Is it possible that our economic recovery is a case of “out of the frying pan and into the fire?” The current indicators are weakening, and many economists are suggesting the U.S. economy is hitting a “soft patch,” a normal part of the economic recovery cycle. But is it, or are there signs we may be in some economic trouble down the line?
I wonder if this is the case. I am not sure because of two intertwined factors that could derail the U.S. economic recovery, or at least slow it down considerably. The housing market and the Federal Reserve balance sheet are connected at the hip and if things don’t change for the better in the housing market, the Federal Reserve may run out of ammunition to keep the U.S. economic recovery on track.
At the end of this month, the Federal Reserve is ending the second phase of its quantitative easing program (QE2), one step toward ending the unprecedented expansion of liquidity in the market. This falls in line with what the other central banks are doing around the world. The question is will the Federal Reserve be able to do much more than simply end the quantitative easing program. Will it actually be able to reduce liquidity, raise rates, or reduce its balance sheet appreciably? You see, in order to reduce liquidity or raise rates, the Federal Reserve has to reduce its balance sheet. To do this, it has to sell assets. Now here is the rub. Through quantitative easing, the Federal Reserve has added $1.8 trillion of longer-term GSE debt (Fannie Mae and Freddie Mac) and Mortgage Backed Securities (MBS) to its balance sheet.
Since these assets are directly related to the real estate market, so is their value, and since this is the case, the question becomes can the Federal Reserve afford to sell these assets in a market that is now seeing a reversal in the median price of homes across the country? And how will the Federal Reserve raise interest rates if that means a further crimping of the U.S housing market, since mortgage rates are directly tied into what the Federal Reserve does and does not do with its balance sheet? So this begs the question: can the Federal Reserve truly consider monetary tightening or reducing its balance sheet if it means selling highly devalued assets? This is quite a conundrum.
Further complicating its position is the reality of the U.S dollar. One of the mandates for the Federal Reserve is to support the U.S. dollar. To do this, it must take money out of circulation, which means selling assets on its books. Recently, the U.S. dollar has shown some resiliency because of the fear around the European debt crisis, but what happens if this issue finds a satisfactory resolution in the near future? Perhaps this is unlikely, but who knows? Nevertheless, the primary issue looks as if it will not resolve in the near term – the housing market seems bound for continued weakness, at least until the unemployment numbers move more strongly to the upside, and with consumer confidence once again sliding, consumer spending just might dry up a bit.
So when you put all of this together, it seems unlikely the Federal Reserve will be able to do anything more in the near term than simply announce the end of QE2. In fact, it is unlikely the Federal Reserve will be able to raise rates anytime soon or appreciably support the U.S dollar for one simple reason. It will not be able to sell any of its $1.8 trillion in real estate- related debt in the near term without causing unintended consequences that could further derail the fragile recovery. What does this mean for the market?
The first and most obvious thing to consider is inflation. Will the Federal Reserve be able to do anything if the inflationary pressures lurking about begin to release? Consider as well what happens to the U.S dollar in the near term if it is simply free floating “out there” with little to no means of support, other than the perception that it is still a “safe haven” or a hedge against the events in Europe? At the other end, what is the effect on the U.S. economy if the dollar continues to gain strength from the seemingly inability of the Europeans to fix their debt issues.
I am not an economist, and it may well be my analysis of this truly complex issue is off the mark, but, minimally, one has to wonder if the Federal Reserve can appreciably reduce its balance sheet in the near term, especially the $1.8 trillion in real estate relates assets portion of it. One has to wonder, given its inability to sell assets at this time, if the Federal Reserve can do much more of anything, other than to print more money or somehow pull something else out of its bag of tricks. Yes, one has to wonder what this could mean both in the near and long term, but in the interim, perhaps there is a near term trade waiting in the wings of all this uncertainty. Watch the U.S. dollar.
With so much to look at overall, sometimes it is better for traders to focus on the specific. The issues with the Federal Reserve are out there, but the effects are not here just yet. To the specific, day in and day out, the European debt crisis is front-page news, which means the euro/U.S. dollar relationship is in play. Check out VantagePoint, as it clearly has something to say about what this relationship will do in the near term.
Lou Mendelsohn
