From Brian Rogers of Fator Securities
QE3, coming to a market near you
To have more QE or to not have more QE, that is the question. With apologies to the Bard, that is generically the question all investors are asking regardless of the asset class(es) they trade. Whether or not QE2 is behind the recent bout of food price inflation that is making its way around the globe is debatable. What isn’t debatable is that since Federal Reserve Chairman Ben Bernanke announced his intention to launch QE2 at Jackson Hole, WY on August 27th, 2010, asset markets have rallied in impressive fashion. All asset markets that is except US Treasury debt which has seen yields widen significantly, for example 10yr Treasury yields have widened from 2.644% on 8/27/10 to 3.637% today, almost 100 bps. Since the current low coupon on the 10yr is pushing out the duration of these bonds to around 8.5yrs, investors in US Treasury 10yrs have taken unleveraged losses of almost 8.5% over the last 5 months. This is a disaster in the normally staid world of Treasury investing. The story is even worse in the 30yr bucket where bonds have widened from 3.689% in late August to 4.727% today. With the longer duration of about 16.5yrs, 30yr Treasury bond investors have taken quite a beating since Mr. Bernanke started buying bonds to support lower yields. And now Tim Geithner’s Treasury is contemplating issuing 40, 50 and even 100yr bonds. The notes of the Treasury Borrowing Advisory Committee of the Securities Industry and Financial Markets Association says that, “…significant demand exists for high-quality, long-duration bonds from entities with longer-dated liabilities.” (link here) Good luck with that one!
However, if we suspend reality and pretend like the sell-off in Treasury bonds isn’t something to be quite worried about, other asset markets have posted extremely strong returns. Stocks, corporate bonds and commodities have all rallied hard since late August 2010. Much, if not all, of this price appreciation has been attributed to the “magic” of QE2 injecting billions of liquidity into the market. The problem the Fed and Chairman Bernanke now face is that the so-called wealth effect of the rising stock market has been dependent on the existence of QE2 and removing that punch bowl could cause the party to end and reverse the gains, both economic and market, that we have seen in the last 5 months.
In addition to the reversal of the wealth effect, there are two other reasons why I think the Fed will be loathe to remove QE. The first is the huge benefit (from the government’s perspective) of creating an inflation problem for China which will eventually force the Chinese to strengthen the Yuan. Congress has been pressing for harsher measures to force the Chinese to strengthen the Yuan (link here) for years and QE2 is turning out to be exactly the kind of pressure that just might work. I’ve long argued that this is a case of be careful what you wish for because the second the Chinese allow the Yuan to strengthen materially, the prices for everything that we buy from China (which is basically every single item on Walmart’s shelves) will rise an attendant amount. Mr. Bernanke doesn’t see any inflation now but he certainly will when the Chinese begin sending it back to us via an appreciated Yuan.
The other reason why QE is going to be with us for a long time is the ongoing need to support the massive size of monthly Treasury issuance. With the US expected to run a $1tr - $1.5tr deficit this year and another $2.5tr in maturing bonds to roll, there is very little chance that the US could continue to issue bonds at the current low rates without huge support from Mr. Bernanke’s POMO operations. Our total new borrowing and refunding needs will be greater than $300bn per month which is simply astronomical. Even bond investing legend Bill Gross is calling the US Treasury a ponzi scheme (link here). If Bill Gross isn’t buying Treasuries who is?
Playing poker with the Fed
Anyone who has ever played Texas Hold’em poker knows that the secret to winning is not just playing your own cards well but understanding how others are playing theirs. With this thought in mind, let’s consider the tells that the Fed has recently given. First, Mr. Bernanke has said for some time now that the recovery that we are currently experiencing in the US is going to take a long time to build strength. The job market is being particularly stubborn and some even argue that the “natural” rate of unemployment has risen (link here). During his speech yesterday at the National Press Club, Mr. Bernanke had the following to say about the current economic situation we face,
“The economic recovery that began in the middle of 2009 appears to have strengthened in recent months, although, to date, growth has not been fast enough to bring about a significant improvement in the job market. The early phase of the recovery, in the second half of 2009 and in early 2010, was largely attributable to the stabilization of the financial system, the effects of expansionary monetary and fiscal policies, and a strong boost to production from businesses rebuilding their depleted inventories. But economic growth slowed significantly last spring as the impetus from inventory building and fiscal stimulus diminished and as Europe's debt problems roiled global financial markets.” (link here)
“While indicators of spending and production have, on balance, been encouraging, the job market has improved only slowly. Following the loss of about 8-1/2 million jobs in 2008 and 2009, private-sector employment showed gains in 2010. However, these gains were barely sufficient to accommodate the inflow of recent graduates and other new entrants to the labor force and, therefore, not enough to significantly reduce the overall unemployment rate.”
With this thinking in mind, that the challenges we face economically aren’t about to go away anytime soon, let’s take a look at what Fed hawk Thomas Hoenig had to say about QE2 recently, from Reuters,
The Federal Reserve could debate extending its bond-buying program beyond June if U.S. economic data proves weaker than expected, Kansas City Fed President Thomas Hoenig said. Another round of bond buying "may get discussed" if the numbers look "disappointing," Hoenig told Market News International in an interview published on Tuesday. (link here)
If you blinked you may have missed it but the man at the Fed who has been famous for his hawkish stance on the Fed’s balance sheet expansion, Kansas City Fed President Thomas Hoenig, just admitted that if the data remained weak, the Fed would consider extending QE. Then yesterday, Bernanke said that “economic growth slowed significantly last spring” and the recent gains in the job market are “barely sufficient to accommodate the inflow of recent graduates…” In other words, we’re running to stand still. To my mind, when you add this up, you end up with the Fed tipping their cards a bit and revealing their hand. QE is here to stay. Whether you call the next round QE2 lite or QE3 is irrelevant, the Bernanke put is here to say.
In other words, to put it back into poker terms, the Fed is playing as if they have a pair of aces, however, with economic and job growth slowing and long-term Treasury yields rising rapidly, the Fed is actually holding 2-7 off-suit (the worst hand in Texas Hold’em poker) and telling us as much.
The bottom line, if I am right about QE continuing ad infinitum, is that hard assets like commodities and claims on hard assets like corporate bonds and stocks, will continue to surge confidently with the Bernanke put providing support. This is not to say that stocks will go straight up and sovereign debt straight down, they certainly may reverse course over the short-run, but the trend is your friend and your new motto should be “Buy the dip.” Mr. Bernanke does not bluff, he has spent his whole career studying the Great Depression and is convinced the situation was made worse by the Federal Reserve not supplying enough liquidity. He is determined not to repeat the mistake this time around.
In Brazil, we would recommend the following names to take advantage of the 2-7 off-suit Mr. Bernanke is holding:
- Petrobras (PETR3/4 and PBR) – Love it or hate it, oil is going up and PBR will benefit, don’t fight it.
- Port concessionaires like Wilson, Sons (WSON11), Santos Brasil (STBP11) and Log-in (LOGN3) – Infrastructure spending, growth and pricing power make these names attractive.
- AmBev (AMBV3/4 and ABV) – Rising salaries and low unemployment bode well for this beverage king.
- Utilities Copel (CPLE6), Light (LIGT3) and Cemig (CMIG4 and CIG) – Defensives that will do well as emerging markets continue to underperform.
- Telecom names like Vivo (VIVO3/4) and Telesp (TLPP4), Contax (CTAX3/4 and CTXNY).
- Confab (CNFB3/4) as a good play on Petrobras capex which also has contracts which allow it pass along input price increases; very important during times of rising inflation.
- Marcopolo (POMO4) – Great visibility for bus production going out for years in everything from school buses, urban buses or buses for Olympics/World Cup.
- Valid (VLID3) – Leader in every market they participate in with strong barriers to entry
- Localiza (RENT3) – Car rental firm with strong management and excellent growth prospects from rising economy and Olympics/World Cup.
Have a great weekend and go all-in on Bernanke’s weak hand!
* Fator Securities LLC, Member FINRA/SIPC, is a U.S. entity and a subsidiary of the Fator group of companies in Brazil. The comments below are from Brian Rogers, who is employed by Fator Securities (Brian’s opinions are his own and do not constitute the opinions of Fator Securities or the Fator group of companies).
This material was not prepared by Fator Securities LLC.. U.S. Persons seeking further information must contact Fator Securities LLC in New York at (646) 205-1160. This material shall not constitute an offer to sell or the solicitation of any offer to buy (may only be made at the time qualified participants are in receipt of the requisite documentation, e.g., confidential private offering memorandum describing the offering, related subscription agreement, etc.). Securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful or until all applicable regulatory or legal requirements of such jurisdictions have been satisfied. This material is not intended for general public use or distribution and is intended for distribution only to appropriate investors. The opinions contained herein are based on personal judgments and estimates and are, therefore, subject to revision. Past performances are not indicative of future results.