on the overall returns of the S&P 500. However, since the end of July, if you exclude the first half hour of trading from the S&P 500's return, the market would be 9% higher than it is now, suggesting the market has become more reactionary to global events and trading.

Even an on-the-surface strong reading in the leading economic indicators out today didn't ease concerns. Although the LEI was up more than expected, it was driven by the wide yield spread and rising money supply. Both of these financial indicators may be less relevant to growth than in the past: Indeed, every recession in the past 60 years has been preceded by an inverted yield curve (when short-term interest rates are higher than long-term rates); but with short rates pegged at zero, that’s not going to happen. As for money supply, it's been boosted by fear and lack of confidence as investors of every variety have sold riskier assets in favor of cash holdings—not presently a positive sign.

The strong LEI but weak market action is characteristic of what still remains a somewhat mixed set of indicators. Corporate profits have remained healthy, though earnings estimates have been trending lower. Industrial production and durable goods orders have remained healthy. But macro concerns have taken precedence over some micro positives. And weaker manufacturing growth reported in China yesterday only added fuel to the global slowdown fire.

Finally, there may be another government shutdown pending given the inability to pass a stopgap budget measure that would keep the government running into next month. Just what markets didn’t need is further lack of confidence in political leadership in Washington DC.

We’ve received a lot of questions about the likelihood of a double-dip recession and what the stock market's saying about the economy. As we've often noted, the risk of another recession is certainly elevated, but it's not yet conclusive. Part of why we think another official recession might be avoided is actually not great news: Many segments of the economy, including small business and housing, never came out of the 2007-2009 recession to begin with, so they may not drop from recent levels sufficiently enough to hurl the economy into another official contraction.

Recessions are defined as sharp declines in activity, but the rebound from the last recession was relatively anemic, suggesting that a sharp decline from these levels is less of a risk. In addition, historically there's not much difference between the depth of a cyclical bear market that's accompanied by a recession and one that isn't followed by a recession.

More troubling is the potentially unique relationship we're seeing between stocks and the economy. Normally the stock market is a discounting mechanism, and its weakness could indeed be sending a message about future economic growth. But the stock market has also become a catalyst, and its weakness (and the attendant weakness in confidence) could actually be the trigger for another recession … the "self-fulfilling prophecy" concept possibly in play about which we've written and spoken, most recently in the latest Schwab Market Perspective.

(Post-Fed meeting comments from September 21):

No doubt in reaction to the significant weakening of the economy over the past several months, the Federal Reserve acted as expected and announced what's known as "Operation Twist" (OT). The goal of this program, first instituted in 1961 and indeed named after the dance popular at the time, is to lengthen the average maturity of the Fed's balance sheet. The result, ostensibly, will be to lower longer-term borrowing rates, including mortgage rates.

The details Specifically, the Fed will buy $400 billion of US Treasury bonds with maturities of six to 30 years through next June. Over the same span, the Fed will sell an equal amount of shorter-term Treasuries, with maturities of three years and less. The Fed also announced that it will reinvest maturing mortgage debt into mortgage-backed securities (MBS) instead of Treasuries. This is intended to help reduce mortgage borrowing costs and stimulate additional mortgage refinancings and demand for new mortgages.

Over the past three months, the value of government agency securities and mortgages on the Fed's balance sheet has contracted by nearly $40 billion, and the move to reinvest into MBS is to prevent a shrinking of its balance sheet.

My office is adjacent to that of Kathy Jones, our fixed income strategist. We listened to the announcement together, and she had this to say: "The only surprise was that the Fed will shift nearly 30% of its $400 billion in bond holdings into 30-year Treasuries, which is more than most thought would occur at the very long end of the yield curve. This will flatten the yield curve even further. We've been using the mantra 'lower for longer' … now I guess we'll have to say 'lower and flatter for a lot longer'."

Not everyone's a fanAs has been the case recently, there were three dissenters on the Federal Open Market Committee (FOMC): Dallas Fed President Richard Fisher, Minneapolis Fed President Narayana Kocherlakota and Philadelphia Fed President Charles Plosser. They've been more "hawkish" on recent Fed decisions, concerned about the unintended consequences of extremely easy monetary policy, including inflation.

That said, the statement accompanying the FOMC's decision did note that "inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks." The statement did note additional downside economic risks though, specifically mentioning "strains in global financial markets."

50 years laterToday's OT has the same rationale as that of 1961—to stimulate a very weak economy while trying to keep inflation at bay. The decision to "sterilize" the purchases of longer-dated Treasuries with sales of shorter-dated Treasuries, thereby keeping the balance sheet at its current size, is an attempt to keep inflation at bay. Recall that both rounds of quantitative easing, QE1 and QE2, did expand the balance sheet and helped unleash a rapid acceleration of commodity inflation. The Fed had been very transparent about its desire to prevent the unintended consequences of more quantitative easing.

What differentiates QE from OT is that OT does not impact the amount of money supply in the markets and therefore the effect on the dollar, and in turn commodity prices/inflation, is more limited. By adding liquidity at the longer end of the Treasury curve and pumping up the supply of Treasuries at the shorter end of the curve, the Fed is hoping that cash will venture into the real economy.

Will it work?There are risks that the money won't find its way into the economy and create jobs, as intended by the Fed. Remember, full employment and stable prices are the Fed's dual mandates. There's legitimate fear that the Fed's siphoning of liquidity at the short end of the curve won't actually lead to increased lending in the real economy. Instead, the move could destroy yields on savings without the beneficial effect on growth, leading to a form of liquidity trap.

We've consistently expressed concern that the Fed is unable to cure what ails the economy. The problem is not that interest rates are too high, but that we're in a debt-deleveraging cycle that started three years ago in the private sector and is only just beginning in the public sector. This will take time—a lot of it—and although the Fed is not impotent, it does not possess the Holy Grail for the economy.

As for housing and mortgage rates, we're also still in a mortgage deleveraging and foreclosure cycle, and frankly, policy makers may be missing what ails the housing market. The focus has been on getting mortgage rates down further in order to stimulate refinancings and new borrowing. But as I've noted many times, it's the "real" mortgage rate that matters to prospective borrowers, not the "nominal" mortgage rate. What do I mean by that?

The math of "real mortgage rates"Back at the peak of the housing bubble in 2005, the 30-year fixed mortgage rate (the nominal rate) was about 6%. To get the "real" mortgage rate, you have to subtract the appreciation in home prices (the "deflator"). Home prices were appreciating at a 17% annual rate at the bubble's peak. So, the real mortgage rate was actually -11%: 6% - 17% = (11%). No wonder we had a bubble … who wouldn't want to borrow at negative rates? You could borrow at 6% to buy an asset appreciating at 17% per year.

Fast-forward to the trough in housing in 2009. The nominal 30-year fixed mortgage rate had dropped to 5%, but home price appreciation became depreciation at an ironic 17% rate. So, the real mortgage rate was actually +22%: 5% - (17%) = 22%. Who wants to borrow at any rate to buy a rapidly depreciating asset?

I think this is what many policy makers are missing. It's the "rapidly depreciating" part of the equation that needs to heal. If home prices are still declining, even with rates low, there's likely to be limited demand to borrow. I do think mortgage refinancings could get at least a marginal lift from OT if rates go lower, but we need to be realistic about the overall affect on housing.

Confidence is keyUltimately, confidence has to improve before we're likely to enjoy any reasonable pace of economic growth. Whether this move by the Fed starts the confidence-healing process remains to be seen. But we suggest you keep your expectations relatively low.

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