QE3 is here. The US Federal Reserve will finish Operation Twist and launch open-ended buying of mortgage-backed securities (MBS) at $40 billion per month. What will this do and what will be the effect upon markets?
The Fed will be buying agency-backed MBSs. These are those MBSs that are packaged and sold by the government sponsored enterprises, Fannie Mae and Freddie Mac (and others), which constitute most of the US mortgage market. These securities are, in turn, linked to the yield of the 30-year government bond, which the Fed is also driving down using its existing Operation Twist.
By doing so the Fed hopes to keep the return (interest rates) on MBSs lower than they’d otherwise be and close the yield spread between them and the 30-year government bond. Although most US mortgages have fixed rates, the result will be lower mortgage interest rates for longer and that should enable more mortgagors to refinance at lower interest rates.
According to Credit Suisse, there is also one other potential reason. As European banks deleverage, the risk is rising that some will sell their US assets. That could risk rising interest rates for MBSs so the Fed is backstopping that outcome.
So, who wins and who loses when this goes ahead? Obviously US equities have gotten what they wanted. QE is a free pass for stocks, so who’s going to refuse that? That may also boost consumption at the margin with some wealth effect helping consumption. The same applies for hosuing.
Second, we can surely again expect a weak US dollar for the period that QE3 persists. Whether it’s actually true or not, markets believe that Fed money printing debases the value of the dollar. That will further help the US economy through a boost to export competitiveness. But it is doing so into a chronically weak global economy so the uplift is likely to be muted beyond the immediate effects of higher profits for US dollar-exposed firms.
By extension, however, a falling greenback raises the immediate prospect of higher commodity prices through the combined effects (real or imaged) or a debased dollar, in which most commodities are priced, and rising inflation, which prompts markets to buy real assets. Last night gold, oil, grains, copper and the CRB all rallied handsomely.
But it is not all plain sailing. The broader conditions for a commodities rally are not as good as they were during the second round of QE in ‘10-‘11 with Europe in perpetual recession and China wrestling with a hard landing. Last night’s price action was a good guide to how it may play out. Industrial commodities such as copper and oil were a up 1% or so. But precious metals were up twice that. Gold and silver will be the biggest winners here.
The next winner is global inflation. Thus, sadly, US households are just as likely to give up any gains from the stimulus to the secret tax at the bowser and grocer. That leaves a lower dollar as the major benefit.
Which is where things start to go pear-shaped for everyone else. The recently stabilsied euro will find itself under increasing upwards pressure, damaging ECB stimulus efforts. This may be made worse by a burst of commodity inflation, which will prevent further ECB easing. The Chinese reaction may be mixed. QE in the US pours money into China through the yuan peg. That will help reverse recent capital outflows and could prompt higher lending. A falling US dollar is also a falling yuan so there is some export benefit too.
But a new flood of ill-directed liquidity will not be welcome and comes with a second problem for the Chinese, food inflation. There is a strong correlation between global food prices and Chinese inflation. Having just contained price rises, the last thing Chinese authorities will want is to see is a new outbreak. The policy environment for the Chinese has gotten more complex as it wrestles with its slowdown.
It’s not called competitive devaluation for nothing.
Which brings us to Australia. In the short term, the risk is that the Aussie will rise strongly on QE3, as it did last night. This is clearly bad news as we enter an external shock already under way from falling bulk commodity prices. It is not altogether easy to judge, but iron ore and coal prices do not tend to be as effected by monetary inflation as other industrial commodites. As still heavily contract-priced commodities with undeveloped derivatives markets, they are less subject to the short-term whims of speculators (and more exposed to fundamenal supply and demand). This raises the difficult prospect that bulk commodities remain weak on the Chinese correction but the Australian dollar remains near highs on US dollar monetary inflation.
A higher dollar will also choke off any benefit we might have seen as the ASX rallied in sympathy with Wall Street.
The broad Australian economy is still travelling OK, if slowing, but unemplyment is set to rise as the mining boom slows. There is no obvious offset as mining investment slows. The consumer remains very cautious and broader tradeables sectors are weak. The consensus that the RBA will be cutting interest rates by the end of the year is right. But that is now complicated in some measure by the inflationary pulse that will come via oil and food.
At this stage I think it unlikely to be sufficient to derail any RBA cuts. Indeed, lowering the dollar is fast becoming a prioirty.