The market will be awaiting Bernanke’s pronouncements this Wednesday in his monetary policy report to Congress. Ben will likely have prepared two speeches, one hawkish and the other dovish. Almost a month ago Bernanke telegraphed the Fed’s intention to eventually taper off QE. Since then the Fed has prevaricated and indicated that monetary policy would be accommodative. Bernanke himself talked a dovish position as recently as a week ago. Today, Bernanke is likely to be hawkish in his report to Congress. 

Employment, manufacturing, capacity utilization, personal income are all up. The stock and bond markets were initially roiled by his June 19 comments about QE tapering but have since taken this eventuality in their stride. The market is therefore well placed to tolerate another hawkish signal from the Fed.

The risks are that we are in the middle of earnings season and earnings could disappoint. The market is unlikely to fare well under the cosh of both weaker earnings and tighter monetary policy. Also, inflation is perking up, ever so slightly, but it is perking up.

On balance, however, conditions are sufficiently benign that Bernanke can deliver a hawkish signal at this turn. It will be a sequence of hawkish and dovish signals yet before the Fed actually moderated asset purchases. If the market becomes sufficiently desensitized, the. QE tapering may go ahead as planned in September.

The risk that faces the Fed today is that it will not be able to taper of its asset purchase program. All indicators point to a sustainable, albeit weak recovery. It is only reasonable that if this were true, the Fed would at some stage be well advised to reduce its balance sheet, if nothing else so that it would have the means to address the next crisis whenever that might be. By maintaining its current policy the Fed would have few other policy tools to deal with another recession or financial crisis. QE tapering is therefore a good thing and the markets appear to have come to that conclusion. Attention needs to turn now to economic fundamentals. A slowdown from here would not allow the Fed latitude to moderate its asset purchases. A climbdown by the Fed on QE tapering might come to be construed as a sign of weakness.

It is useful to consider the possibilities. A climb down from QE tapering would be negative for US risky assets if coupled with a slowdown in earnings growth, an re-emergence of financial crisis in Europe or a stronger deceleration in China. If markets are driven by both a slowdown and a postponement of QE, one would expect fixed income to rally or at least outperform. Duration would outperform and credit would underperform. Thus Treasuries would outperform investment grade, which would in turn outperform high yield. Floating rate senior loans would underperform. There would likely be a knock on effect to international and emerging markets equities and possibly their corporate bonds. The USD will generally be weakened, unless Europe or China were also sources of weakness in which case the USD might actually strengthen.

If QE tapering proceeds as planned in September, the impact on US risk assets is likely to be muted. The Fed has prepared the market for this eventuality and its execution will have been priced in. Equities will likely continue to rise, and will outperform high yield, which in turn will outperform investment grade. Floating rate non agency MBS will outperform agency MBS. Credit will generally improve even as duration underperforms. The relative exposure to credit and duration in each debt instrument will drive their performance. What if the Fed tapers but earnings slow down? This is an unlikely combination but an interesting one. It would indicate an improving labour market and economy but not generally an improvement for corporate America. How could this combination arise? The US might exhibit this phenomenon if the world is adjusting towards a less globalized, more trade protectionist, more insular state. There are reasons why this might occur which we will not discuss here. However, this might result in an internal rebalancing of the US economy towards a less export driven, more domestically driven, self sufficient economy. The predominance of global companies in the stock market, coupled with weak emerging market and European economies might result in slowing earnings growth while domestic US output continues to improve. If this held true then the asset allocation will need to be more specific. In a sense this scenario might be the most difficult to navigate since both credit and duration would underperform together.

As expected the Fed is prevaricating over its plan to slow the pace of QE. The Fed was always going to telegraph its intentions well in advance and to prevaricate publicly until the market was weaned off the idea of perpetual QE before they actually taper it off. 

The fact is that the US economy is now on the path of self sustaining growth and therefore not in need of further QE. It is therefore rational for the Fed to slowly reduce the size of its balance sheet. Consider the analogy of a person in intensive care. This was the US economy in 2008. The Fed quite rightly prescribed morphine. Most analgesics are addictive, yet when there is recovery, the continued administration of morphine is not only unnecessary, it is harmful. And there is no way the patient can get up and walk out until it is weaned off the morphine. That the doctor feels that the patient is ready to go off the drug is good news not bad.

The markets have yet to come to grips with the Fed’s withdrawal from QE and elevated volatility is to be reasonably expected. But he prognosis is positive. While equilibrium GDP growth may not revert to pre 2008 levels of 4%, a real recovery is underway evidenced by improvements in manufacturing, the labour market, household income, consumption and confidence. The post crisis equilibrium rate may have halved to 2% but corporate earnings have continued to be robust on higher productivity.

There will be threats to the new growth. Trade is likely to fall globally as each country tries to export their way to growth. Other regions in the world continue to see slowing growth from China to Europe. Asset markets reflect similar trends with the US and Japan bucking a trend of tepid returns and sometimes outright negative returns. China is a significant risk as its economy slows beyond expectations. Being the largest external holder of US treasuries is not very reassuring. The strong USD is also a brake on US exports. Fortunately much of the growth in the US appears to be domestically led.

The past few decades saw a surge in growth driven by credit and globalization. The bursting of the credit bubble has reset matters and to an extent rolled back globalization. The search for growth may now take a more insular and domestic turn. While the US is self sustaining threats remain from without, as the global economy readjusts to a less globalized state. The inequality between countries that converged in the past few decades may begin to widen once again. But if the inequality that has diverged to so long within countries is not reversed, the political and social stability of many a government may be challenged.

Lest we forget, the job of the Fed is not to support equity and bond markets but to promote price stability and stable economic growth, the former a stated goal, the latter an implied one. Yet market participants continually watch the Fed as if it was the primary driver of asset markets, at least in the short term. For the last 20 years, the Fed has, for better or worse, acted to rescue the economy, and concomitantly, financial markets, from crises. The previous Fed chairman Alan Greenspan stated that averting a financial crisis was not feasible and that the best that could be done was curing a crisis situation after it had been precipitated. In the days when the only policy tool wielded by the Fed was the short term interest rate, it was clear that this policy had its limitations. Each rate cutting cycle was less effective than the last and in fact sowed the seeds of the next crisis. Thus interest rates trended lower and featured a cycle of rate cuts to address crises or recessions followed by rate hikes, not merely to cut of inflation but to reset the policy tool in case it was needed in future. That rates trended down meant that the policy was ineffective in that rates could not be reset fully before the each subsequent crisis.

Since the crisis of 2008, new policy measures have been adopted by the Fed to supplement short term interest rates, mainly in response to the scale of the crisis. Whatever the scale of the crisis or the policy employed to meet it, certain things remain. The Fed’s raison d’être remains price and growth stability. The unprecedented scale of balance sheet expansion of the Fed has led to a precarious position where the US economy is perched between high inflation and deflation. The current equilibrium of low inflation is an unstable one because on the one hand the economy remains weak and energy costs are falling leading to a deflationary environment and on the other the velocity of money multiplies through the money supply to obtain nominal output leading to high inflation risk. Any sign of self sustaining growth, even at low levels, must reasonably encourage the Fed to reduce the size of its balance sheet to avoid the tail risk of high inflation, and to be clear it is a tail risk and not a smooth risk. The size of the Fed’s balance sheet and short term interest rates are loosely related, but sufficiently loosely, that it is reasonable given the low growth, even if self sustaining, that short rates will be held low even if the balance sheet is shrunk. It would be irresponsible of the Fed not to reduce the size of its balance sheet. Moreover, the extreme open market operations we call Quantitative Easing have a perverse impact on lending. Since 2008 much lending has taken on collateralized form with the collateral consisting mostly of low risk, high quality assets like treasuries and agency mortgage backed securities. By specifically targeting these assets in its asset purchase programs, the Fed is starving the financial system of collateral necessary to facilitate secured lending. Mortgage production has kept pace, however, a sustained recovery is improving government debt service burdens and resulting in a slowdown of US treasury debt issuance. The Fed’s need to taper its QE is driven partly by the need to avoid buying an ever increasing portion of new issuance thus crowding out private and foreign participation.

A reduction of asset purchases and an eventual reduction of the balance sheet of the Fed is a desirable outcome for the economy. It resets a policy tool which was considered acutely unconventional when it was implemented to address the crisis, and which one hopes need never be used again. It also removes the tail risk of high inflation through a purely technical transmission system, and it puts back eligible collateral into the financial system. The conditions for a moderation of asset purchases is that the feeble growth in the economy today is at least self sustaining, that is that it will not be derailed by the withdrawal of QE. One aspect that has not been dealt with here is the management and expectations of QE withdrawal which bears some thought as well. The communications and management of expectations is as important as the actual withdrawal itself.

I guess if you wanted to skip the theory and causality, what I’m saying is that if the Fed shrinks its balance sheet, or even slows its growth, it’s a sign that the US economy is in good shape.

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