Yesterday was a day dominated by moves and expected moves by central banks. After a complete lack of any action from the Bank of Japan there were various views on what the Federal Reserve should do of which more later. However, before I get to that there have been one or two other things going on in financial markets recently. Commodity prices drifted a little lower again with the Commodity Research Bureau spot index dropping back to 443.52 with metals prices falling for once and wheat prices are now around US $7.30 per bushel. Also the yields on government bonds in some of the peripheral countries of the euro zone have started to drift a little higher again after their recent improvement. As an example Spain’s ten-year government bond yields rose to 4.17% and Ireland’s equivalent which had fallen to 5% recently are now 5.26%. As ever Greece is the outlier and hers rose to 10.47%, so all the talk of improvements in her finances and praise from the IMF/EU/ECB troika has had no impact at all in this area.
Japan’s economy and her stock market
One further development overnight was a 2.7% fall in the Nikkei 225 equity index in Japan as it fell 258 points to 9292. I have written several times recently about the widening gap between it and the Dow Jones Industrial Average and this spread widened further yesterday with the Dow Jones closing at 10644 leaving the difference at 1352 points. Reasons for the fall include two economic factors as the Yen strengthened again against both the Euro and the dollar reaching 85.19 versus the dollar and machinery orders (which are considered to be a leading indicator for the Japanese economy) rose by 1.6% in June when the expectation was for a rise of more than 5%. Coming on top of talk of economic slowdown in the US following the statement produced by the Fed these factors unsettled the Japanese stock market as they contemplated a Japanese economic slowdown too. They may well have also been contemplating the lack of action from the Bank of Japan, although to be fair to it there is not a lot it hasn’t already tried in the past!
The statement from the Federal Open Markets Committee
After much debate in the run-up to the meeting the Federal Open Markets Committee (FOMC) decided to take further action. In my update on Monday I suggested that option 3 was the most likely route any action from the FOMC today would take. Here is my explanation from Monday.
3. A technical change which would pump around US $250 billion a year into the economy. Should the Fed act this is the most likely move. As part of its asset purchases it bought large amounts of Mortgage Backed Securities or MBS’s. At the moment it is receiving interest and principal repayments on these of some US $ 250 billion or so per year and is using this to pay down the amount of debt it has. The Fed could choose to reinvest this money in what has been described as QE-lite. The most likely place it would put this money would be in US Treasury Bonds although if you are logical then in fact it should go into the MBS market and the corporate bond sector.
Reading the statement put out by the FOMC today we see this.
“To help support the economic recovery in a context of price stability, the committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities,”
So in essence we have a programme that involves the principle of my option 3 if not the exact detail. The meaning of the statement above or Fed-speak is that they will use income they receive from the sale of mortgage-backed securities or MBS’s as they expire ( these are assets they have purchased as part of their Quantitative Easing programme) to purchase more long-dated Treasury Securities. At first it appeared that this would support the prices of the ten-year and thirty-year government bonds I have written about often on here and their prices initially rose to new highs for this period. However clarification then came out that in fact the FOMC actually meant that it would purchase government bonds with maturity of between 2 and 10 years. So the price of 30 US Treasuries dropped back to where they started probably leaving one or two traders with singed fingers!
This left me with two initial thoughts. Firstly I wondered whether the FOMC knows what long-dated means in bond markets and secondly a more subtle point by doing this did they reveal what long-dated is to them and hence gave an implication of timescales? Two years as “longer-term”?
Why have they done this?
Using their own words they feel that “the pace of recovery in output and employment has slowed in recent months” and that “the pace of economic recovery is likely to be more modest in the near term than had been anticipated”. So they too feel that the US economy is slowing down and they are projecting this forward and feel that it will contribute to slower growth going forwards.
One Other Move
The FOMC indicated that it felt that official short-term interest rates would remain low with the implication of lower for longer than previously thought or indicated.
continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
Scale of QE-lite
There is some debate over the scale of the new purchases. They will be of an irregular pattern as the MBS’s expire/mature but the scale is likely to be around US $20 billion a month although the initial impact will be smaller as in the short-term not a lot of MBS’s are expiring and the last month only amounted to around US $6 billion. Hence the name which has sprung up overnight of QE 1.1 as this is intervention on a smaller scale than the Fed’s original effort. Also it will be a flow of purchases rather than a lump sum stock as previously.
Clearly the market reaction indicates that this is considered as a statement of intent and signals that in effect the FOMC is back in easing mode. In other words so much for an exit strategy!
The relevant areas in the US Treasury Bond market rallied strongly and remember this rally took place from what I consider to be high prices and low yield levels already. The two-year Treasury Note’s yield has dipped below 0.5%, and the five-year is now at 1.43%, ten-year government bond yields have fallen to 2.73%. After the initial confusion and rally thirty year yields rose a little as investors considered the implications of this move over the next 30 years and well they might in my view.
I feel that this move of reinvesting payments from MBS’s is a mistake for the following reasons.
1.It hits the fundamental problem that asset purchases have taken place on an enormous scale in the US, so that if such enormous purchases have not worked why will an extra $250 billion a year that will take time to build up let alone have an economic impact?
2. In my opinion central banks should hold their nerve and not give way to market opinion. Many will feel that the FOMC has done so here and this sets a poor precedent. Imagine that the US economy dips further and then imagine the pressure that will be on the next meeting of the FOMC if this quite conceivable state of affairs should take place.
3. If the FOMC was to authorise further asset purchases it would be more efficient to use private-sector assets as policy tools rather than government bonds. If anything it is going the other way here. It makes me wonder if it feels that support will be required for government bonds in the future.
4. I can see no reason at all why the FOMC should target a level of US $2054 billion as some sort of magic number of government bonds and mortgage-backed securities for it to hold. If it thinks it is then surely an explanation is required. It smacks to me of that old bugbear that the FOMC felt it had to do something and settled on the smallest action it felt it could get away with.
5. The issue in the real economy is not the interest rate which applies to relatively prime borrowers. I wrote on Monday about IBM recently borrowing at 1% for 3 years. So the problem is not price it is availability, as we all know that borrowers with weaker finances are struggling to borrow at all. This move does not address this.
As to the talk about keeping interest rates low for longer I see that as a virtual irrelevance. Let’s face it they were expected to keep them low for quite a while anyway.