Recently I was interviewed by Jerry Slusiewicz of the Southern California radio show, Your Money Talks. This show is heard in Orange County and the Greater LA Inland Empire on KSPA am 1510 and KFSD am 1450 in North San Diego County. In the segment we discussed the unwinding of the Fed’s QE program and other topics. What follows are highlights of the interview. The full interview can be heard HERE (my portion of the interview begins at the 10 minute mark).
Here are some introductory points made by Jerry:
· Italy announces 0.2% decline in Q2 GDP thus qualifying them for a recession – a triple dip since 2007.
· Germany reported 3.2% decline in factory orders in June. Pipelines for Russian oil and natural gas destined for Germany traverse Ukraine.
· Sprint and T-Mobile fell on news of the end of merger discussions.
· It will be important to keep an eye on market action as the Fed winds down QE.
Question – Should we be concerned about the sell-off the early part of August?
Response – The market has been historically complacent. We have had a very low VIX, a very low St. Louis Financial Stress Index (Federal Reserve calculation), a very bullish sentiment is also being displayed on the part of investment advisors and the dividend yield has been incredibly low. While this creates a historically complacent market, there are signs of increasing risk aversion. The junk bond/Treasury bond ratio has recently ticked higher. I received short-term sell signals in the Dow Industrials and Utilities. The short-term signals don’t mean the market has turned abruptly. I have two other time horizons that I use for more confirmation.
Question – The utilities index and small cap index (previous leaders) are rolling over. Are you seeing this as a warning sign?
Response – Until the intermediate term indicator changes, which it has not, it is close, but it has not it is not a warning sign. Since the low of 2009, the intermediate term indicator has changed only once or twice. Until that changes, the bull market that has occurred within a broader secular bear market will continue until I see that indicator change.
Question - Can you give us your take on QE and what may happen when they take the punch bowl away?
Response – We keep hearing the term QE, which is an effort by the Federal Reserve to make the security purchases to bolster the balance sheets of banks. The Fed has always conducted open market operations (buying and selling securities) in order to control the money supply. QE is something they have been doing but add MBS to their balance sheet. They increased their balance sheet by $4 trillion.
Question – What effect did Mortgage Backed Securities (MBS) have on housing market?
Response – The Fed purchased $1.7 trillion in MBS. Prior to 2009 they owned no MBS. The economy after 2008 entered a new deflationary/deleveraging phase that has very real psychological components. Prices can rise during a deflationary stage (subject for another show). Mortgage debt collapsed by $1.5 trillion. So you have the Fed buying $1.7 trillion in MBS and mortgage debt collapsing by $1.5 trillion. People are less willing to have debt. In the housing market you have some homeowners who cannot move since they are underwater. You also have entrants making cash purchases. Some are owner occupiers but others are simply investors. This creates a more fragile housing market since an owner-investor is more likely to run at the first sign of trouble.
Question – What will happen to the MBS and Treasury market after QE ends?
Response – US Treasuries are considered almost like a near-cash instrument. We have had a significant influx of foreign purchases of Treasuries even since 2009. They own $6 trillion of Federal debt. If you look at debt held by Federal Reserve and general public, those things have actually gone up. The higher risk bonds (HYG ETF mentioned) are more vulnerable. When the stock market heads down, you should see higher risk bonds falling out of favor and a move towards higher quality issues. Fed action has punished savers with low interest rates. While Treasuries will still attract foreign and domestic interest, how would listeners evaluate the Treasury as a borrower (apply a hypothetical FICO score). When I wrote E$caping Oz I suggested they were a fair borrower. Is the U.S. a better credit risk now than in 2007 when 10-year rates were double what they are now? That question is going to be answered at some point in the future.
Question – What is QE going to do to other areas of the economy?
Response – The velocity of money has not increased despite this massive intervention. Removing QE probably won’t affect this indicator, since it has not helped it. The things that will deleverage are those things where credit was most prevalent.