U.S. stocks ran into an ever so slight headwind yesterday morning on news that China will cool growth by increasing reserve requirements for a couple of months (thereby reducing loan activity) and one of the Fed’s most dovish members expressed reservations as to how effective additional QE will be.  But that was before the latest FOMC minutes were released, at which point the market reversed course and moved into positive territory. 

On the morning statement, Fed Governor Janet Yellen mused that additional accommodation from the Fed could lead to excessive risk taking (what a revelation) and questioned how effective more stimulus from the central bank would be.  Her comments were actually reported on Monday afternoon, but on such a quiet trading session they didn’t get much attention.  Yellen is among the most dovish within the central bank (meaning she’s not an inflation hawk and is very likely to go along with further easing Bernanke recommends) and so the market should not read too much into her comments. 

And if anyone did take those comments seriously, such views were quickly dispelled after release of the latest minutes (summary of notes from the previous FOMC meeting), which showed the Fed was prepared to ease “before long.” 

Financial and tech shares led the broad market higher.  Utilities and energy were the losers.  In all, six of the 10 major industry groups gained ground for the session.

Market Activity for October 12, 2010

NFIB

The National Federation of Independent Business’s gauge of small business confidence remained floored in September, up just a touch to 89.0 from 88.8 in August.  So the gauge remains below that reading of 90, a mark that heretofore has only been hit during periods of recession – and the previous two recessions/downturns (1990-91 and 2001) never even hit 90.

The survey’s plan to hire and expect higher sales readings both fell from already low levels.  The former deteriorate to -3 from 1 in August ( the lowest since November 2009) and the latter fell to -3 from 0 (long-term average is 7.7 and usually hits 20 during recoveries).  The expect a better economy reading did improve to -3 from -8, but does it really matter if small business doesn’t believe it will result in higher sales? 

The plan to increase capital expenditures reading improved to 19 from the 35-year low of 16 hit in August.  Unfortunately, the chart below only goes back to 2001, but the NFIB report explained that 16 is the 35-year low point. 

As we’ve talked about for some time, firms are engaging in maintenance levels of capital spending – for the most part, replacing aging equipment rather than ramping up equipment and software purchases because they see a bright economic road ahead.  How exactly are firms supposed to estimate a return on new investment when uncertainties over tax rates and regulations abound?  If they can’t estimate this figure, then it makes them that more hesitant to increase spending.  Of course, there are always risks, but there’s a big difference between knowable risks (as economist Frank Knight explained in the book Risk, Uncertainty, and Profit) and full-blown uncertainty. 

FOMC Minutes

The minutes from the September 21 FOMC meeting showed the Fed is prepared to act and will do so with additional Treasury purchases and by attempting to manufacture inflation – they again, talked about pushing their stated comfort zone higher; I’m guessing their new target for inflation is 4%, up from a top-end range of 2%. 

The Fed, for a third time now, reduced their economic growth forecast for the remainder of this year and all of 2011 – although the specifics won’t be released until the November 3 meeting.  The lowering of their economic outlook sets the FOMC up to precisely explain what QE2 will involve via the next meeting. 

(I’ll note that some members of the FOMC “thought that additional accommodation would be warranted only if the outlook worsened and the odds of deflation increased materially.”  The former is surely the case, but not so much for the latter – not with commodity prices marching higher again.  But Bernanke & Co. have cornered themselves in.  If they don’t deliver on another round of quantitative easing, the market will punish them for it – and a slide in stock prices is among Bernanke’s main worries.)

So, what’s QE2 likely to involve?  As previously discussed, my view is they’ll end up buying another $1.5 trillion in assets (all Treasuries) and unfortunately one can’t rule out other assets in the future – as we all know the Bank of Japan has shifted to buying REITs and equity-market ETFs as they’ve explained that’s the only way QE can work at this point.

But the Fed is unlikely to announce they’ll buy this much in assets.  More likely is a promulgation that they’ll buy something closer to $500 billion, with a pledge to do more if needed.  I think they’ll eventually get to $1.5 trillion because the $500 billion won’t work.  Look, banks already have $1 trillion sitting in excess reserves and that money sits fallow for a variety of reasons – chief among them are poor credit quality, fear of another round of home-price decline, and pretty low expectations regarding intermediate-term growth.  Why is another half-trillion going to work in getting this money out the door?  This is the textbook liquidity trap.

So, this will prompt the Fed to do more, but that “more” won’t work either unless fiscal and economic policy out of Washington comes to the Fed’s aid and clears a mound of uncertainty and concern about the budgetary path.  I think Bernanke and Co. will eventually realize that continuing down this QE route is futile and hopefully they stop at $1.5 trillion.  At which point, possibly we’ll have progressed down this economic road long enough so that the malaise provokes real and beneficial shifts to the fiscal policy path. 

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900