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Empty Words Are Words Enough

The Fed today, as I had expected, gave no indication that QE2 is on the near-term horizon. While indicating that the Committee felt inflation to be somewhat lower than they would like, and pledging to “continue to monitor the economic outlook and financial developments,” the Fed also declared that it is “prepared to provide additional accommodation if needed to support the economic recovery.”

That’s a relief. It would have been really ugly if they had said something like “the Committee is not prepared to provide any additional accommodation, even if it is needed.” The market, however, reacted to this empty gesture in very curious fashion. Going into the meeting, there was definitely some expectations in many quarters that the Fed would at least signal QE2, even if they probably wouldn’t start it today. When there was only the vaguest wave of the hand in the direction of such a move – in my mind, reducing slightly the chance of QE2 at the November meeting – one would have thought that bond and stock holders would have been disappointed.

Not by half! Both bonds and stocks rallied significantly, raising the question of what in the world the Fed could have said that would have caused a bearish reaction! Gold rallied. Inflation swaps rallied. What were people worried about, a rate hike?

As I have said several times, there was simply no reason to begin QE2 today; while data has been weaker than expectations, it hasn’t been dreadful, and the main argument for QE2 is and has been forward-looking based on the likelihood that tax rates will rise sharply in 2011, leading to a sharp contraction in growth. But Congress still might prevent that from happening, which would obviate the near-term need for QE2. Ergo, the FOMC didn’t have enough information to confidently declare that QE2 is needed, and so they made the merest nudge towards the possibility.

QE2 is the last bullet in the gun. The Fed will use it if necessary, and I think they will use it before the absolute last resort, but it is no surprise that they aren’t anxious to do so. It seems the market believes that they have itchy trigger fingers, although by the end of trading the equity indices had retraced most of their gains. Bonds, however, had not, and the 10y note closed at 2.59% with the 2y note at another all-time low of 0.425%. Gold also closed at an all-time record. The dollar was hammered. What news service are all of these investors getting? I must be reading the wrong Fed statement.

Earlier in the day, Ireland sold lots of debt (1.5bln€) at yields (above 6% for 8y money) that will be terrific for investors if the bonds eventually redeem in full and there’s not much inflation. The same statement can be made about almost any fixed-rate bond on a rotten credit, I suppose! But in this case, my question is: what are the odds of a slow-growth environment, which would be the one that would be most likely to result in low inflation, being coincident with a non-default of a country that has an overwhelming burden of debt and deficit? If inflation is high, the odds of repayment of a fixed-notional bond increase but you won’t like the real return very much. If inflation is low, the real return is very good but the chances of default are much higher. It seems to me you need two bets to work out in order to like your investment, and the odds don’t look right to me.

Housing Starts came out above expectations, at 598k, but still around the middle of the last year’s range. Pretty weak, but not so weak as to suggest that quantitative easing is imminently necessary.

Banks perhaps could use a little more help padding their bottom lines with cheap Fed money. According to Bloomberg as cited by Financial Advisor Magazine, Bank of America is firing as many as 400 employees; Barclays and Credit Suisse are also laying off people. This move comes following the predictable decline in bank profits. An article in the Sunday New York Times declared that “business has taken a surprising turn – downward.” I have been commenting on the trading volumes, which fell off a cliff as the Volcker Rule neared passage and the SEC began questioning liquidity providers after the “flash crash.” The downshift has been surprisingly abrupt, even for someone (me) who said it would happen.

But the arrow of bank profits should come as a surprise to no one. We knew that return on equity was almost a slam-dunk to decline since two of the three components of ROE – asset turnover (volumes) and financial leverage – were destined to be under severe pressure after the financial crisis, and the third component (net profit margin) came under pressure as a result of the regulatory diktat to start moving over-the-counter product to exchanges. Add up three negatives and it is hard to get a positive result. According to the article, stock IPOs worldwide are down 15% from a year ago; bond issuance is down 25%; and August NYSE volume was 30% below year-ago levels. Meredith Whitney sees bank earnings down from $56bln last year to $42bln this year. If that’s right, then next year ought to be worse since proprietary trading revenues will also be missing. And once interest rates rise and remove the yield curve benefit…well, I’m just not sure why people are so interested in bank stocks. They look like mostly downside to me.


The only data out on Wednesday is the Home Price Index (Consensus: -0.2%), although Geithner is testifying before the House Financial Services Committee on the state of the international financial system. That testimony is due to start around 2:00ET. I don’t see any big catalyst for volume, but perhaps after digesting the Fed’s words overnight some investors will realize they don’t seem to be as supportive as initially believed. In the meantime, I remain flummoxed.


A quick announcement for regular readers of this column: I’ve been asked to speak at the New York Investing Meetup scheduled for next Tuesday. My talk will begin at around 7pm. If you’d like to see me wear a tie, and especially if you are interested in my topic “Why I Don’t Worry About Deflation And You Shouldn’t Either,” go to http://investing.meetup.com/21 for details. You don’t have to be a member of the group to attend; attendance is only $10 to cover the group’s expenses. My honorarium is…well, hopefully some people will buy copies of my book, which I will have on hand.

I’d love to meet you. Please consider coming to the meeting.

Categories: Uncategorized
  1. Fabio De Gaspari
    September 22, 2010 at 4:57 am

    Obviously none was expecting a rate hike, but after a good equity rally, some inflation pressures deriving from agricultural and soft commodities prices, a modest ecodata recovering, a moment of stabilisation could be useful,instead they were more dovish than expected (also if not acting now) but fed committed a huge error according to me: they linked further accomodation to inflation results. So they want inflation, but how can we move on monetary policies when we have 2yr treasury at 0.4% and 10yr a 2.35%? and what about paradox of thrift?
    Debt monetization and money printing, there’s no other way: US treasury mkt is dead, they not only control short term rates but also long term rates, so there’s only a way to venting these policies: FX!!!

  2. Lee
    September 22, 2010 at 7:54 am

    Excellent essay.

  3. Andy
    September 22, 2010 at 12:50 pm

    The Fed said inflation not growth
    Is the critical part of our oath
    If it weakens anew
    Then here comes QE2
    Unemployment? We can’t handle both

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