Bernanke Still Pouring Shots Of QE To Markets Already Drunk On Liquidity
The Federal Reserve’s Federal Open Market Committee concludes the first of its eight scheduled two-day meetings today at a critical juncture for markets and the U.S, economy.
Financial market distortions – as evidenced by the value of bonds and stocks – are at extremes not witnessed in over 90 years. Yet oddly, the economy is poised for higher than expected growth in a low inflation environment – at least for now.
The economy is stronger than indicated by the stale GDP statistics released this morning. The 0.1% slide in Q4 GDP is a function of defense cuts and whittled inventories, with each subtracting 1.3% or a total of 2.6% from the overall figure.
With this backdrop, further gains for riskier assets such as stocks and relative under-performance for bonds are likely in coming weeks.
Economy Poised For Bounce
Leading indicators of economic well-being are beginning to show important signs of a recovery. After all, the period of sub-par growth is now 21 quarters old.
The key issue here is that over the last five years the Federal Reserve has pumped an enormous amount of money into the financial system. Many of those resources have remained trapped at financial institutions or on the balance sheets of corporations. For example, the holdings of cash and marketable securities of the top 100 companies in the S&P 500 (SPY) and Nasdaq composite recently reached .1 trillion. The top five companies alone – Apple (AAPL), General Electric (GE), Microsoft (MSFT), Google (GOOG), and Cisco Systems (CSCO) – accounted for 6 billion in cash hoards.
We are now seeing signs that those balances are beginning to migrate into the economy. In today’s GDP report, investment in equipment and software advanced by 12.4% on an annual basis in the most recent quarter.
Similarly, money and confidence in the U.S. financial system is increasing. At the Center for Financial Stability, we specifically measure the banking system and broader money supply existing in the private sector. This is critical. For instance, money created by the Fed or total reserves held by banks at the Fed represent a mere 8% of the broader money supply in the U.S. economy, so it is no wonder that the economy barely responded to monetary policy actions over the last few years.
Although the Federal Reserve dramatically increased liquidity, the money supply in the banking system barely budged. Fear and uncertainty restrained growth in the financial system and economy. This is beginning to change. The broadest measure of money available today (CFS Divisia M4) gained 6.9% in December 2012 on a year-over-year basis. This represents the most rapid expansion in broad money in the economy since 2008. So, the financial system and the economy are on the mend.
New Unemployment Target In Reach
Another bright spot is that our monetary data suggest that the unemployment rate may reach 6½% earlier than presently being anticipated by the FOMC. The chart below highlights a close relationship between broad money growth and the unemployment rate.
Monetary Growth and Unemployment
In the last Federal Open Market Committee (FOMC) meeting, the Fed critically altered its trigger for a shift in monetary policy from a specified date to the unemployment rate. The Fed is now set to preserve an accommodative monetary stance as long as the unemployment rate remains above 6.5% and forward looking inflation is “no more than a half percentage point above the Committee’s 2 percent longer run goal.”
At present, the Federal Reserve Board members and presidents of the regional Federal Reserve banks expect the unemployment rate to reach 6.5% some time in 2015. The Board estimates a central tendency forecast range of 6.0 to 6.6% for 2015.
Bond and Stock Market Distortions
Distortions exist between equity and fixed income markets. Bonds are overvalued and stocks are near their long-term average valuation. Similarly, on a relative basis, the dispersion between bond and stock valuations has never been this extreme – at least by our analysis which dates back to 1920. The most recent large distortion dates back to the late 1990s, when stock valuations (as measured by the long-term price-earnings ratio) meaningfully exceeded comparable bond market metrics before the bust in tech stocks.
Stocks are fairly close to their long run valuation, so a meaningful move higher will be dependent on future economic and earnings growth. Our monetary data strongly suggest that the real economy has bottomed and may be in the first phase of a recovery. There may be more upside for stocks, as corporate cash on bloated balance sheets is put to work.
Source: Robert Shiller (Yale University), Bloomberg LP, and Center for Financial Stability.
No Free Lunch
Unfortunately, there is no free lunch for central banks.
Bond valuations remain troublesome. Distortions across the yield curve represent an equal and offsetting reaction to direct purchases by the Federal Reserve in the US Treasury (TLT) and mortgage-backed securities (MBS) markets (MBB). A more rapid drop in the unemployment rate, a modest move higher of inflation on a sustained basis, or question surrounding the credit quality of sovereign assets could readily reverse valuations that are already stretched and pulled to extremes.