The winners and losers of QE3

On Wednesday evening our time, the January FOMC meeting delivered the following statement:

Information received since the Federal Open Market Committee met in December suggests that the economy has been expanding moderately, notwithstanding some slowing in global growth. While indicators point to some further improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment has slowed, and the housing sector remains depressed. Inflation has been subdued in recent months, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth over coming quarters to be modest and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that over coming quarters, inflation will run at levels at or below those consistent with the Committee’s dual mandate.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.  

That’s a clear declaration of intended QE3 if conditions are met. The two conditions are price stability and inadequate employment growth. Price stability now has a number with the Fed also announcing a new inflation target of 2%. Anything under that number potentially triggers QE3. Courtesy of Calculated Risk, here are the FOMC projections for inflation:

And unemployment:

In short, unless the Fed is surpised by jobs growth or inflation very soon, QE3 will commence. Bernanke politely dismissed any objections to the efficacy of QE as a policy measure in the press conference afterwards saying that it had effectively eased financial conditions and boosted asset prices, even if its transmission to the real economy was questionable:

So, who wins and who loses when this goes ahead? First, the market action since the announcement has been quite muted. Commodities have rallied a couple of per cent and the $US has fallen a little but for the time being at least the effect of the announcement has been to subdue confidence. My impression is that a genuine hope was taking hold in markets that the US was about to enter a faster period of recovery on the back of boosted housing markets. It was always a false hope in my view, with today’s batch of data showing continued weakness in pending home sales and decent but hardly stellar industrial performance. It seems the announcement of impending QE3 has punched that an organic growth breakout was imminent.

This should pass and after some correction and I’d expect equities to resume their rally. QE3 is a free pass for stocks so who’s going to refuse that (notwithstanding a Greek default)? That may also boost consumption at the margin with some wealth effect and cheaper finance, though I’m not sure how much cheaper it can get and has initially reversed.

Second, we can surely again expect a weak $US for the period that QE3 persists. That will further help the US economy through a boost to export competitiveness.

By extension, however, that raises the immediate prospect of higher commodity prices. Since the Fed meeting, gold, grains, copper and the CRB are all up a couple of per cent. Oil has been flat.

Again, the reaction has been subdued even if positive. But any number of commodities now look poised for breakouts on the charts. This may take a while. The broader conditions for a commodity rally are not as good as they were in the second round of QE of 10/11 with Europe in perpetual recession and China still an unknown. Still, for those that believe in the China soft-landing scenario, there’s little downside to commodities now.

My guess is gold and oil are the two one way bets. Especially so given the brewing problem in the Straights of Hormuz. Grains too perhaps but with global weather patterns better than last year we may not see quite so big a spike.

So, the next winner is global inflation. Thus, sadly, US households are just as likely to give up any gains from the stimulus to the secret tax at the bowser and grocer. That leaves a lower $US as the sole benefit.

Which is where things start to go pear shaped for everyone else. The euro will suddenly find itself under upwarps pressure again, choking off the ECB’s stimulus efforts. This will be made worse still by a burst of commodity inflation which will prevent further ECB easing. The Chinese too may not be too happy. QE in the $US pours money into China through the yuan peg. We all know they’re set to stimulate but the plans to do so are quite targeted and do not involve any broad based recovery in general mortgage lending. A new flood of ill-directed liquidity will not be welcome and comes with a second problem, inflation. There is a strong correlation between global food prices and Chinese inflation. Having just contained price rises, the last thing the PBOC is going to want to see is a new outbreak. The policy environment for the Chinese has gotten more complex.

It’s not called competitive devaluation for nothing.

Which brings us to Australia. Of all the international currencies, it is the Aussie that is set to rocket most on QE3. As most of the nation finally realised this week amid job cuts and a currency bounce, this is bad news.

It is quite clear that the broad Australian economy is under increasing pressure and that the RBA is behind the curve on providing an interest rate remedy. This month the trade surplus will all but evaporate on ore/coal price falls and incomes will take a modest hit. This will be made worse by rising unemployment which is putting increasing downward pressure on wages growth. This was already obvious in the closing months of 2011. The transmission of a lower cash rate to the real economy is going to be impeded by the banks need to rebuild net interest margins so the last thing we need is a burst of inflation emanating from oil and food, even if rising metals prices ease the trade correction.

To spook the RBA from its rate cut cycle of 2012 would be most unfortunate.