OMT. Part I

These blog posts eventually lead to the Outright Monetary Transactions (OMTs), which was recently announced by the ECB.

First, I think it’s important to get a refresher on the problems in Europe.  I am going to use Spain as an example. 

1. Countries like Spain ran up large debts earlier in the decade, which was a boom to asset prices and growth. 
2. Thus, as capital began to leave Spain asset prices began to fall.  And so started a negative feedback loop – lower asset prices, capital flees, resulting in lower asset prices, more capital flight, etc.
3. This puts Spanish banks in a bad spot as their assets decrease in value and their funding sources dry up.  This results in a pullback in lending.
4. So back to point 1, growth was also dependent on credit, which is now being taken away.  As a result, growth stalls.  Again this creates another negative feedback loop – lower growth, less lending, resulting in lower growth, thus less lending, etc.
5. The combination of 2 and 4 lead to private defaults and exacerbates the fall in asset prices and growth.  Further, it puts the banks at risk.
6. This also leads to a collapse in tax revenues, a massive increase in stabilizers (i.e. the social safety net), a possible bailout of the financial system, and thus a ballooning of the public deficit to GDP.  This in turn causes interest rates to rise.
7. Rising interest rates create a self-fulfilling prophecy.  Higher interest payments = higher deficit = higher interest rates.  This continues until a breaking point when interest rates are too high and governments default.  
8. Simultaneous to #1, foreign capital is being pulled out of banks (i.e. “a run on the bank”) as the probability of public default rises.  This is because after the default deposits will be in the new local currency, which will be devalued relative to the Euro.
9. Number 8 exacerbates the problem of interest rates rising, as the reserves used to pay off public debt being to dwindle.

If you read the above and thought “this sounds a lot like the US” you would be correct… up until number 6.  So why aren’t we seeing the same sort of interest rate problem as Spain?  The most basic reason is that a key ingredient in the above is missing – monetary policy (the Fed and ECB).  

In Retrospect, What Did QE1 and QE2 Bring?

Again, I hope to get to some economic charts shortly, but for now let’s focus on asset prices.  The Big Picture posted some great charts on the previous QEs and Operation Twist (OT) and how various asset classes reacted.  Since I am not sure if I can post them (please check out the link), here is summary:

• Yields.  It’s interesting that yields rise after QEs.  They do drop drastically before QEs though.  Markets are basically buying the rumor and selling the news.  The same could be said about OT, while yields have gone lower it wasn’t until earlier this year.  I don’t think it was coincidence QE3 rumors started then.  I can’t see a divergence between the 10 and 30 year.
• Stocks.  Equity prices did rise rather nicely.  However, it does appear that there is a near-term pullback in prices at first.    Again, it appears investors start buying QE before it even happens.
• Commodities.  Prices rise pretty much throughout QE and on the rumor.  Like equities, there appears to be a selloff at the launch before a nice move higher.  

Also, from those charts I took a look at some numbers and came up with the following chart:

One thing that jumped out was that stocks and oil didn’t have as big a jump after QE2 as they did in Q1.  This would be concerning now given that the QE3 has already seen about the same rise.  Still, the highs and lows are relatively subjective.  Further, maybe the open-ended nature or current economic conditions would generate higher returns than QE2.

Gold and commodities appear to have the most upside, as rose by close to the same amount both QEs and have barely got off the ground this round.

QE3 – A Quick Thought

On September 13^th the Fed statement was extremely accommodative.  Here are some highlights:

1. Extending language "exceptionally low … federal funds rate are likely to be warranted at least through mid-2015"
2. New round of QE to MBS (not Treasuries) & rolling maturing MBS from previous asset purchases "purchasing additional agency mortgage-backed securities at a pace of $40 billion per month... maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities... increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year"
3. Extending operation twist "continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June"
4. Asset purchases appear open-ended (as opposed to a set $ amount) "outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability". 
5. Fed officials also upgraded their economic forecasts significantly.

So that was the announcement.  The takeaways?

• There also isn't a consensus this is actually economically stimulative.  I myself wonder how will lowering already low mortgage rates will help stimulate demand?  I will post on this shortly after I look into some data.
• Even if it doesn’t help the economy, does that mean QE is meaningless?  No.  If it follows the past QEs stocks and commodities should have a nice go of it.
• So if we assume it doesn’t help the economy, how can it help stocks?  Multiple expansion. 
• One measure of stock value is Price/Earnings.  So if Price is $100 and Earnings are $10 then P/E = 10.  If we assume QE doesn’t affect the economy then earnings stay at $10, but QE does help a stock’s P goes to $110.  The P/E is now 11, however fundamentals remain unchanged.  
• The open ended comment essentially assures Treasury yields shouldn't have a large move up and volatility in that market should be muted.
• Treasury and agency spreads should narrow further.
• The Fed won't be tightening until there is a dramatic change in the economic data.  
• Is the Fed now out of bullets?

In my next post, I want to touch on what happened to various asset prices the last two times we have QE.

Apple to Consume Cable?

The headline might be a bit much, especially the inevitability.  Still I got to thinking after reading this article on Apple.  I instantly thought cable will be dead over time. 

First, for those who aren’t familiar with Apple TV is a small box that hooks up to your TV.  From that you can order movies off of iTunes, watch shows from Hulu, stream NetFlix movies, view anything like photos or movies from any computer in the house,  and other features.  My brother has it, and I can attest it’s very smooth, clean, and easy to use.  So why will it end cable?

• Who likes their cable operator?  It’s overpriced; you pay $200 a month and watch three channels.  Rarely do you find anything worth watching.  The customer service is awful.  Everyone seems to think they have the worst cable company.
• With Apple TV you wouldn’t deal with any cable company and only buy the box once. 
• The business model is not consumer friendly.  Most of it is all or nothing and you pay for channels you don’t need.  For example, if the Oprah Channel costs Time Warner $1 per subscriber I am incurring that cost even if I don’t watch that channel.
• With Apple TV you would only pay for what you wanted, at least how it is currently set up.
• You can stream a lot of shows now on your computer.  You can even stream Bloomberg TV all day live.  This adds cheap alternatives at a fraction of the cost.
• Streaming will be easy to wrap into an Apple TV and it only costs $100 at the onset for the box.
• The marketplace is evolving.  Record companies, cell phone manufacturers, hardware, software, publishers, etc.  industries that all changed because Apple innovated while others didn’t. 
• Do you think Apple or cable companies will be quicker to innovate or set the marketplace?  Further, Apple products at the very least tend to be the most user friendly, efficient, clean, and glitch free of any on the market.  I have a Samsung Blue-Ray player that cost $150 and offers similar features to that of Apple TV, but it is a pain to use.

Will this happen overnight?  No, it might not even happen at all.  However, when I look at the landscape cable seems like easy pickings for Apple.  While I admit Apple TV isn’t there yet to overcome cable, in time it should evolve.  When that happens, I know I won’t be purchasing cable.