The Overnight Report: It Must First Get Worse

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By Greg Peel

The Dow closed down 48 points or 0.4% while the S&P closed flat at 1341 and the Nasdaq lost 0.5%.

“Most participants saw the incoming information as indicating somewhat slower growth in total demand, output, and employment over coming quarters than they had projected in April, and most carried forward some of that downward revision to their projections of medium-term growth. However, some participants judged that the recent weakness in a variety of economic indicators was more likely to prove transitory, and thought that the outlook beyond this year was essentially unchanged.

“A few members expressed the view that further policy stimulus likely would be necessary to promote satisfactory growth in employment and to ensure that the inflation rate would be at the Committee’s goal. Several others noted that additional policy action could be warranted if the economic recovery were to lose momentum, if the downside risks to the forecast became sufficiently pronounced, or if inflation seemed likely to run persistently below the Committee’s longer-run objective.”

My emphasis. These are excerpts from the minutes of the last Fed meeting, held on June 20. At the time, a new president with a pro-growth agenda had just been installed in France, and Greece had finally managed to form a tenuous government. We were yet to find out what Germany's response might be, which did not become clear until the more recent EU summit.

At the FMOC meeting, the Fed extended Operation Twist – the selling of short date bonds and the buying of long date bonds without expanding the balance sheet. In the accompanying statement on the day, there was no mention of QE3. Traders thus sold stocks with their ears pinned back. But in the press conference that  followed the statement release, Ben Bernanke suggested “We still do have considerable scope to do more. If we're not seeing sustained improvement in the labour market that would require additional action”. In other words, QE3 was still a possibility, and traders all bought back again.

The situation in Europe in the interim has arguably stabilised, if not particularly improved. US and global economic data have weakened. US housing data have shown some signs of improvement, but jobs growth has remained allusive. Yet as the first excerpt from the minutes above highlights, the Fed is not expecting such weakness to last. And as the second excerpt highlights, the Fed is implying that QE3 would be rolled out only if things got worse from here.

So now the question is: How much worse is worse? That second excerpt suggests “sufficiently pronounced” downside risks must be evident. Is a manufacturing PMI slipping into contraction “pronounced”? Is tepid jobs growth – not enough to change the unemployment rate – “pronounced”? Will a worse than expected June quarter earnings result season be considered “pronounced”?

If not, then we must assume no QE3 – yet. The Fed did discuss the implementation of “other tools” as a possibility, which it is assumed would take the form of direct Fed mortgage purchases as an obvious first choice. But overriding the whole QE3 debate are accusations from the sceptics. What did QE1 and QE2 do for us? they ask. Why is everyone so desperate to see QE3? The US economy is not much better off than three years ago and the stock market has not regained its losses.

I suppose the best way to look at this is to ponder what might have been had there been no QE1 and QE2. Where might stock markets be then? If you consider quantitative easing as providing no more than a safety net under the market rather than a shot of adrenalin for the market then you would welcome the knowledge that QE3 is there if needed. If you're looking for QE3 to drive the stock market to new highs then you might be disappointed.

Many argue that until the fiscal side of the equation provides its support, the Fed can only play catcher. Fiscal policy has descended into a farcical political battle in the US (and we won't mention anywhere else) and there's more fighting to come as we approach the election.

The Fed minutes were released at 2pm NY, at which point the Dow was mildly weaker but steady. On the release, the Dow plunged 119 points. Thereafter followed yet another late session fight back. More interesting, however, was what was going on over in the bond market.

At 1pm NY, the US Treasury auctioned US$21bn of ten-year notes. The auction was highly over-bid, matching demand levels not seen since October. Foreign central banks and sovereign wealth funds took 40%, consistent with the recent average, but direct bidders – US domestic money managers – took 45% compared to a recent average of 17%.

The minutes had not been released at this point, but the supposed “smarter” bond market was not waiting for a result. The settlement yield of 1.459% marks the lowest ever recorded. Locals and foreigners are clearly playing the safe haven hand as global economic data weaken, and if QE3 is ultimately rolled out it means Fed buying of ten-years, which only supports the safe haven buyers. The trading yield quickly rebounded to 1.5% where it remained after the release of the minutes.

If the US and global economies improve dramatically, buying US bonds might prove a losing bet. Can anyone see dramatic improvement ahead?

And while on the safe haven theme, can we now officially declare the Aussie a safe haven currency, having reformed from its dark days as a commodity currency and risk proxy? The US dollar index is up 0.1% to 83.39 after last night, but the Aussie is up 0.6% to US$1.0252. We might ascribe a little bit of strength to yesterday's consumer confidence surprise, but it was not that long ago that strong demand for safe haven US bonds would by default imply higher risk and a weaker Aussie.

On the commodity front, gold ticked back up US$8.70 to US$1576.00/oz. Base metals were mixed on smallish moves, but they must be suffering whiplash over on the Nymex. Last night's release of weekly US inventory data were a surprise (they always are) and oil jumped again, with Brent up US$2.26 to US$100.23/bbl and West Texas up US$2.17 to US$86.08/bbl.

The SPI Overnight is up one point.

It's unemployment day today in Australia, and Iluka ((ILU)) will release what is now likely a redundant production report.

Rudi will be appearing on Sky Business today at noon and again at 7-8pm with Peter Switzer.

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