Fed Hands QE Helm to Japan

Stocks finished a smidge higher last week in a set of sessions so quiet that you felt compelled to check your Internet connection because it seemed like prices just were not moving. Knock, knock, Wall Street, anybody home?

Still, let’s not be jaded. The S&P 500 did manage to post a gain, and every little bit counts. The most prominent news makers on the wires were Federal Reserve officials. Boston Fed President Rosengren, one of the more dovish members, reiterated that the central bank can be patient when it comes to liftoff given sluggish inflation trends.

Philadelphia Fed President Plosser, the most hawkish central banker, argued that inflation is not that far below target and downplayed concerns about a stronger dollar.

Another hawk, Dallas Fed President Fisher, said that liftoff for rates could occur sooner than the markets currently anticipate.

Before reading too much into these comments, remember that the Fed plays investor sentiment like a violin. Fed Chair Janet Yellen, like Ben Bernanke before her, makes sure that investors do not have a sense that central bank policy is a one-way street. The Fed wants you to think that rates might possibly rise quickly even if the real plan is to stay on hold all year. This is not sneaky or underhanded; it’s good message management and public policy.

Message management is going to be important as U.S. central bankers hand off the keys to the quantitative easing locomotive to the Japanese.

If global central bankers’ plan works, I suspect U.S. big-cap stocks will rally sharply over the next year, with the potential for the benchmark S&P 500 to reach the 2,500 level in synch with improving employment, a stronger dollar, low inflation and rising price/earnings multiples.

Analysts at the boutique economics firm Cornerstone Macro made this case succinctly in a note to clients this week. In the report, excerpted here, they pointed out the following:

— Quantitative easing in the United States is over and likely won’t come back barring a clear risk of recession. The European Central Bank’s balance sheet is likely to expand modestly. However, the Bank of Japan’s balance sheet will grow very rapidly as recent quantitative easing expands.

— The BOJ’s balance sheet will prevail and global liquidity (which is largely determined by the three major central banks) will continue to increase at a fast pace, just like it has for the past several years. It’s just the leadership will shift from the United States to Japan.

— A headwind to global liquidity expansion is the weakening of the yen and the euro. However, the sheer magnitude of the BOJ’s balance sheet expansion should trump almost any yen depreciation.

— Key point: Global asset classes that benefited from Fed liquidity in the past are unlikely to distinguish where the liquidity is coming from in the years ahead.

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Some further details excerpted directly from the Cornerstone report:

— Fed’s balance sheet. With the last installments of QE, the Fed’s balance sheet reached about $4.5 trillion, or 25 percent of U.S. GDP in October. Even if the Fed is likely to start raising rates around the middle of next year, the balance sheet will remain constant in nominal terms beyond the first rate hike. When the balance sheet begins to shrink, likely about a year from now, it will do so at a slow pace and only by attrition (that is, there won’t be any asset sales; the balance sheet will shrink because maturing securities will not be replaced).

— ECB’s balance sheet. The ECB has all the intentions to expand its balance sheet towards the levels of early 2012 (roughly 1 trillion euros higher than it is now), but it is unlikely to be able to do so with the measures it has announced so far, i.e. asset-backed security purchases. These measures are likely to keep the balance sheet constant at best. Expect the purchases of some corporate bonds, which are the next logical step in the ECB’s policy sequence. Those should be sufficient to expand the balance sheet by a couple of percentage points relative to euro-zone GDP. Euro-zone growth will be anemic at best, so it doesn’t take a massive nominal expansion to increase the size of the balance sheet relative to GDP.

— BOJ’s balance sheet. This is where most of the action will be. The BOJ’s balance sheet is already about 51 percent of Japan’s GDP. With the increase in the pace of QE announced recently, the balance sheet will reach a whopping 75 percent of GDP by the end of 2015. This means that the equivalent of roughly a quarter of Japan’s GDP will be added to available global liquidity next year. And that’s a lower bound because there is always the possibility that the BOJ will do more if inflation and inflation expectations don’t improve as the BOJ anticipates.

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Cornerstone analysts conclude by observing that putting the Fed, ECB, and BOJ balance sheets together suggests that global liquidity should increase by about 10 percent by the end of 2015. That is roughly the same pace at which global liquidity has increased in the past. The difference going forward will be that global liquidity will be driven by the BOJ instead of the Fed.

World equity indexes and other risky asset classes are unlikely to distinguish where the liquidity is coming from. In fact, the actions of Japan’s Government Pension Investment Fund are likely to reinforce the BOJ action as it moves funds from Japanese bonds to global equities.

Bottom line from Cornerstone: Under any realistic scenario, global liquidity should increase and should continue to be very supportive of global risky assets over the next year.

There will still be 2 percent to 8 percent corrections, which can start anytime out of the blue. But with central banks on the case in an effort to breathe life into the Japanese and euro-zone economies, dips should be relatively infrequent and relatively shallow.

Best wishes,

Jon Markman