Articles - Global Spotlight –September 2011


Pushing on a piece of string.

 By Andrew Milligan, Head of Global Strategy, Standard Life Investments

 The headlines in the past week have been dominated by the latest efforts by the US Federal Reserve to kick start the American economy. A separate series of reports demonstrate why this particular policy will not work. Indeed, we fear that the central bank is following the wrong path, in effect pushing on a piece of string.

 The latest version of QE is called Operation Twist. Under this exercise, over the coming nine months the Fed is selling up to $400bn of shorter-dated bonds (3 month to 3 year debt) and buying an equivalent amount of longer dated debt, across the 6-30 year parts of the curve; the 30 year is so important for the US mortgage rate. The initial announcement had quite an impact: US 30 year yields fell below 3%, back towards the all time lows of 2.7% seen three years ago.

 If Operation Twist is to have a positive effect on the US economy, the main channel should be through cheaper money, especially lower mortgage rates. There should be a boost to consumer spending as mortgage refinance and housing activity picks up.

 The problem is that a series of reports also announced this week show a US housing market that is, at best, stagnant. Existing home sales have been erratically moving sideways since mid 2008, and new housing starts since mid 2009. The inventory of unsold homes is improving slowly but remains double the levels seen before the housing crisis began, in turn causing house prices to fall about 5% a year.

 The danger with the Fed's latest form of QE is that the US is falling into a classic trap - indeed one which it made back in the early 1930s, during the Great Depression. The Fed is overly concerned with the cost of money, the bond yield or interest rate, and not sufficiently concerned with the quantity of money, whether measured in terms of money supply and credit growth or financial conditions. Although tensions in money markets are not as pronounced in the USA as they are in Europe, there are worries about the pace of monetary expansion.

 We fear that Operation Twist will be a failure. Even though US mortgage rates have fallen sharply in recent months - currently at 4.1% they are at record lows - the impact on the US housing market or indeed the wider economy has been limited. Mortgage refinancing remains little different to the levels seen a year ago. Indeed, the classic relationship between US home sales and mortgage rates appears to have broken down since 2008. The reason is that there are too many structural impediments to the housing market which Congress has not tackled: too many home owners in negative equity, too many mortgages where the ownership remains questionable, too little support from the government agencies Fannie Mae and Freddie Mac to help a wholesale refinancing programme.

 It would be a mistake to conclude that policy failure means the US will inexorably enter recession - conversely, there could be positive surprises in coming months. ‘Watch what they do, not what they say' is an important maxim in turbulent times. For example, a recent survey of almost 1000 Chief Financial Officers from major companies around the world reported, not surprisingly, that a majority of them were less optimistic about the world economy than they were three months ago. Around 60% of US CFOs were a little or moderately concerned about the US entering recession over the next year. However a key feature of the survey was that spending intentions were holding up remarkably well - indicators of future corporate spending into 2012 remained strong, mainly on new capital spending, to a lesser extent new hiring and debt repayment. Similarly, surveys of consumer confidence showed sentiment back at levels last seen in 2009. However, the latest weekly retail sales figures indicated spending growing about 4-5% up from a year ago, as it has since the late spring. The recent fall in oil prices and hence gasoline costs should further support consumption in coming weeks.

 To sum up, while Operation Twist will not make a great deal of difference to the US economy, it will not do any harm - lower borrowing costs are helpful at the margin for indebted households and companies. Elsewhere, there are a few positive economic straws in the wind that the market should pay attention to. There is even a risk that Twist - together with any other measures announced by the G20 - might get credited with sustaining the US economy through difficult times.

 
  

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