Fabrizio Quirighetti at SYZ Asset Management looks for the Fed’s next hat trick

Fabrizio Quirighetti, chief economist at SYZ Asset Management, looks at US monetary activity and the risk of global recession.

The Fed acknowledged on 9 August that “economic growth so far this year has been considerably slower than the committee has expected”. It also said it now expects a “somewhat slower pace of recovery over coming quarters” and that “downside risks to the economic outlook have increased”

This seems a fair statement in line with the current environment and outlook. However, rates were already slashed to zero at the end of
2008 and in spite of the multi-trillion dollar launch of QE1 and QE2, there is apparently still a problem with the US economy.

Fortunately, Ben and the Fed’s wizards have lots of imagination and have thus decided to pledge for the first time to keep its benchmark interest rate close to zero at least until mid-2013 in order to try again to jump-start the economy towards a more solid recovery. For those who had the leisure and pleasure to play with the Adidas Power Soccer on the PS1 a few years ago, this trick really looks like a Power Soccer Shoot Trick… in order to continue to kick down the (heavier) can down the (steeper) road.

This extremely dovish statement and commitment lets the door open for a (desperate) QE 2.1 or 3.0. In fact, Bernanke already told Congress on July 13 that the Fed was prepared to buy more Treasury bonds if the economic appeared in danger of stalling (or if the threat of deflation re-emerged).

 

Market implications

Such a move by the Fed is certainly positive for gold, TIPS, Treasuries and other OECD government bonds. By fixing nominal yields at zero percent for the next two years, the Fed is clearly manipulating real yields by fixing them below zero, since we assume inflation should remain in positive territory during this time period.

Especially if the USD weakens further on this move. As regards classical Treasuries, the rationale is quite easy: fixed income managers now get 0.16% for a US 2Y Treasury. Not really enough to pay for management fees that fund managers probably don’t fully deserve, even if rates fall to zero, as there is no upside in prices. As an obvious result, every respectable bond manager is going longer into the US curve in order to grab some yield. This provides the very favourable outcome of immediately providing a strong gain in prices as rates collapse under this frenetic crowding demand.

The ripple effect means that the same must be applied to other OECD countries, especially core Europe, Switzerland or UK, as it will be now very difficult if not impossible to hike much before the Fed. As a result, European bonds still offer the most relative value as the ECB now has some room to cut rates after hiking its target rates twice to 1.5% this year.

As noted above, the Fed’s move was rightly perceived as dollar negative when it lost 5% against the Swiss Franc on the news before recovering some of this impressive loss. But watch out! The Swiss franc has been an easy and golden choice among poison currencies. The recent episodes of equity market sell-offs, the US government debt downgrade by S&P and the Fed’s new hat trick have “logically” benefited again the Swiss franc and gold. This trend may last for a while but watch out… in the very dark night, all assets are gray!

Indeed, in the case of a complete meltdown similar to the one we experienced at the end of 2008, this logical correlation tends to be broken. In this case, the USD may experience a kind of technical rebound due to a massive “repatriation” of the world’s reserve currency. Looking at the behaviour of the USD/EUR on 11 August, the USD regained some grounds when markets resumed their downward trend that day, in a similar way as we regularly observe with the Japanese yen. As a result, gold or the Swiss franc may perhaps be under pressure in a very extreme meltdown case.

Corporate, emerging bonds and equities would receive a short to mid term “band-aid” relief with another injection of liquidity. Hopefully it will not be the much talked about killer “inflation” liquidity injection that some fear. But long-term funding problems have not been solved. Also note that ultra-loose US monetary policy won’t really help many emerging market economies to keep their inflation problems under control because their economies are pegged to the USD or they face dollar-denominated, and thus inflated commodity prices, inflation. It is also well worth mentioning that if credit spreads widen in the event of a global, generalized and severe recession, investors may be better off with Italian or Spanish government bonds than with some high yield or emerging markets debt.

 

Fabrizio Quirighetti is chief economist at SYZ Asset Management.

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