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By David Franklin for Sprott Asset Management LP
With Wednesday’s discussion of ending its $85 billion per month asset purchase program known as ‘Quantitative Easing”, The U.S. Federal Reserve sent tremors through all asset markets.
The major stock indices remained steady until the 2:00 pm release of the Federal Open Market Committee (FOMC) statement marking the conclusion of its two-day monetary policy meeting. With no mention of the future of the Fed’s quantitative easing program in this release, stock prices vacillated as investors tried to determine the programs fate. At 2:30 pm, Fed Chairman Bernanke began his press conference and wasted no time getting to the ‘heart of the matter’. When asked why the future of quantitative easing was not discussed in the FOMC Statement, the Chairman said that he was “deputized” to explain it at the press conference because the phase-out of the program involved too many “subtle contingencies” for the matter to be adequately explained in the written statement. The phrase that shook the markets was found in Bernanke’s prepared comments for the press session. He stated, “the committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year and that the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year”. But the market clearly interpreted these comments to mean that quantitative easing WILL be reduced or ‘tapered’ late this year and WILL END by mid next year.
Investors did not stick around to understand the nuances of the statement and started a selloff in all asset classes. The Dow Jones Industrial Average dropped 175 points in the blink of an eye and was off more than 350 points by Thursday’s close. The spot gold price traded down as low as $1,255 and the yield for the 10-year US Bond jumped to over 2.46%. Adding further selling pressure was data showing continued economic weakness from China with further deterioration of their purchasing manager indices. The TSX Materials Index now sits at levels not seen since the depths of the financial crisis in January 2009. There was not a major asset class that did not bear the brunt of Mr. Bernanke’s comments.
This wild ride provides more evidence that asset prices have been driven more by expectations of monetary ‘juice’ from the central bank than by economic or business fundamentals. However, it’s important to note, that Mr. Bernanke included many qualifiers about exactly when monetary policy in the U.S. would change. The Chairman made it clear that an improving economy coupled with lower unemployment and an uptick in inflation are all pre-requisites for a policy change. Providing more clarity during the question and answer session, Mr. Bernanke stated “I think one thing that’s very important for me to say is that, if you draw the conclusion that I just said that our policies – that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion, because our purchases are tied to what happens in the economy.”
So what is an investor to do? While Mr. Bernanke clearly intended to signal to the market that there would be an end to the quantitative easing program, he has left himself with plenty of ‘wiggle’ room to change the decision at a later date.
Economic data published recently out of the U.S. shows a recovery is far from certain. A drop in government spending dragged on the U.S. economy in the first three months of the year, a sign of increasing pain from Washington’s austerity drive. New jobless claims have remained persistently high, and together the data reinforces the view that the U.S. economy may be entering yet another soft patch. Gross domestic product, expanded at a 2.4% annual rate during the first quarter and is down a tenth of a point from an initial estimate. That growth rate is much faster than the prior quarter’s pace, but likely still too weak to fuel faster improvements in the labor market. Meanwhile, the economies of the U.S.’s major trading partners continue to falter. The ongoing depression in the euro area will not help U.S. exports, nor will the slowdown in China. Recent economic comments from FedEx and sales weakness at Caterpillar suggest the economy may not return to robust growth anytime soon potentially delaying any reduction in asset purchases. Another hurdle the Fed needs to clear is unemployment.
Since December 2012, the unemployment rate has fallen from 7.8% to 7.6%, but much of that improvement was due to a decline in the labor participation rate as opposed to actual job growth in the United States. And of course inflation is far below the Fed’s target. Over the first four months of 2013, the Personal Consumption Expenditure price index (a favorite measure of inflation used by the Fed) increased at a 0.3% annualized rate. This is significantly below the Fed’s stated target of 2% inflation and we expect that the Fed will want to see some increase in inflation before reducing the pace of asset purchases.
While we are skeptical that the terms of ending asset purchases will be met according to the timeline given by the Fed, we are forced to contemplate a financial world without the tail wind of an easy US monetary policy.
