Kass: What to Expect When We're Expecting

This column originally appeared on Real Money Pro at 9:30 a.m. EDT on Sept. 13.

NEW YORK ( Real Money) -- Though I believe the odds are less (probably closer to 65%/35%) than the near unanimous market view of more easing, in all likelihood the Fed will announce more cowbell this afternoon and will also probably announce a modest reduction in domestic economic growth projections for 2013-2014.

A weak jobs report last Friday; less robust economic data in the U.S., which has disappointed the Fed relative to its expectations (business investment, etc.); slowing in growth in Europe and China; the emerging drag and growing threat of a domestic fiscal cliff at year-end; and continuing reports by Jon Hilsenrath of The Wall Street Journal (and others) all point to this decision.

Perhaps most importantly, in strongly worded phrases, the Fed (in Jackson Hole and in the FOMC minutes) has led the market to expect more easing -- and the Fed is not typically in the business of shocking the markets.

I expect:

  • a one-year lengthening (through mid-2015) of the period when the federal funds rate will remain low;
  • coincident with a continuation of the maturity extension program (i.e., Operation Twist) until year's end, large-scale, unsterilized and open-ended asset purchases will be initiated; and
  • forward guidance might even be expanded beyond the forward guidance of the fed funds rate (similar to what has been recommended by Chicago Fed President Evans, in which there would be no interest rate hikes unless unemployment was below 7% and/or inflation exceeded 3%, appeasing both doves and hawks that vote).

The Fed's Impact on the Real Economy Is Waning

As I have previously written, blind faith in the continuing easing policies and in the forecasting ability of Ben Bernanke and the Fed seems unjustified. Ben Bernanke's poor forecasting capabilities rival those of predecessor Alan Greenspan, and that is not a good thing for investors who hold onto the premise of a self-sustaining domestic recovery.

Bernanke got the housing bubble wrong, he failed to anticipate the recession in 2008 and the role and systemic risk of derivatives (which Warren Buffett calls financial weapons of mass destruction), and he didn't recognize until 2010 that the U.S. unemployment problem was nearly as much structural as cyclical.

And now I believe he is wrong regarding the benefits of further quantitative easing. Remember, we are over three years after the Great Recession and after the implementation of QE1, QE2, Operation Twist (and its extension), and U.S. real GDP is growing at only about a 1.8% rate.

In reality, more cowbell may actually be counterproductive in penalizing the savings class, creating a disincentive for banks to lend and by putting more pressure (as commodities rise) on the middle class (which I call screwflation).

Low interest rates have become a blunt instrument for generating growth, but the growth problems lie not in the level of interest rates -- rather, the problems have been long in the making and are structural (in the categories of employment, education, etc.).

From my perch, we don't need any more bond buying or quantitative easing, which is no longer positively impacting the real economy; we need pro-growth fiscal policy that addresses fundamental economic issues that have been several decades in the making.

A U.S. stock market buoyed by the promise or notion of a monetary put might be misguided.

The Myths of Quantitative Easing

There seems to be an almost universal view in the business media and on the part of many investors that quantitative easing boosts all asset prices and has a positive wealth effect, improves the housing market and buoys economic growth, lowers interest rates, improves employment, and simultaneously fails to cause inflationary fears and pressures. In fact, recent jawboning by the Fed and by European leaders and central bankers is seen as almost singularly responsible for the recent rally in stock prices.

I not only view the impact of easing as waning in influence but also believe that the problem with this parsing is that history shows (QE1 and QE2) that the aforementioned positive impact is not guaranteed and not founded in fact. In support of this view, I wanted to briefly reemphasize five quantitative-easing myths.

Myth No. 1: Quantitative easing boosts asset prices and has a positive wealth effect. While I agree that quantitative easing has, at times, pushed up some asset prices, the problem is that sometimes the wrong assets are being pushed up in price. My analysis shows that the previous quantitative-easing programs pushed up all sorts of commodities but actually pushed down the market's valuations (P/E ratios). While there has been a close relationship between QE1 and QE2 to higher stock prices, with more easing now perceived as having less of an impact, I am less certain that QE3 could result in a positive net influence. What I do know is that prior quantitative easings produced declines in real personal income (as gasoline prices and the price of other commodities rose). If QE3 is implemented, I am concerned that the outcome will be even worse than the previous one.

Myth No. 2: Quantitative easing helps housing and buoys economic growth. Since the Great Recession of 2008-2009, there is little evidence of a link between Fed easing and improving economic conditions. Fed easing (and a generational low in mortgage rates) during 2009-2012 failed to arrest the drop in U.S. home prices. Housing's problem was (and is) structural, as the shadow inventory of foreclosed, heavily delinquent and unsold homes created an imbalance between supply and demand. In actuality, home prices and mortgage activity plummeted to new lows during QE2. It was only after QE2 ended that home prices and sales activity began to recover as the inventory began to be absorbed. The unclear link between quantitative easing and economic growth is captured by Boenning & Scattergood's Rich Farr, who recently wrote the following:

During QE1, the economy did indeed improve; however, it is impossible to prove whether or not QE had any positive impact. When the economy bottomed in first quarter 2009, stocks were near all-time lows in valuation, oil prices and interest rates had collapsed, and TARP and other fiscal stimuli were in effect. As for QE2, the economy actually slowed. During the September 2010 quarter, real GDP expanded at a 2.8% year-over-year rate. Just one quarter later (and only one month into QE2), the economy slowed to just a 2.4% year-over-year rate. In the first full quarter of QE2 (first quarter 2011), GDP grew at just a 0.1% annualized rate (or just 0.01973% quarter over quarter). The U.S. economy continued to slow on a year-over-year basis until fourth quarter 2011, well after QE2 had ended.

Myth No. 3: Quantitative easing lowers interest rates. Most analysis I have seen of quantitative easing suggests that both QE1 and QE2 failed to lower interest rates. Indeed, interest rates rose persistently during quantitative easing. (The yield on the 10-year U.S. note has already recently risen by about 30 basis points in anticipation of today's announcement.)

Myth No. 4: Quantitative easing lowers the unemployment rate. Jobless claims rose during QE2. The problem with the U.S. jobs market is not a function of lack of liquidity or that interest rates are too high. Rather, housing's problem in the past was one of an imbalance between demand and supply and now stems principally from structural unemployment. The factors contributing to continued elevated joblessness -- namely, technological innovation, globalization, reduced mobility (after a 35% drop in home prices), a mismatch between available talent and employer needs and the fact that corporations (facing the costly burden of regulation, health care and taxes) have opted to make temporary employment a more permanent feature of the workplace -- are not going away and are not easily solved.

Myth No. 5: Quantitative easing fails to cause inflationary fears and pressures. The recent drop in inflation occurred only after QE2. Again back to Rich Farr:

When QE was enacted in November 2010, headline CPI was just 1.1%. In the months during and shortly after QE2, headline CPI surged to nearly a 4% annual rate! Although inflation has slowed since then, prices have not declined. Rather, prices are merely going up at a slower pace. Thus CPI is still 1.5% higher than it was a year ago, when QE ended. All told, the CPI index currently stands at 4.2% above where it was when QE2 was enacted just 20 months ago (a 2.5% annual rate). These lingering effects can still be witnessed in "core" CPI, which is still up 2.2% year over year. The Fed must recognize that there is actual inflation as well as expected inflation. The market reacts to expectations and many times may overreact to inflationary monetary policy from the Fed. If the market believes that future inflation will be higher than any benefit from the Fed's attempt at lowering interest rates, then rates will rise, not fall, from Fed actions.

How Might Mr. Market Respond to Today's Easing?

It is easier to divine what to expect from the Fed today than what the market's reaction will be.

The consensus (and bullish view) seems to be (with what I believe market probabilities to be in parentheses):

  1. If the Fed delivers to the market a closed-end or traditional easing, the S&P 500 will likely be unmoved (55% probability).
  2. If the Fed delivers to the market an open-ended easing (see above), the S&P 500 could spike to 1460-1470 (35% probability).
  3. If the Fed delivers to the market no quantitative easing, the S&P 500 might drop by 1% or so (10% probability).

Not surprisingly, I feel the market expectations (above) are too optimistic for the following reasons.

When quantitative easing was first announced at Jackson Hole a few years ago, it was largely unexpected and certainly not priced into the markets, which were collapsing going into the meeting. Asset prices -- equities and (more so) commodities (such as gold and oil) -- moved up dramatically after the Jackson Hole announcement.

Interest rates were higher then than they are now, while commodity prices were lower, as were stock prices and P/E ratios. At the time, there was a widely held view that monetary easing would improve the trajectory of domestic growth and lower unemployment. And, importantly, coincident with QE1, economic data points were starting to get better -- they were moving in this direction before quantitative easing started and continued for a while coincident with quantitative easing. Lastly, QE1 was at least at the front end of something that could go on for a lot longer.

Let's fast forward to the potential for QE3. Boy, have these guys gotten themselves over a barrel! Unlike QE1 (which was a surprise), QE3 is now widely anticipated. In fact, it is way behind schedule, as the pundits have been expecting it for a year or so. Although the market has recently advanced in anticipation of more easing, stocks never really sold off as the expectation of QE3 (a.k.a., "the Bernanke put") at the next meeting (or the one after that!) wasn't met. Last Friday was a perfect example, as, from elevated market levels (up considerably over the last few months), the market rose on a negative preannouncement at Intel ( INTC) and coincident with an awful jobs report. Stocks rose because traders and investors concluded that the weak employment release heightened the likelihood of QE3.

This is the monster our Fed has created, in which we celebrate bad economic news.

Today, almost every observer now expects more easing -- and they will likely not be disappointed.

As I have written, I believe we are at or near the top in world equity prices.

No doubt, quantitative easing produces more liquidity, but the Fed can't control where it goes. To date, most has become banking industry excess reserves, and I suspect some more will be added to reserves. Could more liquidity work its way into the stock market (and into commodity prices)? Of course, this is possible.

More Cowbell Is No Longer a Surprise

So, maybe today will provide some more fuel for stocks. But, maybe it won't, as so many now expect it.

As I wrote, there are some important differences between prior easing and today. For example, interest rates are already rock bottom, economic data points are turning negative, and commodity prices are already high.

To conclude, today QE3 is expected, equity prices and valuations are higher, and importantly, QE is no longer a novel concept nor at the front end of something that can be viewed as having an infinite shelf life. Also, it has been established that, given structural issues, quantitative easing has failed to meaningfully revive the domestic economy -- and most view more easing as waning in influence.

I like Miller Tabak's Peter Boockvar's take this morning:

Does anyone outside of the Fed think that any new policy news today, in the context of already historically low interest rates, will alter the behavior of any lender, corporate CEO, small business or large, or any individual consumer? Will the decision to build that plant, make that loan or buy that car or home be triggered by any new news by the Fed today? I think not.

Today it is almost as if more quantitative easing is being introduced because we are conditioned to it and the notion that it might help stock prices but not have a great impact on economic growth.

I am comfortable saying that, unlike QE1, QE2 or Operation Twist (and its extension), QE3 seems much closer to an end than a beginning. And clearly, the most important thing is that it doesn't appreciably help the real economy and frankly seems to hurt.

Now the Fed is damned if it does and damned if it doesn't. This is what The Fed has pigeonholed itself into with all the jawboning.

And after QE3 is announced, what next?

Unfortunately, from my perch, there is limited economic, corporate profit and capital market profit promise ahead.

In light of my views above, I remain net short.

At the time of publication, Kass and/or his funds were short SPY common and short SPY puts, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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