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Friday, September 28, 2012

Notes from the USA – a guest post

For the past 4 months, FIIs have been net buyers in the Indian stock market while DIIs have remained net sellers. QE1 by the US Fed had released a flood of liquidity in global markets that led to a strong bull rally from early 2009 to end 2010.

QE2 had less of an impact on the Indian stock market, but helped the US market to scale new highs. Now QE3 has finally come along, and perhaps in anticipation, FIIs have been in a party mood. Despite all the liquidity flow, the underlying economies in US and Europe have remained weak while China and India are in the midst of slowdowns.

In this month’s guest post, KKP explains some of the new financial terminologies and the ‘fiscal cliff’ that the US will be confronting soon. He also suggests a course of action for small investors. 

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QE3 and Fiscal Cliff – New Vocabulary for our World!

We learned a lot of new words from Greenspan, and in recent years, we have started to hear about Quantitative Easing…LSAP…LTRO from Fed and Central Banks. What does all this mean to us as small investors in the US and India?

Well, LSAPs are Large Scale Asset Purchases that the US Government started in 2008 to create a balance under special circumstances. EU’s version of the same is called LTROs, which are Long Term Financing Options. Both of these flavors are nothing but a method of pumping fiat money into the economy at the discretion of the Fed/Central Bank to create a balance where they determine the situation/environment has created an imbalance. Of course, it is done with a controlled private risk.

The unusual situation is that in the last 50+ years, the primary tool of monetary policy has been the Federal Funds rate. During the recent crisis, however, the Federal Reserve unveiled a variety of new policy measures never used before. What forced its hand initially was the disruption of credit markets in the wake of the deterioration of the subprime mortgage market, which began in August of 2007. By February of 2009, however, a second factor came into play i.e. the Funds rate effectively reached its lower bound (zero), implying that despite the severity of the recession, the conventional option of reducing the Funds rate was no longer available as the common Fed weapon. Fed kept giving solace to the markets that the future path is zero rates for Fed Funds, but had to come up with these special measures to combat and stimulate the economy.

Shortly after the meltdown that followed the Lehman failure in September 2008, Fed initiated QE1, which was purchase of a variety of high grade securities, including agency mortgage backed securities (AMBS), agency debt, and long term government bonds, with AMBS ultimately accounting for the bulk of the purchases. It also set up a commercial paper lending facility, which involved the purchase of commercial paper since the Fed accepted these instruments as collateral for loans made to the facility. In October 2010, the Fed announced a second wave of asset purchases (QE2), this time restricted to long term government bonds that was smaller in scale than QE1.

Finally, in September 2012, the Fed embarked on QE3, specifically targeting mortgage bonds in particular, on the grounds that lower mortgage-bond yields will feed through into lower mortgage rates, which in turn will feed through into healthier housing prices, igniting jobs. In short, the Fed is not trying to kick-start the economy any more: instead, it’s promising a steady extra flow of monetary fuel for the foreseeable future — or at least until the labor market improves “substantially”, which is likely to be a pretty long time. I kid you not, this is a large deal by itself since they have all but promised a zero interest rate environment until mid-2015 with a $40B per month funding out of QE3.

In short, the Fed has already pumped a lot of money into the economy, has already put interest rates at subterranean levels at this point and if those interest rates aren't low enough now to get people to borrow money, it's not totally clear to anyone that it is guaranteed to have the desired huge effect going forward. Ben Bernanke is making a fairly simple bet that a stable stock market is going to be better for the economy than a collapsing stock market, and lower mortgage rates are going to be better than higher mortgage rates at this point. And he's hoping that all of this will boost confidence and give people more money to spend, which in the end can boost job creation.

There's some evidence to support both of those points, but he also seems to realize that this isn't going to really solve all problems. In his commentary carried live on CNBC and Bloomberg, he was very clearly pointing out that Fed can't fix our underlying problems with any guarantee, but will be fully supportive in doing whatever it needs to do. Central Banks in EU are pretty much convinced of making similar moves, and getting similar results. For now, EU is getting support from the investment community, in a similar manner to that in the US.

In the short term, I am expecting to see higher stock markets in EU and the US – probably till November (US elections). I will then look for signs in the economy that will show deterioration in the under-current of the economy (tax dole-outs/receipts, housing, manufacturing, welfare programs, import/export, retail sales, big-ticket-items, leading-indicators, unemployment, corporate revenue/earnings, and of course the insider trades). The biggest of all will be the “Fiscal cliff” - which is the popular shorthand term used to describe the conundrum that the US government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

These laws have to do with the 2001-03 tax-cuts, taxes related to Obama Health Care, 1000+ government program cuts and other elements. We’ll definitely get events from Central Banks in EU as well as the Fed that will shake the perception of the investment community. If all of that is not enough, remember that the first year of a new president is always a down year, since there are no promises of the ‘better world’ (mostly given during the election year). So, between now and November, going long might be OK, but get ready for going to cash or short after that in most global markets.

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

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