Our long wait is nearly over. The Fed meets this week and is widely expected to announce a reduction in their purchases of Treasuries and Mortgage Backed Securities. The consensus seems to be that the Fed will reduce its purchases by $10-20 billion per month with the emphasis on reducing Treasury purchases. The reasoning is that with the reduction in the budget deficit this year a reduction in Treasury purchases is not only warranted but maybe necessary so the Fed doesn’t completely hog what is left of the available supply. That Fed policy is dictated to any degree whatsoever by the borrowing needs of the US Treasury is something that is frightening in and of itself but that is the brave new world in which we now live.
I wonder if the market has sufficiently factored in the Fed’s coming actions (or inaction) though. Bernanke has said that 7% unemployment is a target for QE to end and with the current reading of 7.3% it would seem that a larger reduction is at least a possibility. Of course, Bernanke could justify a smaller reduction in light of how the rate has fallen to that level, but since one of his other main monetary policy tools is transparency and predictability of Fed policy I’m not sure how he can square that circle. If he now abjures his previous policy target how does that make monetary policy more predictable? For transparency and forward guidance to work as advertised it would seem critical for the Fed to actually do what it says it is going to do.
It should also be noted that while the budget deficit has fallen this year and therefore the Treasury might not issue as many bonds, the MBS market is not exactly booming either. The recent rise in mortgage rates has taken a huge bite out of the market as refinance applications have plunged. If the announced layoffs in the mortgage departments of the big banks are any indication, the supply of MBS may be crimped even more than the Treasury market. Wells Fargo, Citigroup and Bank of America have all announced thousands of layoffs in recent months and you can bet that if the big three are doing it, smaller lenders are doing it too. That has implications beyond the potential supply of MBS obviously, something else the Fed might consider next week.
Fed policy has been the driver of the economy and the markets for a long time and I think often in ways the Fed didn’t want or anticipate. The Verizon deal to buy the portion of their wireless company owned by Vodafone is a good example of what I mean. Last week Verizon floated $49 billion in new debt to the markets and indications are that they could have sold even more. That is nearly 3 times the record offering that was floated by Apple earlier this year. One would be hard pressed to see any way that either deal is good for the US economy. Verizon was already laying off workers in an effort to reduce costs and my guess is that with the new debt load, more is in the offing. Interestingly, it was the recent rise in interest rates that spurred Verizon to up its bid to Vodafone. They had originally offered $100 billion but the rise in rates pushed Verizon to raise the bid and get the deal done while rates are still relatively low. In other words, absent the Fed’s rate suppressing actions, this is a deal that never gets done and ironically, if rates rose because of the tapering talk, it was consummated by QE’s coming end. If all the Fed wants is activity it would seem the best way to accelerate the process is to let the market know that QE is ending sooner rather than later.
Verizon is overpaying to consolidate its wireless division by issuing debt. Apple and a lot of other companies have sold debt to fund dividends and stock buybacks with the market near all time highs. It is hard to see how any of this financial engineering is beneficial to the economy as a whole but it is the inevitable consequence of suppressing the cost of capital. One of the winners from the Fed’s policies is of course Wall Street since someone has to manage those bond offerings and stock buybacks. Maybe that explains the decision last week to add Goldman Sachs to the Dow Jones Industrial Average which looks less and less industrial every year although it does seem to reflect the make up of the US economy. Alcoa, Bank of America and Hewlett Packard get removed and Goldman, Visa and Nike get added. That’s the US economy in a nutshell – financial engineering and conspicuous consumption.
The Verizon deal probably isn’t good news for the market either. Market tops are often marked by big deals that ultimately prove unwise. The 2006-2008 period was a golden time for buyouts with the largest deal of the period (and biggest private equity deal ever at the time) being TXU going private in a $45 billion deal. TXU, in case you missed it since PE isn’t known to publicize their failures, is now a mess sliding toward a likely bankruptcy. Of the top 20 private equity deals done during the period, half of them are still underwater. The fact that we are in the midst of a lot of big deals is not something that should be applauded; it is a warning that easy money is coaxing people into doing things they otherwise wouldn’t have done. I suspect Michael Dell will rue the day he succumbed to the siren song of cheap money and took his eponymous firm private.
Twitter announced its long awaited IPO last week although they didn’t release any financial information. Based on the repeated rounds of financing leading up to the IPO I think it is safe to say that Twitter is not yet making money but will still be able to raise new funds via IPO at a valuation that is expected to exceed $10 billion. I would just point out that the last time unprofitable internet companies were able to command such high valuations was not a particularly auspicious time to be on the buy side of the market equation. Having teased the market for years now about its IPO intentions why has Twitter decided now is the time? My guess is that their advisors convinced them that the window for risky IPOs is one that can close quickly and if they want this done, they better get it over with.
The recent deal activity is just one more sign that 5 years after the crisis, the Fed, most every other policymaker, business leaders and especially Wall Street has learned very little. Monetary policy that is good for Wall Street and big business isn’t necessarily monetary policy that is good for the economy as a whole. In fact, I would argue that the two are almost diametrically opposed. One last sign of the new Wall Street excess; the cover story of TIME magazine this week is titled How Wall Street Won. It features the Wall Street bovine wearing shades and a party hat amidst a sea of confetti. The last time Wall Street was partying like this, the confetti turned out to be the US economy. Maybe if the Fed gets on with the task of normalizing policy this week that won’t be true this time. But the clock is ticking.