At some point, the U.S. federal Reserve will end is current version 2 of quantitative easing. How soon, no one really knows, but the mere suggestion sets off tumults in the bond markets.
And those tumults have been severe, the worst since 2003 and, before that, 1993. But those two periods were both marked by rising short-term interest rates. Short-term interest rates in the U.S. are unlikely to go anywhere soon, not until the QE2 apparatus stops pumping $85 billion a month into the U.S. economy. Nevertheless, according to New York Fed researchers, investors are demanding a term premium.
But has QE2 been all that successful in lowering long-term interest rates? Researchers at the San Francisco Fed suggest that, by itself, QE2 has added 2 bps to inflation. With forward guidance, it may have added 3 bps. The effects on GDP have been similar: 4 bps versus 13 bps. Not at lot of change for the billions involved. If the Fed could do it, a 25 bps cut in the overnight rate would have had twice the impact, the researchers conclude.
So the expectation of an impact is more important than the impact, however small. What happens to stocks, and all those other risky assets that investors have shunned in favour of safety? Again, New York Fed researchers provide a clue.
As Fernando Duarte and Carlo Rosa write, the U.S. equity risk premium has reached historic highs.
“The value of 5.4 percent for December 2012 is about as high as it’s ever been. The previous two peaks correspond to November 1974 and January 2009. Those were dicey times. By the end of 1974, we had just experienced the collapse of the Bretton Woods system and had a terrible case of stagflation. January 2009 is fresher in our memory. Following the collapse of Lehman Brothers and the upheaval in financial markets, the economy had just shed almost 600,000 jobs in one month and was in its deepest recession since the 1930s. It is difficult to argue that we’re living in rosy times, but we are surely in better shape now than then.”
The culprit? QE2 (or financial repression, as some call it): “We find that the equity risk premium is high mainly due to exceptionally low Treasury yields at all foreseeable horizons. In contrast, the current level of dividends is roughly at its historical average and future dividends are expected to grow only modestly above average in the coming years.”
Were Treasury yields at their average historical levels, the equity risk premium, they find, would be negative.
They are not alone in thinking that the U.S. market may be well ahead of itself.
Back in November, Clifford Asness, at AQR Capital Management, suggested that, on an historical basis, P/Es were getting frothy, despite optimism from analysts.
“They point out that we had two serious earnings recessions recently (though only the tail end of the 2000-2002 event makes it into today’s Shiller P/E), including one that was a doozy following the 2008 financial crisis. … In principle, we must grant that there are times that 10-year earnings may be misleading. They are by no means a panacea. If the last 10 years is much better or much worse than might be expected going forward, the Shiller P/E can indeed be locally “broken” as some would call it now. It’s certainly possible that one-year earnings could give a more accurate picture at such times.
“The question is, of course, are we in such a time right now? Not surprisingly, if one compares one-year earnings to history, things look much rosier, though the stock market is still not cheap. Instead of a Shiller P/E that is in the 80th percentile versus history right now (expensive), the one-year P/E is in the 54th percentile since 1926 (trivially expensive). So we have to ask ourselves, is the argument against using the Shiller P/E today right? Are the past 10 years of real earnings too low to be meaningful going forward (meaning the current Shiller P/E is biased too high)?”
He suggests cherry-picking by the optimists.
Who is right will depend on the voyage of QE2, one suspects – and what gets sucked into its tow as it makes its turning arc, and at what speed.