Friday, October 8, 2010

‘Bernanke Put’ Risk for Shareholders?

Michael Mackenzie and David Oakley of the FT report, ‘Bernanke put’ risk for shareholders:

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.

There are no guarantees that QE2 will work, but as as more come on board with QE2, risk appetite is rising:

The Bank of Japan's announcement earlier in the week, of new quantitative easing measures designed to help a flailing Japanese economy, further cemented the notion of the Federal Reserve also embarking on a similar path in the market's eye, traders said.

For sidelined investors, who begrudgingly came on board with the notion of what QE2 come November might mean, this led to new monies being allocated into more risk-friendly and higher yielding instruments.

Emerging markets, commodities and commodity currencies benefited from renewed risk appetite, as did the euro and other major currencies.

This week's trading action provided satisfaction for a variety of players even though movements were choppy at times.

Risk bears took comfort in the fact that U.S. Treasury yields kept moving lower, with some analysts talking about a move to 2.0% in the 10-year note before the end of the year.

The 10-year U.S. Treasury yield was closing at 2.3925% Friday, up from an earlier low of 2.334% and compared to last week's close at 2.526%.

For risk bulls, commodities and currencies suddenly became the rage, with gold posting a new life-time high of $1264.60, NYMEX light sweet crude posting a five-month high of $84.43 and the euro posting a new eight-month high of $1.4040, all Thursday.

Gold was ending the week at $1346.50/oz, oil at $82.66/barrel and the euro at $1.3930.

While prices in these instruments were down from Thursday's peaks, traders look for a new wave of buying next week, if fixed income markets continue to push U.S. Treasury prices higher and yields lower, traders said.

Barring some unexpected event that causes U.S. yields to rise, it is hard to find a reason for a sudden reversal in sentiment, they said.

MNI's Fed watcher Steve Beckner observed Friday that this was "a week that began with heightened expectations of renewed quantitative easing ended with an employment report that arguably warrants such action but by no means guarantees it in the near-term."

He stressed that Fed officials "remain divided on what needs to be done and when," adding that "with three weeks left before the Federal Open Market Committee meets to revise its economic forecast and set monetary policy, 'QE2' remains in doubt."

Market players would seem to disagree and that is why U.S. yields continue to edge lower, analysts said.

This persistence about the Fed potentially implementing aggressive QE2 is dragging the dollar lower, creating problems for emerging market central banks around the world, they said.

In addition, dollar weakness is acting to push commodity prices higher, which wreaks further havoc in that at some point inflation will again become a concern, they said.

However, until the U.S. employment situation improves and the economy again begins to thrive, the market will remain wary.

"If the economy continues to grow at a rate that will not reduce unemployment nor drive inflation up to 2%, QE2 could be around for years as opposed to quarters," said David Gilmore, economist and partner at FX Analytics in Essex, CT.

If indeed there is a double-dip recession, "it could get very big and in very short order," he warned.

For those favoring a risk-off trade, he favors taking the QE side of the trade over the prospects of new eurozone peripheral debt jitters.

Gilmore would use any new revelations about eurozone sovereign debt that propels the dollar higher and the euro lower to add to "risk longs, (dollar shorts)."

The release of U.S. non-farm payrolls had only a short-lived effect on currencies and commodities, with the data mixed.

The headline of 95,000 job losses was worse than MNI's median of -8,000, but the unemployment rate was steady at 9.6% instead of rising to 9.7% as expected, and the private payroll result of +64,000 was about what analysts expected after the ADP release earlier in the week.

On the commodity front, the Reuters-Jefferies CRB index posted a new two-year high of 295.17. The CRB closed up 2.72% at 295.11.

Traders pointed to the jump in soft commodities on the day with the majors (wheat, corn, soy) all limit up at one point.

The USDA Crop report, released earlier, suggested supply concerns, and was the driver of the move, they said. (http://www.usda.gov/oce/commodity/wasde/latest.pdf).

On the U.S. stock front, Dow Jones Industrial Average and the Nasdaq Composite made headlines by breaking above key psychological levels of 11000 and 2400 this week.

The S&P 500 closed Friday at 1165.15, after trading in a 1131.93 to 1167.75 range this week.

The market wants to see the index clear 1173.46, the May 13 peak seen before eurozone peripheral debt jitters put the kibbosh on risk appetite.

Only then will there be a shot at revisiting the 2010 high of 1219.61, seen April 26, analysts said.

Looking ahead, U.S. data releases (CPI, PPI, trade, retail sales, preliminary University of Michigan Sentiment) will be closely eyed as will Tuesday's release of the FOMC minutes of the September meeting.

Key Chinese data is also set for release next week (new loans, FDI, trade, and foreign exchange reserves) and will attract attention.

Earlier Friday, Moody's Investors Services put China's A1 rating on review for a possible upgrade.

While China's economy has show "strong resilience during the crisis," an upgrade may be premature, with BBH's model rating the country as A+/A1/A+, which is in line with China's actual ratings, said Win Thin, senior currency strategist at Brown Brothers Harriman.

As such, Moody's upgrade "would be the first to put China into double-A territory," he said.

Nevertheless, "the upward ratings trajectory for China (and really, for most of EM) is undeniable and so whether an upgrade happens this year or next year is really just splitting hairs as markets have already priced it in," Thin said.

Rodrigo Campos of Reuters reports, Fed to run the show despite big earnings:

Not even earnings from big names like Google and GE next week will be able to pull Wall Street's focus away from the possibility of more cheap cash flowing in from the Federal Reserve.

Normally when the likes of JPMorgan or Intel --also reporting next week -- tell investors how much they earned in the previous quarter, the stock market hangs on every word.

But after Friday's surprisingly anemic payrolls report, the increased likelihood the Fed will buy more assets like Treasury bonds to stimulate the economy has investors ignoring the usual benchmarks.

"Markets have been oscillating between macro and micro data, and the upcoming week will focus on macro," said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management in Menomonee Falls, Wisconsin.

The fact that Wall Street closed Friday in the black despite the weak payrolls data is evidence the Fed's action is top of mind for investors at this time.

Action from the central bank has already been baked into the equities rally, with $500 billion as the most talked-about injection. And the risk of a decline in equities is off balance as both good and bad economic news could have a bullish effect on stocks.

"Good news is clearly good and the market goes up," said John Praveen, chief investment strategist at Prudential International Investments Advisers LLC in Newark, New Jersey.

"If earnings or economic news is bad, then we'll get" a second round of quantitative easing, he noted. "Therefore the market will still go up. In that sense, risk is asymmetric."

Economic data next week, including consumer and producer prices, retail sales and consumer sentiment could shed further light on whether the economy has slowed enough to require swift action from the Fed.

"If CPI shows core inflation is going to fall, further odds of aggressive QE --as opposed to a trickle -- will increase and that will be viewed positively by the market," said Praveen.

EARNINGS TAKE BACK SEAT

Intel Corp, JPMorgan Chase & CO, Google Inc and General Electric Co are among the largest companies that will post earnings next week. Intel warned in late August that its revenue could fall short and its shares got punished, so there's little space for a negative surprise.

And if Alcoa's report on Thursday was any indication, even bellwethers' numbers may have to vary enormously from expectations to be noted amid all the QE2 talk.

Alcoa Inc marked the unofficial start to earnings season, rising 5.7 percent to $12.89 a day after its results beat estimates. While the stock rose sharply, it was far from the market's focal point, which hinged on the expectation of the Fed's action.

And next week's Treasury auctions, especially of longer-term bonds, may also provide a boost to stocks.

Investors are getting fatigued and bids on the 30-year bond might be a little bit weaker from past auctions, according to Wells Fargo's Jacobsen.

A decline in interest would suggest "people are more interested in going into equities rather than bonds," he said.

Turning the balance even further in favor of the bulls, expectations of more easing from the U.S. central bank should keep the dollar on a downtrend, which is another signal of gains for Wall Street.

An inverse correlation between the greenback and U.S. stocks has prevailed strongly in the last weeks The 30-day correlation between the S&P 500 .SPX and the dollar index .DXY was at -0.88, while the 50-day correlation was -0.89.

That said, with the International Monetary Fund meeting discussing the issue of competitive currency devaluations and shorts on the U.S. dollar piling up, a big move up on the greenback may become a hurdle for stocks.

OPTIONS CALL FOR CALM MARKET

S&P 500 charts show the previous resistance at 1,150 has turned into short-term support, with the next resistance level around 1,170-1,175. The current trend channel doesn't hit that area until late next week.

Options trading implies low volatility levels, as reflected by the CBOE Volatility Index and the CBOE Nasdaq 100 Volatility Index, said Scott Fullman, director of derivative investment strategy at WJB Capital Group.

"While the rally appears to have stalled," he said, "we continue to see indications of an upward bias toward prices."

Finally, today I got to speak with one of my favorite senior pension fund officers who manages a sizable bond and hedge fund portfolio. I leave you with some of his thoughts, in point form:

  • On QE: The multiplier effect is diminishing;
  • There will be no double dip in the US. The leading indicators they look at (economic, not based on QE) are showing tepid growth in 2011;
  • Europe lags behind the US by roughly six months. Problems in the periphery persist, with Spain heading into a double-dip;
  • Commodities like copper and oil are on fire, but most of the move can be explained by the weak USD;
  • Currency wars are raging...race to the bottom continues;
  • Employment - or lack of - will be the political issue of the next decade;
  • Leading indicators are pointing to tepid growth. Not strong enough to take any major risk so he is neutral now, hedging to protect against downside risk, and sticking close to his benchmarks;
  • Risk trade is on. Some trades like short USD are getting crowded...need to be careful, last time this happened, greenback rallied sharply;
  • QE is promoting risk-taking behavior but risks are high. He is surprised to see the VIX so low;
  • Asset mix call: slightly long stocks (QE, record operating margins, tepid growth) but hedge downside risk. Bond yields can fall a further 20 basis points on the 10-year but bonds are pricey at these levels.
My feeling is that going into year-end, asset managers and hedge fund managers are going to squeeze all the beta juice they can because most of them are underperfoming their benchmarks. The biggest problem now is that risks are asymmetric (see Greenspan below), and very few pensions are prepared for fat tail risk. But the risk of underperformance is the one that's weighing on most portfolio managers who are nervously betting on the 'Bernanke put'.

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