Don’t fight the Fed. That is the mantra driving financial markets now.
As the prospect of another super-sized dose of cheap money from the world’s most powerful central bank has gained traction, the dollar has tumbled. Almost everything else, be it Brazilian government debt, the Thai baht, UK gilts, gold or the price of crude, is rising.
Equities, though, are among those assets that have felt the biggest impact from rising expectations that the Federal Reserve, under chairman Ben Bernanke, will revive emergency efforts to pump money into the US economy through the process known as quantitative easing – in other words, buying government bonds and other assets to stimulate bank lending.
Since the Fed’s last policy meeting in September opened the door to another round of bond purchases, being dubbed QE2 in financial markets, all the main global stock indices – S&P 500, FTSE 100, the FTSE Eurofirst 300 and the Nikkei 225 Average – have rallied strongly. Emerging market equities have surged, too, boosted by the idea that the money created by the Fed’s buying of bonds will end up in other assets worldwide.
Some respected investors, including David Tepper, the billionaire hedge fund investor who runs Appaloosa Management have publicly extolled the virtue of a “Bernanke put” for the stock market. Mr Tepper, for his part, has taken to the airwaves arguing that, .should the economy weaken further, then the Fed’s embrace of renewed monetary easing should protect equities from the risk of losses. The central bank’s stance, in other words, amounts to an equity put option for investors.
Weaker than expected US jobs data on Friday only reinforced speculation that the Fed might resume its asset purchase programme when its interest rate-setting committee meets in November to prevent sustained disinflation and a feared double-dip recession.
Some investors believe that the Fed itself has been encouraging that belief. Speeches by Fed officials have drawn attention to its unhappiness with America’s fragile economic recovery and the fact that core measures of inflation sit below the bank’s targeted level. There is a widespread view the Bank of England could also act.
“Some market participants believe that QE is not a good idea from a fundamental view, but Bernanke believes it and, as a result, we view QE as a certainty,” says Richard Tang, head of fixed income, forex and equity sales, Americas at RBS Securities.
As those expectations have hardened, so the relationship between equities and US Treasuries, which have tended to move in opposite directions this year as investors’ appetite for risk has fluctuated, has reversed. Now stocks and bonds are rising together.
One reason for this is the falling dollar: a cheaper US currency is good for S&P 500 companies, who derive half their revenues from outside America.
Another reason is that a heavy dose of quantitative easing, assuming it is successful, will not only support the bond market, but lower borrowing costs for households and companies, stimulating growth.
“QE is as much about falling yields as it is about weakening the dollar,” says Dominic Konstam, global head of rates research at Deutsche Bank.
Since the Fed’s policy meeting last month, the dollar has tumbled 4 per cent on a trade-weighted basis, hitting a succession of 15-year lows against the yen. It has lost 5 per cent of its value against the euro, too.
In turn, dollar-denominated commodities such as oil have soared. Crude is up 10 per cent, while gold has risen nearly 5 per cent, to a record high this week of $1,364 a troy ounce.
The S&P is back above 1,160 and is at its highest level since May, while US Treasury yields have fallen back to below their lows of August. The 10-year note yields less than 2.4 per cent, its lowest level since January 2008.
The question now is how long this rally in stock markets and dollar-denominated asset classes will continue. For stock markets bulls, much is riding on the Fed delivering QE2 on a scale that justifies the run-up in share prices. The problem is nobody knows how big any asset-buying programme might be.
Too small and the market will be disappointed. Too big and sharply higher inflation may follow. Beyond questions about the scale and scope of QE2 – or the “Bernanke put” – a bigger risk for investors is that quantitative easing fails.
Tony Crescenzi, portfolio manager at Pimco, says the effectiveness of quantitative easing is “a major unknown even for the Fed, as few truly know the effect that a given amount of QE will have on financial conditions, and few truly know the impact that any loosening of financial conditions will have on the economy”.
The pessimists point to Japan, where quantitative easing has failed to stimulate the economy, or the stock market, over the past decade. Some analysts argue that, if US banks remain reluctant to extend credit, then the Fed is unlikely to prevent a prolonged period of anaemic growth, or even another recession.
There is no guarantee that QE2 will work, says Ken Wattret, chief eurozone economist at BNP Paribas. In Japan’s case, deflation – falling prices and economic stagnation – was the outcome. He adds however: “The difference in the US and the UK is that they have moved much more quickly than the Japanese did and the financial injections have been much greater. This means the chances of success are much higher, which is good news for equities.”
Mr Tepper, and other fund managers betting on a Fed-inspired recovery rally, will be hoping so.