A Game of Chicken
Politicians failed to make any headway on the U.S. fiscal cliff, but with only 18 days to go, stocks are holding up relatively well in light of additional monetary stimulus announced by the Fed and more evidence that China’s economy is reaccelerating. In contrast to modest losses in domestic blue chips stocks, emerging market equities rallied 1.6 percent and provided a nice tailwind to investors owning international stocks in general. Though international equities lagged domestic benchmarks by notable margins throughout 2012, after a strong rebound in recent weeks, both equity styles are now up 13 percent for the year. With global equity indices mixed, benchmark U.S. Treasuries sold off modestly on news that the Fed will ring in the New Year by expanding their balance sheet an additional $45 billion per month.
QE4 Investors expected the additional quantitative easing, but what caught most by surprise was the Fed’s announcement that it was dropping reference to any calendar restraints on its open market operations in favor of instituting explicit macroeconomic targets. The yield curve grew steeper on news that monetary largess would remain in place as long as projected inflation remains quiescent and unemployment remains above 6.5 percent. The Fed’s announcement had some asking the question, “Does this mean monetary policy is now partly beholden to the U.S. Bureau of Labor Statistics?” Probably not. The Fed’s post-meeting statement disclosed that Bernanke & Co. would consider drops in the unemployment rate caused by people giving up their search for work to be one of the contingencies that would preclude it from prematurely raising rates.
Its latest moves come in addition to the $40 billion of mortgage backed securities it is already purchasing, putting our central bank on track to add $85 billion of liquidity to bank balance sheets every month. While the monetary base expands, we question how many more loans banks will actually make with their additional cash reserves, and more broadly, whether additional monetary stimulus will produce the incremental jobs targeted by the Fed. One thing seems certain -- the Fed’s new communication strategy promises to make each month’s employment and inflation statistics that much more meaningful in divining central bank policy.
Good News from Europe? While the Fed continues to do its best to ensure that the U.S. economy doesn’t end up like Japan’s, a meeting of Euro-zone finance ministers made key progress in its attempt to backstop the region’s banking system. Leaders announced broad new powers for the European Central Bank to supervise the Continent’s biggest banks, granting the ECB regulatory oversight similar to that enjoyed by the Fed. Just as importantly, this agreement will enable the European Security Mechanism Bailout Fund to make direct investments in large banks without first lending money to regional governments already saddled with too much debt. In combination with ECB President Draghi’s promise this summer to backstop the bond markets of troubled southern European nations, this latest pronouncement should further reduce systemic risk in the region and promote healthier capital markets in general.
Our Takeaways from the Week
- International stocks outperformed on regulatory progress in Europe and further evidence of an economic rebound in China
- Odds of a meaningful year-end deal to avert the fiscal cliff appear to be waning