The mood on Wall Street has changed dramatically since the Fed announced it planned to scale-back QE by the end of 2013. Although the Central Bank continues to purchase $85 billion of US Treasuries (UST) and Mortgage-Backed Securities (MBS) per month (as it has since the program was launched nearly a year ago), the expectation of reduced accommodation has pushed the 3 major indices to 6 week lows and roiled currency markets around the world. The fear of –what one analyst called– “The Great Unwind” has triggered “a period of sustained, savage volatility” that has burst the bubble in emerging markets (EM), put jittery traders on hair-trigger alert, and sparked a vicious selloff of US debt. Managing director and co-CIO of PIMCO Bond funds Bill Gross summed it up best on Thursday in a tweet that was widely circulated on the Internet. He said: “No more QE’s? No more bull markets.” Stocks went into freefall shortly after Gross issued the tweet.
Here’s more on the recent rout in USTs from Reuters:
“China and Japan led an exodus from U.S. Treasuries in June after the first signals the U.S. central bank was preparing to wind back its stimulus, with data showing they accounted for almost all of a record $40.8 billion of net foreign selling of Treasuries.
The sales were part of $66.9 billion of net sales by foreigners of long-term U.S. securities in June, a fifth straight month of outflows and the largest since August 2007, U.S. Treasury Department data showed on Thursday.
China, the largest foreign creditor, reduced its Treasury holdings to $1.2758 trillion, and Japan trimmed its holdings for a third straight month to $1.0834 trillion. Combined, they accounted for about $40 billion in net Treasury outflows….
“Holding too much U.S. debt is not wise at a time when Treasury yields rise and prices fall.” (“China, Japan lead record outflow from Treasuries in June”, Reuters)
Yields have been edging higher on benchmark 10-Treasuries since Fed Chairman Ben Bernanke first announced his “taper” plan in May. On Thursday, the 10-year yield hit a two-year high after the minutes of the FOMC’s meeting suggested that the Fed thought the economy was strong enough to begin scaling back sometime in the Autumn. The announcement pushed stocks into the red while the 10-year yield spiked to 2.9 percent perilously close to psychologically-important 3 percent milestone. The sudden rise in yields has slashed mortgage applications and forced over-extended speculators to trim their margin debt exposure. There is no scenario in which higher rates are positive for stocks or housing. As for margin debt; check out this 38 second video from Bloomberg News which shows how margin debt (the amount of stocks that are purchased with credit) traces the rise and fall of the S&P 500.
Just as extra leverage helps to drive markets higher, any downturn in prices forces heavily-exposed investors to dump stocks in order to cover the declining value of their collateral. That’s what leads to crashes. In the video, the Bloomberg anchor asks if we are on the verge of another full-blown meltdown saying, “Some have asked if we are in a 2000 or 2007 environment?” To which she blandly responds, “It looks that way.” (Talk about understatement!)
As late as March, margin debt amounted to $379.5 billion “the second-highest in the history of the NYSE’s figures, going back to 1959.” Investors felt confident loading up on debt knowing that Bernanke “had their back”, that is, that the Fed would prevent stocks from falling too far. Traders call the Fed’s liquidity support the “Bernanke Put”. Winding down QE means the Bernanke Put will no longer be in effect which will lead to a repricing of risk and lower stock prices. The Fed is now trying to convince investors that QE is no big deal and really didn’t have the impact on stocks that traders think. But no one is buying it. Here’s an excerpt from a recent paper by the SF Fed which attempts to downplay the effects of QE:
“Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation. …. Moreover, the magnitude of LSAP (Large Scale Asset Purchases) effects depends greatly on expectations for interest rate policy, but those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.” (“How Stimulatory Are Large-Scale Asset Purchases?”, San Francisco Fed)
In other words, what really matters communication, expectations, and short-term interest rates, not the $4 billion the Fed is pumping into financial assets every day of the month. Does that sound credible to you?
No, of course not, and the market’s not buying it either which is why stocks have been violently seesawing for the last 60 days.
The looming taper has also shoved emerging markets to the brink. Blogger Wolf Richter gives a first-rate rundown of recent goings-on in a post at his website Testosterone Pit. Here’s a clip from his latest on the turbulence in the EMs:
“QE drove yield-seeking investors.. to chase down yield wherever they could find it, no matter what the risks, and they found it in emerging markets and in junk. India, Indonesia, Thailand, Brazil, and other developing countries could suddenly borrow from the future at record low rates – much like developed countries – to goose growth. Companies, governments, and consumers ran up debts. Imports ballooned.
It had nefarious consequences. As the Fed was trying to devalue the dollar, other currencies rose. In September 2010, Brazilian Finance Minister Guido Mantega denounced the “international currency war” that the money-printers in Washington and elsewhere were waging against his and other emerging countries where the hot money had washed ashore. “This threatens us because it takes away our competitiveness,” he warned.
But in early May, when the Fed penciled “taper” on the calendar as something to consider, the hot money got antsy. That month, interest rates started to soar globally. Junk bonds got slammed, as did the debt of emerging markets, particularly of countries that had splurged on imports and had to fund large current-account deficits.
The selloff doused all sorts of hopes in India and has since contaminated Indonesia, Thailand, and other countries. … the Indian rupee lost 20% of its value, hitting a historic low of 64.13 to the greenback early Tuesday, after a 2.3% swoon on Monday. The Indian stock market index Sensex has fallen over 11% since mid-July. Government debt, a hair above junk, got hammered, with the 10-year yield jumping 20 basis points on Tuesday to 9.43%, a Lehman-moment high. The stench of crisis was in the air, and investors who’d been holding their noses for years, finally smelled it and tried to yank their money out.” (“When ‘QE Infinity’ Turns Into A Pipedream: Hot Money Evaporates, Rout Follows”, Testosterone Pit)
So the zero rates and extreme ”pump priming” in the US lowered borrowing costs in emerging markets which led to higher inflation, bigger current account deficits, and a credit boom. Now the tide has turned and the Fed’s tightening is wreaking all kinds of havoc on EM economies. Policies which had been hyper-stimulative, are now a drag on growth; borrowing costs are rising, demand is drying up, and EM currencies are being whipsawed by capital flight. All the problems in the EMs can be traced back to the Fed’s ZIRP (zero interest rate policy) and QE. Bernanke was warned that QE would fuel widespread financial instability, but he shrugged off the warnings to keep stocks marching upwards. (Wall Street always comes first) Now Bernanke has lost control of long-term rates and the hot money has begun to flee vulnerable, mostly commodities-dependent economies. The storm in the EMs has just begun, too. The scaling back of asset purchases will not take place until September at the earliest. That’s when the full impact of the Fed’s extraordinary price-fixing program will be felt. Here’s how the higher rates are walloping mortgage applications. This is from Wall Street Cheat Sheet:
“According to the Mortgage Bankers Association’s latest report, for the week ended August 16, loan applications dropped 4.6 percent on a seasonally adjusted basis from one week earlier — the thirteenth decline in 15 weeks.
The average interest rate for a 30-year fixed-rate mortgage increased to 4.68 percent from 4.56 percent in the week before. …. Between the beginning of May and the end of June, the average interest rate for a 30-year fixed-rate mortgage surged from 3.59 percent to 4.68 percent.” (“Is the Housing Market Losing the Battle Against Higher Interest Rates?”, Wall Street Cheat Sheet)
As mortgage rates creep higher, mortgage apps will drop more sharply, slowing housing sales and dimming the prospects for a lasting recovery. And while existing home sales just checked in at an impressive 5.39 million seasonally adjusted annual rate in July, the data does not reflect the sudden uptick in rates following the Fed’s announcement. The bloodbath will appear in the September data. Here’s how analyst Mark Hanson sums it up on a recent post at his blog:
“Remember, “existing” home sales, or “resales”, are counted at the close of escrow. The real house sale — when the “purchase & pricing decision was made — occurred 30 to 60 days prior when the house went “pending”. This means the local, regional, and national “July” existing sales data we get out this month are backward looking to the point of being almost meaningless, as the they don’t incorporate the “surge” in rates in the back half of June that really hit the market.” (July” Existing Sales Data Virtually Meaningless…They Don’t Incorporate Rate “Surge”, Mark Hanson)
The next existing homes sales report–which will be released in late September– will probably show sales tumbling as much as 30 percent as they did following the Firsttime Homebuyer fiasco in 2009. The plunge in sales will put immediate pressure on prices as wary investors and all-cash buyers who–according to a recent report by Goldman Sachs, represent 60 percent of all 2013 home sales–try to avoid bigger losses on their investments by exiting the market before prices slam into reverse. . The Fed has no way to arrest the decline of housing sales without increasing its purchases of USTs and MBS which it cannot do without sparking another crisis in the financial markets. As of Thursday, the 30-year fixed-rate is at a two-year high of 4.58 percent and headed higher even though the Fed is still on track to buy its full compliment of $85 billion in USTs and MBSs. Long-term rates are presently driven by expectations alone, that is, investors expect bonds to drift lower when the market’s biggest buyer (The Fed) reduces its purchases. It’s a safe bet.
Droopy mortgage applications and higher rates are just two of the headwinds facing housing. There’s also this tidbit which wasn’t picked up by any of the major media but will undoubtedly dampen the would-be recovery. This is from National Mortgage News in an article titled “FHA Loan Applications Plummet 49% in June”:
“Applications for FHA single-family loans dropped off a cliff in June as a regressive mortgage insurance policy kicked in early in the month and potential borrowers were dealing with rising mortgage rates.
In a monthly loan production report issued Friday, the Federal Housing Administration reported that loan applications fell nearly 50% in June from the prior month.” (“FHA Loan Applications Plummet 49% in June”, National Mortgage News)
The Fed’s reckless monetary policy is spreading financial instability across the world. Here’s a look at the impact of the fed’s announcement on the bond market. This is from CNN
“Worries that the central bank could taper its $85 billion a month in bond purchases, or quantitative easing, as early as September has spurred a huge sell-off in bonds…
Investors have yanked nearly $20 billion from bond mutual funds and exchange traded funds so far in August. That’s the fourth highest pullback ever, according to TrimTabs data. In June, investors took out $69.1 billion — the highest on record.” (“Is the bond bubble finally bursting?”, CNN)
And here’s what Bernanke’s unconventional pedal-to-the-metal policies have done to the rupee, which could be the prelude to a broader currency crisis. This is from Bloomberg:
“India’s rupee plunged to a record low on speculation a strengthening U.S. economy will prompt the Federal Reserve to pare its $85 billion of monthly bond purchases as soon as next month. Government bonds declined. The rupee slid as much as 1.3 percent today to an unprecedented 62.4600 per dollar and traded at 62.3138 at 10:00 a.m. in Mumbai, according to prices from local banks compiled by Bloomberg. It weakened 1.3 percent last week.
“The rupee is reacting to the strength of the dollar globally and I think the weakness in the local currency will persist,” Ashtosh Raina, head of foreign-exchange trading at HDFC Bank Ltd. in Mumbai, said by phone. “None of the efforts by the government and the central bank seem to be having any impact.” “India Rupee Sinks to Record Low, Bonds Drop on Fed Taper Concern”, Bloomberg)
QE has even ravaged the repo market (repurchase agreement)
“where banks and investors borrow and lend Treasuries and other fixed-income securities.”….
“The repo markets are really the grease in many financial market systems,” Josh Galper, the managing principal of securities-finance consultant Finadium LLC in Concord, Massachusetts.”.
The repo market is also shrinking as the Fed scoops up Treasuries through its monthly bond purchases. The central bank owns about 17 percent of the market.” (Bloomberg)
Less Triple A collateral available, (The Fed owns 17 percent of the market due to QE) means less liquidity and higher borrowing costs for consumers and businesses. In short, the Fed is shooting itself in the foot.
The surge in capital flows from emerging markets, the plunging rupee and (Brazilian) real, the gigantic selloff in bond funds, the spike in long-term interest rates, and the “sustained, savage volatility” in stocks are all prelude to the Fed’s forthcoming announcement that will reduce its bond purchases sometime in the Fall. Despite the ruinous impact the Great Unwind could have on markets and the broader economy, Bernanke has no choice but to end the program and return rates to their normal range. Bubbles are now visible across the spectrum of financial assets, from junk bonds to tech stocks. As Pimco’s co-chief executive Mohamed El-Erian told Bloomberg News, “We see artificial pricing in virtually every asset class.” Indeed, Fed policy has incentivized excessive risk-taking and pushed the financial system to the brink once again. The probability of another global financial crisis is now greater than ever.
Time to run up the red flags.
MIKE WHITNEY lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. Whitney’s story on the Fed’s quantitative easing disaster appears in the August issue of CounterPunch magazine. He can be reached at fergiewhitney@msn.com.