The Overnight Report: Fed Finds The Middle Ground

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

By Greg Peel

The Dow closed down 54 points or 0.5% while the S&P lost 0.6% to 1121 and the Nasdaq fell 1.2%.

It was to be the most anxiously anticipated Fed monetary policy statement of 2010. At 2.15pm New York time, Wall Street was to know whether the Fed would reintroduce quantitative easing (QE2), which the stock market would most likely consider as bullish, or simply remain prepared to act if necessary, which would probably have sparked a sell-off.

The irony of the expected responses is that were the Fed not to act, it would imply the central bank was less concerned than Wall Street over the state of the US economy.

But a nervous Wall Street copped a hit ahead of the Fed announcement, suggesting just how tenuous the support for stocks has been over the last few days. On the opening bell, the Dow plunged 150 points, and it was all to do with China.

As Wall Street slept, China announced its trade balance for July had blown out to a surplus of US$29bn from US$20bn when economists had expected a fall to US$19bn. Aside from perpetuating the “global imbalance” that was one of the fundamental factors underlying the GFC, what spooked Wall Street was that while Chinese exports rose 38% in July (year-on-year), imports rose only by 23% – the lowest increase this year.

That China is growing exports could be taken as a positive sign, given it requires a healthy global economy to provide the demand. However, only about a quarter of the surplus increase was attributable to exports to the US and Europe, with the bulk of exports heading to other emerging markets. This simply indicates the healthier emerging market economies are able to exploit a severely undervalued renminbi, whereas despite undervaluation the US and Europe are not buyers.

It was nevertheless the import figure that caused the most concern. Chinese import growth had been keeping relatively close pace with export growth over the past few months, suggesting Beijing's efforts to boost the domestic economy were working. US companies in particular are desperate to export to the burgeoning Chinese market given lack of consumer demand at home. Waning import growth does not support their efforts.

Lower import growth also points to an undervalued renminbi. Were the currency to be revalued, Chinese consumers would have more purchasing power.

So on that news, Wall Street took flight, regardless of what the Fed might be about to announce. It was a nervous, knee-jerk reaction, and some commentators were quick to point out Chinese monthly trade is volatile, and the numbers could just as easily reverse in August.

Wall Street attempted a late morning rally thereafter, but by 2.15pm the Dow was still down over 100 points. Then came the statement. Over to you Ben (my emphasis):

"Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”

The last line was, in essence, another downgrade of the Fed's forecast for US economic growth, but this was exactly what Wall Street already knew. What it wanted to know was exactly what the Fed was going to do about it. But to understand what followed, it's best we revisit the story so far.

The Fed first begun to cut its cash rate in 2007 in response to a growing concern regarding the subprime crisis. It continued to cut in early 2008 when it was busy saving Bear Stearns, but then failed to see what was coming next. Thus when Lehman went down, the Fed cut the rate to near zero in December 2008.

But near zero was still not enough. With no further scope to cut the cash rate to provide monetary stimulus, the Fed took the next step into quantitative easing (QE1). It bought up troubled loans, it bought up mortgage-backed securities and agency (Fannie & Freddie) debt, and most importantly it bought US Treasury bonds. By buying these debt assets the Fed “expanded its balance sheet” to an unprecedented level above US$2 trillion. By purchasing the debt, the Fed in return flooded the market with much needed cash.

And who provides the cash to the Fed to buy the debt? The Treasury. Where does the Treasury get the cash? It simply prints it. But the most desperate part of QE1 was the Fed's purchases of Treasury bonds. This means the Treasury is printing money to give to the Fed so the Fed can lend that money back to the Treasury – a strategy known as the “monetisation of debt”.

While the Fed was forced to extend the original expiry dates it had set for itself throughout 2009 as the recession raged on, Bernanke's famous “green shoots” eventually sprouted enough toward mid-2009 for the Fed to begin allowing its balance sheet to shrink once more. The stock market was already calling a V-bounce for the economy. Treasury bond purchases were the first to be halted, and mortgage securities the last, in April this year. Just before Europe fell apart.

To shrink its balance sheet, the Fed simply allows debt assets to mature, without replacement, effectively pulling cash back out of the market.

Which brings us to last night. At 2.15pm, Wall Street held its breath in the hope the Fed was about to announce QE2 – that it would once again start buying up debt assets. Probably mortgages, maybe even Treasury bonds. But this was what was announced (my emphasis):

“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. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.”

Huzzah! said Wall Street. Set sail the QE2! And with that the Dow shot up over 100 points, just into the black, by 2.45pm. That was until the market actually stopped to think about exactly what they had just read.

What they had actually read was that the Fed was no longer going to remain on the sidelines ready to act, it was indeed going to act. But that action was not QE2, because realistically QE2 would imply an expansion of the Fed balance sheet once more. But the Fed is not going to expand its balance sheet – it's simply not going to let it shrink anymore. Hence the Fed has come up with a solution that sits right in the middle.

The only concession to what might be considered a form of QE2 is that the Fed is bringing its support for the economy closer in time. It is not going to buy more mortgage securities, with maturities out to as much as thirty years, but rather it will take the maturing securities – the principal payments it receives – and reinvest that money into Treasury bonds (or notes to be precise) with a maturity of 2-10 years. This is still monetisation of debt, but strictly the printing press need not be dusted off. The Fed will simply reinvest incoming funds and maintain a balance sheet of US$2 trillion.

Over the next year, some US$200bn of debt on the Fed's balance sheet will mature. So if you like, all the Fed is doing is replacing that US$200bn when previously it would have allowed US$200bn to expire, which in a sense would have been like taking US$200bn of those fresh banknotes out of the system and burning them.

So once Wall Street figured out exactly what the Fed was on about, the Dow fell 50 points to the close. Wall Street felt like it had just kissed its sister.

The US dollar had a similarly wild ride over last night's session. On the Chinese trade data, it jumped 1% on its index. By the close of Wall Street, it had fallen back to be up only slightly at 80.89. Gold followed a typically contrasting path, falling to around US$1191 before rebounding to US$1203.80/oz, up US$2.60.

What will gold do now? No QE2, but a static Fed balance sheet. There might just be a hole here before Asian jewellery makers begin purchases next month.

The Aussie had to net out what was a poor day on the local market yesterday – given news on business confidence, disappointing earnings results and lower Chinese imports – against the ultimately steady greenback. The Aussie is down a third of a cent to US$0.9133.

For commodities, it was mostly a China story. Oil fell US$1.28 to US$80.25/bbl, failing to bounce back as the US dollar came off its highs. For base metals in London, it was all about weaker Chinese imports and a stronger mid-session US dollar because the final “kerbside” settlements are made at 2pm New York time. Metals are thus yet to respond to the Fed, and aluminium fell 0.5%, copper 1.5%, lead, nickel and zinc 3% and tin 4%.

For the SPI Overnight, it was a case of how much did we account for yesterday on the Chinese news, given the Fed news was neutral at best? The answer is a SPI Overnight up 4 points.

Perhaps the most telling movement last night was in the benchmark US Treasury yield, which fell 6 basis points to 2.77% to mark a 16-month low. The stock market has been hoping investors would start shifting out of the safety on Treasury bonds and into risk assets. But now that the Fed is going to be rolling its longer-dated mortgage debt into 2-10 year Treasuries, why sell?

Incidentally – lost in the Fed wash last night was the US wholesale inventory and sales numbers, which saw inventories rise a less than expected 0.1% in June while sales fell 0.7%. Second quarter productivity also unexpectedly fell for the first time in 18 months – down 0.9% when a 0.3% increase was expected. More grist for the Fed's mill.

We had some worrying business confidence data out in Australia yesterday, and today it's the consumer's turn, with Westpac set to release its monthly survey. We are also set for a much anticipated earnings result from CommBank ((CBA)), along with Stockland ((SGP)) and others.

In China today, Beijing will back up its trade balance with its monthly data spree, announcing the PPI, CPI, retail sales, industrial production and fixed asset investment numbers for July.

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