FED Acts Rightly

The US Federal Reserve launched its new initiative “Operation Twist” yesterday and the main aim of the same is to reduce long term rates and promote greater lending and try to stimulate the economy. The key statements that came out were

“There are significant downside risks to the economic outlook, including strains in global financial markets,” the Fed statement, this statement is different from the one given out last month which just talked about downside risks. It looks like the FED has taken the Euro zone developments into account while formulating this statement.

The Federal Reserve will replace $400 billion of short-term debt in its portfolio with longer- term Treasuries in an effort to reduce borrowing costs further and counter rising risks of a recession. The central bank will buy securities with maturities of six to 30 years through June while selling an equal amount of debt maturing in three years or less. The program will extend the average maturity of the Fed’s Treasury holdings to 100 months, or 8 1/3 years, by the end of 2012, from 75 months.
The Fed’s System Open Market Account held $2.64 trillion in securities as of Sept. 14, which included $1.65 trillion in Treasury notes, bills and inflation-protected bonds and $995 billion of mortgage debt.
The main aim of this move seems to be to take the long term interest rates down and flatten the government bonds yield curve. Due to virtually zero short term rates a large number of banks have been just playing the yield curve and not lending in the markets. As the yield curve becomes flatter over the longer time frame the FED seems to be betting that the banks will be forced to lend. The availability of money in terms of narrow money supply does not seem to be an issue in the US economy, however the broader money supply is not growing and consumer credit continues to shrink.

The central bank said today it will also reinvest maturing housing debt into mortgage-backed securities instead of Treasuries “to help support conditions in mortgage markets.” Previously, the Fed had been reducing its holdings of mortgage securities to reinvest that money in Treasuries instead. Yields on Fannie Mae and Freddie Mac mortgage securities that guide U.S. home-loan rates tumbled the most in more than two years relative to Treasuries after this announcement. This move could have a greater impact on the overall market sentiments and 30 year mortgage rates have fallen to multi decade lows of 4.1%. The bet here seems to be that this will promote refinancing and give greater money in the hands of households which can be used for consumption. Since 70% of the US economy is consumption dependant this move seems to be targeted towards reviving the housing market and also consumer sentiment.
However the FOMC vote was 7-3. Dallas Fed President Richard Fisher, Minneapolis Fed President Narayana Kocherlakota and Charles Plosser of the Philadelphia Fed voted against the FOMC decision for a second consecutive meeting. They “did not support additional policy accommodation at this time,” the Fed statement said today. This essentially means that the hopes that many people are harboring of a QE 3 goes out of the window. Since this programme will run till the end of June 2012 we should expect any move on QE 3 only after that.

The avoidance of QE3 is the best thing to have happened in my view. The additional money that was being printed was only going into speculating in commodities and currencies. This had led to inflation spiking up and as a result had impacted consumer sentiments. The lack of QE3 combined with the issues in the Euro zone is likely to be positive for the US Dollar. The US Dollar index is looking extremely bullish technically and is pointing towards an eventual move towards 82-83 levels from the current levels of 78. This should lead to a significant correction in commodities going forward. Despite economic slowdown commodities were holding on just because of widespread speculation and will see some easing going forward.
The sentiments in the near term were also impacted due to the downgrade of three US Banks by Moody’s. Moody’s Investors Services announced the downgrade of Citigroup, Wells Fargo, and Bank of America — three of the United States’ top banks. Among the primary reasons: the U.S. government is less likely to step in to save a troubled financial institution. This further added to the negative sentiments in the markets.

The initial reactions of the markets have been negative. However, the reaction cannot be just attributed to the US FED action as it is also a combination of the developments in the Euro Zone and data releases from China which indicated slowing growth.
On an overall basis market valuations look cheap at this point of time and slowing global growth combined with a lack of incremental money printing should lead to a significant commodity correction over the next six months. This will bring inflation down and will be incrementally positive for the Indian markets which have largely underperformed due to inflation concerns.

On the other side an up move in the US Dollar, combined with a USD shortage in the global economy has lead to a sharp downward move in most EM currencies except China. This will have two impacts: On one side it will somewhat reduce the impact of the falling commodity prices on inflation as the fall in prices is countered by the weaker currency. On the other side it will make exports of countries like India much more competitive to that of China and help in addressing global imbalances of trade.

There are several indicators of panic in the market today which include
-Record pull-out from equity funds
-Record buying in gold which has taken gold prices to a premium to platinum. As per today’s newspaper reports there is
a shortage of storing space for gold due to the amount of investment buying that is happening.
-The yields of US Govt bonds & German Bunds have gone to all time lows thus indicating a desire for safety over returns.
-Traditional long only funds have been losing money and leveraged hedge funds have seen record flows with theindustry growing rapidly this year

The sentiment play out is likely to happen over the next few weeks, however fundamentally the case for decoupling of Emerging Markets from the developed world has become much stronger. I expect that as fear subsides we will see a significant outperformance of high growth, non commodity focused Emerging Markets. India is likely to be at the forefront of such a move unless and until the impact of government inaction on crucial economic decisions continues for a prolonged time period.

A majority of Indian companies benefit due to a rupee depreciation as it provides an artificial import duty barrier while making exports more competitive. Except for companies that have got significant forex borrowings the current move of the INR is also an earnings accretive for corporate India.

Like overvalued stocks stocks do not start moving down immediately after they are sold, an investor should not expect that undervalued stocks will start rising immediately after they are bought. Patience is required on both sides of the market.

As the market correction continues along with the time correction the downside for the markets is reducing and the upside potential is increasing. The level of 4700 for the Nifty and 15700 for the Sensex should hold for the markets. Valuations at 12X 2013 earnings and a peaking interest rate cycle also provide downside protection. Financial market linkages could create some downside in the near term but it will be a time to BUY.

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