The Fed's Financial Repression 'Game'

The Grand Plan, as we have espoused for years, is to force all 'safe' assets to a point where they appear 'rich' to risk assets - and inflate another bubble to take our eyes off the debt being inflated away in the other hand. In the Fed's mind, they tried this before with QE1 and it worked magnificently - lifting stocks phoenix-like from the ashes of a credit-crunch reality. However, this time is different. The last time the Fed forced MBS CurCpn yields down to 'match' the S&P 500's dividend yield was March 2009 - and investors 'rotated' back to risk (to many people's surprise). Yields were at 4% then and the S&P's P/E multiple was 10x; this time yields are just above 2% and the S&P 500's P/E multiple is a staggering 14.9x. We suspect that rather than re-enacting the post-March 2009 eruption, valuations this time will force that liquidity to flood into non-equity asset classes (and with HY call-constrained, it leaves little but the energy and precious metals complex to soak up the Fed's exuberance).

 

The 8-Step Path to where we are...

1) Fed buys TSYs to fund deficit and keep government alive - under guise of maintaining rates low and performing extraordinary monetary policy out the curve (but there is a limit - see Japan)


2) Fed action pushes market to reach for yield - corporate credit sees huge technical demand, but valuations and call constraints will always limit gains...as well as leverage constraints holding new issuance back at some point.


3) QE1 impact remained the greatest - MBS-related repression to force the mortgage yield down to the S&P's dividend yield.

The lower pane shows the spread between the Current Coupon 30Y MBS yield and the dividend yield of the S&P 500 - notice the similarity to another period in time...


4) QEternity - try that again...but... yields were 4% then, now they are 2% and our balance-sheet-recession minds have changed behaviorally...


5) When it worked before S&P 500 P/E was 10x and was 'defensible' from a valuation perspective (to some) to rotate from MBS to stocks...


6) This time S&P 500 P/E is almost 15x!

 

7) The financial repression will continue until morale improves, but...


8) at these levels of valuation, we suspect non-equity asset classes will get the brunt of the liquidity flush (i.e. Gold/Commodities). HY remains call-constrained and while issuance is very high, there is a limit to just how much debt these firms will want to take on - no matter how cheap.

 

As we noted earlier, fundamentals will matter again at some point but the Fed expecting a pile in at 15x of the scale of the pile-in at 10x is insane - especially with the lower yields empirically setting average P/Es considerably lower (making the current P/E even more fantasy-like).

 

Charts: Bloomberg

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