Goldman Explains Why It Is "QE2 Or Bust" For Stocks Tomorrow
Just in case you missed Goldman's economic team shift to outright bearishness, Jan Hatzius presents several key observations that other economists (particularly BofA's Bianco and Dutta) have yet to grasp. And even as Goldman openly expects a recommencement in debt monetization tomorrow to the tune of $1 trillion, Hatzius openly acknowledges that this decision could be delayed... And such a decision would be a major mistake, as it is already priced in: "Such a decision could prove to be a serious mistake, because a
significant part of the recent easing in financial conditions is
probably due to market expectations of a more expansionary monetary
policy. Indeed, if a disappointment on Tuesday results in a significant
renewed tightening of conditions, the decision might ultimately hasten
the transition to further easing steps." In other words, it is pretty much QE or bust for stocks.
1. The July employment report was weak. All three main sources of US labor market information now show a reversal of the prior trend toward improvement. In the establishment survey, the 3-month average of nonfarm payroll gains excluding the impact of the Census has slowed from +143,000 in April to +13,000 in July. In the household survey, the 3-month average of private employment growth has slowed from +234,000 in April to -12,000 in July. And even in the initial jobless claims data, which never showed as much of an improvement in the first place, the pace of applications has drifted up over the past few weeks to a 3-month high of 479,000.
2. Other recent numbers have been more mixed relative to expectations, but are consistent with slowing growth as well. This is most obvious in the manufacturing sector, where Monday’s ISM showed only a slight decline in the composite but a 5-point drop in the new orders index. Most indicators of final demand—including durable goods and retail sales—have also come in on the softer side, although the nonmanufacturing ISM provided a ray of light last week. On balance, we expect final demand growth in the second half of 2010 to stay at around 1½%, the average pace of the past three quarters. With inventory investment stabilizing, GDP growth is likely to converge to this pace as well.
3. Some forecasters who have been holding onto a more optimistic view are blaming the weaker recent data on the shock from the European sovereign debt crisis. But it is difficult to reconcile this view with the fact that the drop in US net exports in the second quarter occurred entirely because of a rise in imports rather than a fall in exports, and that there has so far been no slowdown in US export growth to the euro zone. And while the tightening of financial conditions in the second quarter undoubtedly weighed on confidence, there is little sign that it had a big impact on the hard economic data. Our view remains that the impact of the debt crisis on US growth has been minor and the real reasons for the slowdown are the loss of domestic inventory and fiscal stimulus.
4. On Friday, we revised down our forecast for 2011 and now expect a more gradual acceleration to a 2¼% pace on a Q4/Q4 basis, versus about 3% previously. (We also made a corresponding upward revision to our unemployment forecast and a largely technical upward revision to our core inflation forecast, although we still expect significant further core disinflation to ½% year-on-year by late next year.) The reason for the growth downgrade is that the deterioration in the economic data has coincided with a deterioration in the fiscal policy outlook. By our estimates, fiscal policy—federal, state, and local—added an average of 1.3 percentage points to growth from early 2009 to early 2010 but will subtract an average of 1.7 points in 2011. This number is based on the assumption that the upper-income income tax cuts passed in 2001-2003 expire on schedule and emergency unemployment benefits end in late 2010, but that all other tax cuts including the Making Work Pay program passed in early 2009 are extended. These assumptions are subject to risk in both directions. Depending on the outcome of the November election, it is possible that Congress will decide to extend all of the tax cuts, which would modestly boost the growth outlook, but it is also possible that stalemate ensues and all tax rates rise on January 1, which would substantially hit growth.
5. The risk of a double-dip recession is material, but ultimately the more likely outcome is that we will manage to avoid it. This is partly because the cyclical parts of the economy, which typically account for “more than all” of the decline in real GDP in a recession, are already very beaten down. The most obvious example is homebuilding, where another drop of the magnitude typically seen in recessions is almost mathematically impossible. But auto sales, equipment spending, and nonresidential construction are also at levels implying that the capital stock in these areas, after depreciation, is either shrinking outright or growing at a very slow pace. In our view, this means that a further sizable drop in spending (i.e. a further slowdown in the growth of the capital stock) would require a sizable negative shock, probably of a financial nature. This could happen, but it is not our expectation.
6. In addition, we are counting on another push from monetary policy to ease financial conditions via further another round of large-scale asset purchases and/or a more forceful commitment to a long period of near-zero short-term rates. If our growth, employment, and inflation forecasts are on the mark—and in particular, if the unemployment rate rises back to 10% as we expect—we are reasonably confident that Fed officials will indeed decide to do significantly more.
7. So what will happen at Tuesday’s FOMC meeting? It’s a close call, but we expect an announcement that the proceeds from maturing or prepaid MBS will be reinvested in the bond market (most likely Treasuries). In our view, the gradual tightening of the policy stance that is implied by the current policy of letting the balance sheet shrink is inconsistent with what we expect will be a significant downward revision in the forecasts of the FOMC as well as the Board staff since the last meeting. We have little direct information about any forecast changes, but some insights are available from public documents and speeches by officials and staff at the San Francisco Fed (arguably the most open part of the system in this regard). On May 13—the last available date before the June 22-23 FOMC meeting—the SF Fed expected real GDP growth of 3¾% in 2010 on a Q4/Q4 basis. On July 8—the first available date after the meeting—the forecast had fallen to 3.1%. And on July 28—the most recent update—it had fallen further to 2½%. These numbers require some interpretation since they are affected by a changing picture of H1, and we have no information on any further changes in the wake of the GDP, ISM, and employment data released since July 28. But our interpretation is that the SF Fed has probably revised down its view of H2 growth from about 3½% (clearly above trend) at the June 22-23 FOMC meeting to 2%-2½% (slightly below trend) at the upcoming meeting. If other officials have made similar changes, this would probably be enough to trigger a meaningful shift. And the most obvious meaningful (but not yet radical) shift would be a decision to reinvest MBS paydowns.
8. However, it is also very possible that the committee will require more time for a shift. One reason to think so was Chairman Bernanke’s speech last Tuesday. This was before the employment data, but it was noteworthy that the chairman sounded relatively upbeat, specifically on consumer spending. Undoubtedly, Fed officials are also encouraged by the recent, broad easing in financial conditions. But while this might argue for a decision to do nothing much on Tuesday, such a decision could prove to be a serious mistake, because a significant part of the recent easing in financial conditions is probably due to market expectations of a more expansionary monetary policy. Indeed, if a disappointment on Tuesday results in a significant renewed tightening of conditions, the decision might ultimately hasten the transition to further easing steps.
And just to reiterate, here is Goldman's Dominic Wilson, head of Global Markets, who pounds on this point as well, while noting that the market continues to be stuck in a mode which accentuates good news, and ignores bad news:
August is only a week old, but so far things look different to either
June or July. We have had three major US data days (Monday, Wednesday
and Friday). The average gain on those three days is substantially
positive, while the market pulled back a little on the other two days.
And for the month as a whole, we are up considerably still. Of course,
this is heavily influenced by Monday’s 25 point gain. But while these
are early days, in a sense that is the point. Monday’s rally was by far
the largest on a day where major US data was released in over two
months. And we have managed to pass through the period of the ISM and
payrolls with equities moving significantly higher, something we did not
manage in either June or July.
- Payrolls disappointment sees fresh lows in yields and USD…
- ….and an easing in our FCI to new record lows.
- We downgrade our 2011 US GDP forecast and forecast fresh easing.
- US data has been the major headwind through June and July as we show.
- But despite Friday, August has proved friendlier so far.
- This is partly because data has been more mixed than before.
- But market also seems to be taking credit for easing ahead.
- Tomorrow’s FOMC meeting is the most important for some time
- We expect a move to reinvest MBS proceeds, but a close call.
1. Financial Conditions Ease as Payrolls Disappoint
Friday’s payrolls came in weaker than expected both on private and ex-census payrolls and the market reacted strongly to the numbers. While equities made up of the sharp losses that they saw earlier in the day, the bond market held onto significant gains and the dollar weakened broadly. This combination saw our US Financial Conditions Index hit its easiest level on record. It has also generally helped our current tactical trades and we are raising our stop on our recommended long AUD/CAD position to 0.93.
Bond yields took out new lows along the curve in the process with the 2-year yield hitting new cycle lows intraday below 50bp, the 5-year yield trading below 1.50% before closing a little above and the 10-year yield closing at 2.82%. The dollar trend is also impressive, with fresh local highs in EUR/$ and lows in $/JPY. The USD TWI has now reversed almost all of the appreciation it saw in the first few months of the year when upward revisions to the US growth picture dominated. Without much fanfare, USD/CNY has also drifted to new lows, though market focus seems to have left that cross.
2. A downward revision to our US forecast
Revisions to our US forecasts on Friday, something our US economists had flagged as imminent for a while, suggest that several of these trends can ultimately run further. We continue to expect 2010H2 to show growth of around 1.5%. But with resistance to renewed fiscal stimulus, we now forecast a more gradual pick up in GDP growth through 2011 than before. The result is that the year-over-year growth rate in 2011Q4 has dropped to 2.25% (around 90bp lower than before) and our year-average forecast has fallen to 1.9% from 2.4%. We continue to see disinflation, though given recent upward revisions to core PCE data and signs that rent disinflation may be ending, at a slower pace than before.
With the unemployment rate rising, we now expect the FOMC to re-engage in unconventional easing through asset purchases (USTs) and/or a more ironclad commitment to lower short rates. And we now expect 5-year yields to trade around 1% and the 10-year yield to around 2.5% by year end. The market has been very focused on a potential shift in this direction. And tomorrow’s FOMC meeting has become the most significant in some time for that reason. While a close call, we think the FOMC will announce that they will reinvest the paydown of MBS in the bond market. This would probably be packaged as ‘preventing a tightening’ but the market is likely to see it as a step – albeit a baby one – towards renewed easing. In fact, the market already appears to be taking credit for some fresh support from policy ahead, as we describe below. As a result any step in that direction from the Fed will probably be welcomed, but it also points to some vulnerability to a decision to leave things as they are.
On the back of our US revisions, we have also lowered our Japanese GDP forecasts (to 3.3% from 3.4% in 2010 and to 1.4% from 1.7% in 2011) and though we have made no changes to our Euro-zone growth forecasts or our view that the first ECB rate hike will in Q2 2011, we now think that the normalisation of money market rates – i.e. the convergence of money market and policy rates – will take slightly longer.
3. US growth risks offset by better news on system risk and global growth
Our own trading stance continues to operate around three themes: a) US growth is likely to disappoint; b) non-US growth is likely to hold up better than expected at least relative to the US and China to back off its tightening policy and Europe suffers less from the sovereign fall-out than feared; c) sovereign and systemic risks have been overpriced at least in the near-term. This has left us with a relatively neutral view on equity markets (US growth problems need to be balanced against better non-US news and excessive risk premia), but a preference instead to trade relative views of the slowdown in the US (and a more positive relative view of China) and to position for further compression of risk premia directly through credit and credit-like areas.
In the first bucket, we remain short the USD (vs SGD and CNY); we have two risk-neutral trades designed to capture relative growth exposures to the US and China (long AUD/CAD and a fresher short MXN/CLP trade); we continue recommending paying Swiss 5-yr nominal rates, and 5-yr UK real rates and we are short consumer cyclicals vs other cyclicals in the US market and have added a similar relative consumer short in credit on Friday. In the second bucket, we are short September VIX futures, exploiting the steepness of the curve there and remain long European financial credits on a relative basis (iTtraxx Financials vs Main). In this context, as published on Friday, our Financial Stress Index (FSI) has also eased over the month. The latest reading is 0.42, down from 0.93 in June. The FSI stood at 0.07 in April, suggesting that we have corrected roughly half of the dislocations opened up by the European turmoil. To remind readers, the FSI is standardized to have a mean of zero and a standard deviation of 1, and controls for economic fluctuations.
4. US data days the drag in June/July, not so far in August
Perhaps the most surprising feature of Friday’s price action was the eventual resilience of equities which remain firmly above their 200-day average. Our US growth view remains the major headwind for the equity market. But as David Kostin and team have pointed out, with a strong earnings season, undemanding valuations and better non-US performance there is much that is still positive about the equity outlook and shorting US stocks on the growth slowdown has so far been a losing trade.
The daily price action makes it clear just how significant an obstacle the US data has been even in the face of other more positive forces. A simple exercise that we described in last week’s Global Market Views, but update and elaborate on here, shows that point clearly. Through June and July, we examined the days on which a major US data release occurred (measuring its importance using our new US-MAP rankings, choosing a ranking of 3 or higher). On those days where major US data was released (around 40% of the total), the SPX fell on average by 8.8 points. On those days without US data, the SPX rose on average by 6.2 points.
The market on average performed much more strongly in July than June (up 70 points versus down 60 points). But the difference between US data days and other days remained remarkably similar. Even in July, US data days were on average 14 points worse than non-data days and the largest gain on a major US data day that month was barely more than 5 points. What changed in July is not that US growth news did not affect the market – the net drag seems to have been large as in June. Instead, other forces overwhelmed that. In particular, better earnings news which kicked off that month, better data in the rest of the world and the sharp relaxation in sovereign fears overwhelmed US growth news. It is on the basis of these forces that we have argued not to translate our negative US growth views into a simple negative view on US stocks.
August is only a week old, but so far things look different to either June or July. We have had three major US data days (Monday, Wednesday and Friday). The average gain on those three days is substantially positive, while the market pulled back a little on the other two days. And for the month as a whole, we are up considerably still. Of course, this is heavily influenced by Monday’s 25 point gain. But while these are early days, in a sense that is the point. Monday’s rally was by far the largest on a day where major US data was released in over two months. And we have managed to pass through the period of the ISM and payrolls with equities moving significantly higher, something we did not manage in either June or July.
5. Watch growth surprises and the FCI
Why the shift? The simplest reason is that the surprises to the US data, Friday notwithstanding, have so far been a bit less brutal in August. Monday’s ISM and Wednesday’s services ISM were both positive surprises on the headline (though we mark down the ISM result given the rise in inventories and drop in orders). And Friday’s payrolls, while negative, was arguably not as large a shock as in some prior releases. This suggests that the market may have adjusted its expectations enough that it has become a little less vulnerable to negative US data news.
But part of the answer also likely comes from a growing anticipation that softer growth news will bring some policy response. Recall that the last major market decline (on 21st July) occurred in response to a more hawkish-than-expected statement from Chairman Bernanke. But since then, the market has shifted footing. Bonds have rallied sharply, the part of the yield curve that still capture views on the effectiveness of policy (5s-10s now or 5s-30s) has steepened and the dollar has weakened. Alongside rising equities and falling volatility and increased market speculation about potential shifts towards quantitative easing, this looks less like a simple disconnect between equities and bonds and more like a market pricing a policy easing ahead. The result has been that our US Financial Conditions Index has already eased, hitting its easiest level ever on Friday.
On both fronts, the critical question is whether the market is right. On growth, our own forecasts suggest that – at some point in the coming months at least – the market will face fresh disappointments. This is because we think that US growth views are still too high. But we still think the implications of that for stocks may be offset by likely better global growth news, a shift away from tightening in China and still elevated risk premia.
On the second, we now do forecast a clearer return to unconventional policy easing. But we also think that this is likely to come in the face of more challenging economic outcomes. And our own view is that a significant move in this direction is most likely not until late 2010 or early 2011, unless there is an even sharper deterioration in growth momentum. So the market may be in danger of expecting too much too soon.
These two issues also highlight the two upcoming tests this week – one on each front. Tuesday’s FOMC is likely to be important to the near-term outlook since the market has started to rely on the notion of a Fed response and may be disappointed if it does not get a firm signal. Friday is the key data day to navigate with the US retail sales release and Michigan consumer sentiment reading (though after a surprising spike last week, Thursday’s claims numbers may be more important than usual)
6. Current Trading Views
The following trading ideas from the Global Markets Group reflect shorter-term views, which may differ from the longer-term "structural" positions included in our "Top Trades" list further below.
1. Stay short $/CNY via 1-yr NDFs, opened at 6.7550 on 10 June 2010, with a target of 6.50, and a 1-day stop of 6.83, now at 6.6875.
2. Stay long AUD/CAD, opened at 0.9112 on 8 July 2010, with a target of 0.9500 and a 1-day stop below 0.8850, now at 0.9452.
3. Stay short $/SGD, opened at 1.3825 on 13 July, with a target of 1.34 and a stop on a 1-day close above 1.41, now at 1.3460.
4. Go short GBP/SEK, opened at 11.30 on 03 August, with a target of 10.80 and a stop set at a one-day close above 11.50, now at 11.2914.
1. Stay short 5yr credit protection in Mexico vs. long 5yr credit protection in Colombia, opened at a spread of -3 bp on 16 Nov 2009, with a target of -150 bp, and a stop of 75 bp, now at -5.1 bp.
2. Close short 5-yr JPY swaps vs. a combination of 2s and 10s, opened at -41 bp on 24 Mar 2010, with a target of -20 bp, and a stop on a close below -50 bp, for a potential profit of 1.4bp.
3. Stay short 5-yr UK real rates through swaps, opened at -78 bp on 21 May 2010, with an initial target of -25 bp, and a stop on a close below -95 bp, now at -70.4 bp.
4. Stay short an equally weighted basket of 5y CDS spreads in Poland, Korea, China and Czech, opened at an average spread of 115 bp, with an initial target of 75 bp and a stop-loss of 140 bp, now at 100.8 bp.
5. Stay short UK inflation vs. long Euro-zone inflation through 5-yr zero coupon swaps, opened on 09 July10 at 1.63%, for a target of 1.2% and a close set at 1.85%, now at 1.56%.
6. Pay 5-yr Swiss swaps vs. 3-months, opened on 30July’2010 at 1.10%, for a target of 1.50%, and a close set 0.95%, now at 1.08%.
Equity Trading Strategies:
1. Stay short GS Wavefront Consumer Rotation Basket (GSWBCONA), opened at 100.7, on 02 July 2010, with a target of 95 and a stop of 103.25, now at 99.21.
2. Stay short September 2010 VIX contract, opened at 27.60, on 02 August 2010, with a target of 22 and a stop of 30, now at 27.75.
7. Recommended Top Trades for 2010 (opened on 02 Dec 2009 unless otherwise stated)
1. Stay short S&P 500 Dec10/Dec11 Forward Starting Variance Swap, opened at 28.20, with a target of 21, now at 30.61.
2. Stay long Russian Equities (RDXUSD), opened at 1645.9 for a target of 2050, now at 1683.0.
3. Stay long GBP/NZD, opened at 2.29, with a target of 2.60, now at 2.1837.
4. Close short 2-yr GBP swap rates vs. long 2yr AUD swap rates on a 1yr forward basis, opened at -268.5 bp, for a potential loss of 24 bp (inclusive of carry).
5. Close short 2-yr TRY rates through cross-currency swaps, opened at 8.77%, with a target of 12.0%, for a potential loss of 168 bp (inclusive of carry).
6. Close long 5yr credit protection in Spain vs. short 5yr credit protection in Ireland at 13 bp, opened at 70 bp, with a target of 20 bp, for a potential profit of 2.9% (inclusive of carry).
7. Stay long the GS FX Growth Current, opened at 103.5, with a target of 111.8, now at 103.84.
8. Stay long PLN/JPY, opened at 32.1, with a target of 37.5, now at 28.5295.
9. Stay long Chinese Equities (HSCEI), opened at 12616.01 on 01 Apr 2010, with a target of 15000, now at 12183.07.