Two Carrots Don’t Make a Stick
I’ve always assumed the adage about a carrot and a stick had something to do with donkeys specifically, but was a great way of summarizing reward and punishment. The “carrot” was the reward. You dangle the carrot as a reward for good behavior. The stick was there to punish failure. In many ways, the Fed removed the stick yesterday. We now live in a carrot and carrot world. I know a few places I would like to stick a stick right now, but I can’t help but think this change is going to have negative repercussions in the longer term.
Two Wrongs Don’t Make a Right
I was wrong yesterday. I didn’t think the Fed would do it. I also thought the initial muted reaction was a sign that it was priced in. I was wrong, but I’ve been right for the most part for awhile, so I can live with yesterday’s mistakes. It bothers me, but not immensely.
What concerns me more is that I was wrong in September 2010. I underestimated the impact of QE2. That is what is bothering me now. Is this a replay of the fall of 2010 where we are at the start of a long relentless march higher, or is that so priced in, that it doesn’t happen again? That is the real question. Will the open ended QE spark another spurt higher, or is it different and too much priced in? I’m trying to get my hands around that, and being wrong in 2010 is clouding my judgment.
Two Mortgage Providers Don’t Make a Fed
If Fannie and Freddie announced that they were going to underwrite more mortgages yesterday, would we have rallied so much? While Fannie and Freddie cannot print, they are as much a part of the U.S. government as the Fed (technical accounting issues aside).
In fact, Fannie and Freddie are shrinking. The government wants their balance sheet reduced. The Fed has stepped in to pick up the slack. Why are we so much more excited about the Fed buying mortgages than Fannie and Freddie? Yes, I can see the printing argument, but the reality is that at least a part of yesterday’s announcement is picking up the slack rather than creating new additional demand.
I am not sure how that plays out, but it is a question we need to ask ourselves. Why does the Fed buying something count more than Fannie and Freddie buying something?
Fed Buying Mortgages Doesn’t Create Final Demand
While the Fed ignited a ramp up in risk assets and commodities, did they do anything for final demand? I spoke to some friends who are senior in real companies (those that manufacture something as opposed to financial services) and they quickly confirmed that nothing had changed on their end. Their stock options were worth more, they had now exceeded their stock price targets for the year, but they weren’t about to change plans. They need to see final demand increase before they change their business plans so nothing about more Fed buying affects businesses immediately.
On the home front, with a bias to people located in overpriced NYC related housing, most people hope this means that their property goes up in value. I haven’t run into anyone looking to buy now because of this. Across the country will this help? Maybe, but rates have been low for awhile, so I’m not sure what benefit this will have in the real world.
Banks Win Big
Anyone long mortgages ahead of this is in good shape. U.S. banks will benefit. European banks looking to shrink will benefit as they now have a ready buyer of a part of their portfolio.
So banks should do well. Bank credit spreads should do well. One consistent theme we’ve had is that bank credit spreads, CDS in particular, have remained stubbornly high relative to their equity valuations. This may be the catalyst that drives them tighter. Any notion that this Fed will somehow let a big bank fail seems ludicrous. They just printed money that helps them at a time when stocks are already at multi year highs and amid signs that housing has bottomed. If there is one trade where you are supposed to shut your eyes and ignore the volatility for 6 months, it is bank CDS. Hit a bid and walk away. As SEF’s come on line, the last and final bid for bank CDS, the counterparty hedging, will go away.
Commodities and the New World Order
As I try and understand what the Fed did, I keep coming back to the idea that commodities will win. In the short term gold may do well, but the reality is that you need useful commodities. Gold may well have been a store of value, but you can’t eat it, build shelter with it, or burn it for heat. Commodities that let you do that may well become the play.
As the Fed abandons any form of restraint in its efforts to keep rates low, debase the currency, and spur asset inflation, the mindset of investors, companies, and countries is likely to change. China is likely to be the leader in that. Stockpiling useful things, basic resources, seems like the trade.
The Fed isn’t “pushing on a string” it is sitting on a water balloon. That balloon will burst and the consequences of that will be something we have never dealt with before, and quite frankly, aren’t prepared to deal with. Maybe everything will work out, and for now it is hard to be bearish, so I will be neutral, but that doesn’t mean the end game didn’t get uglier.
Neutral, Confused, and Annoyed
I’m pretty much dead neutral in terms of positioning. Too much going on that is too confusing to form a solid opinion. At 1,460 on the S&P, at 118 on MAIN (no that isn’t a typo, IG18, so recently at 102 is now at 82) and highs on so many other asset classes, it is hard to say there is a lot of upside. With the Fed printing money monthly, it is hard to say there is any downside, so I will go with neutral and confused.
I think I have separated my anger from my investment decision, but I am angry. Everything about this move strikes me as dangerous. The one thing that I think the Fed does a HORRIBLE job at, is understanding that human behavior changes. The economists don’t seem to understand that the same inputs into the same model don’t produce the same results because behavior changes over time.
I for one, miss the stick, and I don’t even consider myself a masochist, just a believer in meritocracy and that failure is a necessary part of success.