The Federal Reserve is set to cease its buying of U.S. Treasury bonds June 30, but even with more than three months of QE2 remaining many market watchers are turning their focus to what comes next. And if another round of stimulus isn’t on the way, it could mean the lights will dim on the party for U.S. stocks.
David Rosenberg, the former Merrill Lynch economist now at Gluskin Sheff, argues that investors already have a playbook for what happens if Chairman Ben Bernanke and the Fed hit the brakes on stimulus when QE2 hits its expiration date in a few months. (See “Fed Hawks Flap Wings At FOMC.”)
In his note Thursday, Rosenberg writes:
Last year, from April 23rd through to August 27th, the Fed allowed its balance sheet to shrink from $1.207 trillion to $1.057 trillion for a 12% contraction as QE1 drew to a close. Go back a year to the Federal Open Market Committee minutes and you will see a Federal Reserve consumed with forecasts of sustainable growth and exit strategy plans. A sizeable equity correction coupled with double-dip fears were nowhere to be found.
Now over that interval …
• S&P 500 sagged from 1,217 to 1,064.
• S&P 600 small caps fell from 394 to 330.
• The best performing equity sectors were telecom services, utilities, consumer staples, and health care. In other words — the defensives. The worst performers were financials, tech, energy, and consumer discretionary.
• Baa spreads widened +56bps from 237bps to 296bps
• CRB futures dropped from 279 to 267.
• Oil went from $84.30 a barrel to $75.20.
• The VIX index jumped from 16.6 to 24.5.
• The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5.
• Gold was the commodity that bucked the trend as it acted as a refuge at a time of intensifying economic and financial uncertainty — to $1,235 an ounce from $1,140 and even with a more stable-to-strong U.S. dollar too.
• The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%.
Who, Rosenberg asks, will buy bonds when the Fed puts its wallet away? The very same investors who poured into the bond market in the April-August period last year, “the ones who were switching out of equities, commodities and other risk-assets.” That could pressure a U.S. equity market that has seen a mostly unchallenged run higher since Bernanke put QE2 firmly on the table in August.
PIMCO bond guru Bill Gross offered a similar, albeit slightly different, sentiment in his March Investment Outlook. Though he acknowledges that “Someone will buy [Treasuries], and we at PIMCO may even be among them,” Gross also says that the handoff from public to private credit creation has yet to happen. He argues that Treasury yields are currently too low for PIMCO to be a buyer, by as much as 150 basis points, but acknowledges the other side of the argument:
As a counter, one would argue (and I would partially agree) that the U.S. and indeed developed global economies must keep yields artificially low for some time if post Lehman healing is to take place. But that of course is the point. By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab. Ouch! 25 basis point policy rates for an “extended period of time” may not be enough to entice arbitrage Treasury buyers, nor bond fund asset allocators to reenter a Treasury market at today’s artificially low yields. Yields may have to go higher, maybe even much higher to attract buying interest.
Both Gross and Rosenberg indicate that the end of QE2, without QE3 following in its wake, will be a rocky time for investors. Gross goes so far as to compare it to D-Day, “fraught with hope for victory, but fueled with immediate uncertainty and fear.”
He writes:
Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets.
At some stage, the Federal Reserve is going to take the training wheels off the market and the likely result is a few scrapes and bruises. And as Rosenberg points out in closing, a note of caution is creeping into markets. Consensus forecasts for first-quarter earnings growth in the S&P 500 have come down slightly after increasing steadily since October, and nearly one-third of the U.S.
IPOs that came to market since June 2010 are trading below their offering price according to data from Renaissance Capital. (That group does not include General Motors, but just barely as the automaker trades at $33.08 Thursday after pricing its November IPO at $33.)
Stocks have been resilient through the recent jump in oil prices, and rallied on the back of fewer weekly jobless claims Thursday morning, but the Fed’s presence is a market factor that cannot be overlooked or overstated. If the central bank withdraws some of its liquidity at the end of June, the back half of 2011 could be turbulent.
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