Hi Ho Bernanke – Fed Chairman and his Posse ride to the rescue

August 10, 2011

Global Macro

Last night saw a continuation of the turn around we saw in Asia yesterday afternoon. I’m sure that commentators today are going to look like weather vanes, probably me included, but the move down and then back up has been breath taking. Lets recap. yesterday the AUD traded down to 0.9928 and it now sits at 1.0389, Dow Futures were off more than 250 points in Asia Yesterday but the Dow has closed up 429, the ASX200 was down at 3763 yesterday before closing at 4034 and the SPI futures indicate it will open up another 114 points today.

Now I’m not going to say that last night’s bounce was crazy, because it was just as crazy as the price action the previous night and then in Asia yesterday. It is the volatility that I think is the worst part because it breeds uncertainty in people and that as we always is poison to business planning, households and the economy.

So on that basis I welcome the Fed’s commitment, given overnight, to keep rates at these extraordinarily low levels until 2013.

To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.  The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.  The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.  The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

I’m not going to quibble about the why they feel they need to keep rates so low, that being a very weak US economy, and say that this makes last night’s bounce a little crazy because in fact it actually underpins the valuations that have shot up.

Perhaps a little bit of maths can help me explain. When you work out the net present value of a series of cash flows you have to decide on a discount factor which is driven by the interest rate for the time period. The higher the interest rate the lower the net present value. But if the Fed is essentially saying that for 2 more years the discount rate is going to be zero then the value of stocks and by extension risk assets has just shot up exponentially.

We are clearly not talking about the earnings on equities or the real outcomes for companies and the economy – no we are talking about trading, investing, punting and making money. What the Fed is doing is what it has done since the dim dark days of the initial period of the GFC – it is punting (not too strong a word I think) that if it leaves rates low enough for long enough and markets can contain themselves then they are buying the real economy time to heal.

This is a Grand Experiment in my view but one that I believe they have little choice in making. The best case scenario given all of the headwinds that face the US and global economy is in many ways a Japanese style period of low rates and low growth but with slightly elevated prices or inflation. Something akin to what they are doing in the UK with 4% inflation and low growth. In that way stability and certainty can return to the economy, inflation can eat away at the “real” value of the debt pile and the economy can heal itself.

The alternative is to be forced to deal with Sovereign and bank default, have the global economy go into a depression and then try to drag ourselves out of the mire. What the Fed is doing is trying to skirt the mire by buying time for the economy but as you can see from the quote from the FOMC minutes above it is hardly enthusiasatic about the prospects for jobs and growth in the short term.

The impact of last night’s statement can not be under estimated though because in bias US and probably global rates lower, in implicitly (I think) undermining the USD it is in many ways placing back where we were before the April/May Euroipean ructions started. That, is we could be in for a period where traders borrowing at zero can and do chase risk assets. This means that we could get some perverse outcomes where the usual reaction of commodities to weak global growth, ie falls, is more than offset by money manager capitalists chasing returns on their funds and bidding prices higher. Equally the AUD which should go lower in a weak global economic environment may surprise us all because of USD weakness and its place as the world’s favourite punts.  This will take away the opportunity for it to act as Australia’s great economic stabiliser.

The Fed is doing the right thing by the US economy at the moment but in exporting their troubles to other nations via loose monetary policy and a weaker USD they are simply shifting the pressure points elsewhere.

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