Perhaps the Fed has shelved plans for QE because it doesn’t work very well and there is now something better.

What is wrong with QE?

1. Political opposition.
2. Doesn’t keep bond yields low as economic expectations rise, because of anticipated future tightening and inflation fears (the market doesn’t believe in the liquidity trap).
3. It comes to an end, and thus suffers a form of theta decay. If, as in the summer of 2011, QE ends and its revival appears not to be data-dependent, then the end of QE is a tightening (because it works mainly through the expectations channel — it signals a) rates will not rise while it goes on and b) the Fed will fight deflation).

The Fed started using enhanced communications as a tool in the summer of 2011, saying that rates could be expected to stay low until mid 2013. Then it extended that to late 2014. Recent reaffirmations of the expectation of low rates by various officials have headed off an incipient increase in 2-year interest rates, showing that the fact that we are dealing with an expectation and not a commitment is not a problem as long as officials make it clear when they do not see current projections as being strong enough to justify rate hikes sooner than officially expected. Early 2012 has seen the first proper rally since this new tool started to be used, and rates have stayed low even as economic expectations have improved.

It would be better, of course, if the Fed pre-committed to keeping rates low. But that would be politically very difficult (the Republicans might even argue that, by pre-committing, the Fed was abandoning its mandate). Surprisingly, to me anyway, the “expectation” that rates will stay low for a fixed period has so far worked just as well.

So I wonder whether the Fed is rowing back from QE3 because it has found a much better means of conducting extraordinary monetary policy.

Spain, Spain, Spain, Spain, Spain…

After my last morning note, I wrote in my notebook that there would be every justification for buying US equities as soon as, but not before, the Spanish furore starts to turn around. Yesterday’s Spanish bill auction had a positive effect on markets, but I am not sure there has been enough of a turn in the situation to justify buying equities. An auction of 10-year bonds on Thursday might help risk sentiment, but I really don’t think the “success” or otherwise of bond auctions tells you anything at all. Yields in the secondary market are the important indicator of financing conditions. Japan and a couple of small countries have indicated a willingness to increase the resources of the IMF, further to increase the EU firewall if necessary, but an increase is yet to be agreed and in any case the trend towards greater fiscal financing is already in place, so it is hard to view this as a significant change.

One thing that might actually turn the situation around was the government’s assertion yesterday that it had the power to take control of the regions’ finances if they did not keep to their deficit targets (at least partly because regional borrowing must be approved by central government). I do not think that the market realised that this was possible.

A big fear for the markets is the deteriorating performance of Spanish banks’ loan portfolios. Bloomberg reports today that NPL’s were at 7.91% in January. However, it is important to note that the EFSF/ESM has the power to recapitalise the Spanish banks if necessary. Spain’s economy will continue to deteriorate on account of the ongoing credit crunch, but that process could go on for a while before the market comes to fear that Spain is insolvent. There could easily be a couple of years of austerity ahead of us before it happens.

Incidentally I see that John Paulson is shorting German government bonds (through the CDS, according to Bloomberg). I do not like this trade. Economic conditions (partly via expectations for monetary policy) and the demand for safe collateral are the important factors influencing the prices of high-quality government bonds (i.e. in the developed world ex. Eurozone deficit countries). Moreover, Europe as a whole has the fiscal resources to cope with the present crisis, if it will only deploy them. If Germany is not forced to accept the fiscal burden of the Eurozone periphery, then it will be because the crisis slowly abates (via austerity and slightly higher inflation in Germany than on the periphery). If Germany is forced to accept it, then the Eurozone will become a single fiscal entity and its bonds should trade like those of the rest of the developed world. On the other hand, I might like a trade in German corporate CDS as a play on a deterioration in the Eurozone economy.


  • Eurozone CPI 2.7% b.e. Mar. Core 1.6% b.e. Mar.
  • German ZEW 23.4 b.e. 4th improvement in a row. EZ ZEW 13.1 b.e. 5th improvement in a row.
  • Building permits 0.75m b.e. Mar. Another increase.
  • Housing starts 0.65m d.e. Mar. A fall.
  • Capacity utilisation 78.6% a.e. Mar.
  • Industrial production 0% d.e. Mar. Utilities have been holding back IP in recent months (on warm weather?) but they were strong this time while manufacturing was weak.
  • Eurozone current account -1.3bn d.e. Feb.
  • UK claimant count change 3.6k b.e. Mar.
  • UK unemployment 8.3% b.e. Feb.
  • MPC minutes showed Miles calling for £25bn more QE but Posen dropping his call for further stimulus.

Coming Up

  • Japan trade balance