The Peloton Position / 2nd Quarter 2011

Quit Now!

Rarely do movie sequels live up to the expectations set by their predecessor films — even for franchises with mediocre debuts. Rarer still are third installments that don’t flop miserably at theaters. Quite often, movie makers would do well to quit while they are ahead. Ben Bernanke is no Martin Scorsese, but with QE2 set to expire in June, we admonish him to resist the urge to follow one unnecessary sequel with another.

As a sequel to QE1, QE2 did not completely bomb, and it probably did not cause any immediate harm. The question is, did it really do anything at all? As we suspected at the outset, the Fed’s systematic purchase of $600 billion of Treasuries was not the coup-de-grace to end the suffering and misery of lingering high unemployment and drudgingly slow economic growth. And since QE2 did not fix everything that ails us, it is unlikely that the United States will fall apart when it quietly ends in a few weeks.

Before we summarily dismiss QE2 and any and all conceivable next programs, it is important to recognize that the latest installment did achieve several of the Fed’s objectives — albeit with varying degrees of relevance. By definition, QE2 was intended to reduce interest rates thereby having a stimulative impact on the economy. The hope was that a generally stronger economy would help the Fed achieve the ridiculous half of its dual mandate — full employment. With short-term interest rates already at essentially zero, Bernanke’s next best option was to openly purchase longer-term Treasury bonds to effectively lower rates farther out on the yield curve. On the surface, interest rates were probably held lower than market forces might have otherwise dictated. $600 billion is a lot of artificial incremental demand — like a coastal storm surge strong enough to temporarily reverse a river’s natural flow. The other, more sensible half of the Fed’s dual mandate is price stability, and measuring the success (or not) of QE2 on that front is more complicated. Most importantly, the mere announcement of QE2 averted a potentially dangerous skirmish with deflation — an economic poison for which central banks have virtually no antidote. Since the formal unveiling of QE2, commodity prices have soared, and a deflationary malaise now seems borderline absurd.

So why are we so opposed to another round of quantitative easing? For starters, we didn’t think it was necessary in the first place. We saw it as more politically motivated than economically prudent. It was futilely aimed at the half of the dual mandate that Fed action has little ability to influence — employment. As the program was announced we wrote, “We certainly do not believe that QE2 is a game-changer in any sense. It does not create jobs, nor does it bolster confidence. It is likely just an incremental effort by the only remaining functional policy-making body left standing in Washington. And although politically the Fed is a devoutly independent group, one senses that certain not-so-independent politicians are growing increasingly uncomfortable with a 9.6% national unemployment rate.”1

As the program winds down, we continue to question whether it provided any tangible positive economic impact. If it did not, it follows that allowing it to lapse without replacing it with another program would not derail the underlying expansionary momentum in the economy. With regard to interest rates, one might surmise that rates will be freer to flow in a naturally higher direction after the Fed doles out its 600 billionth dollar. Most forecasters, bullish and bearish, agree that interest rates will move higher. (A near-universally shared view that, by virtue of being so widely shared, makes us less confident that it will be accurate. More on “crowded trades” later.) But because lower rates did not necessarily bolster the economy, higher rates after QE ends will not undermine an expansion.

Lower rates definitely did not entice corporations to borrow and spend — simply because they already had tons of cash and plenty of workers. QE2 failed to impact the unemployment rate because the transmission mechanism was not engaged. Managers, still reeling from the recession, assessed their companies’ operating needs and funding sources, and decided not to borrow or hire. Incredulously, some politicians (mostly QE3 proponents) actually attacked corporations for not doing their civic duty to help increase employment. That’s funny. If my wife foregoes a purse sale because, she “doesn’t need another purse” or “would just be buying it because it is on sale,” I would be happy (and a little confused!). Rather than vilifying corporations for their fiscal prudence, policy makers should try to emulate them.

A completely different but also broken transmission mechanism kept households and individuals from benefitting. QE2 was similarly successful in lowering consumer interest rates — mortgage rates are again at historic lows. Theoretically, this would allow millions of homeowners to refinance their homes, lower monthly payments, and consume more as a result. However, home values have declined so severely that few appraisals are high enough to meet the loan-to-value criteria required by gun-shy banks to qualify homeowners for refinancing. In this instance, the would-be borrowers are willing, but (more prudent) lending standards and conservative appraisals are restraining credit from flowing.

The pessimists argue that without QE2, the domestic economy has little fundamental momentum. The scheduled end to the program and resulting higher interest rates will choke off the fledgling economic expansion. Christina Romer, former chair of the White House Council of Economic Advisors, is in favor of QE3 — presumably because she believes that either QE was so effective or that the economy is so weak without it (or both) that we need more government help.2 If one were to be skeptical, one might think that Romer’s last job predisposes her towards pulling out all the stops to reduce the unemployment rate (by, say, mid-2012) — just speculation. The real doomsayers agree with Romer that the economy doesn’t stand a chance without Fed support. But they go on to forecast that we’re doomed either way because adding more QE simply delays and amplifies the inevitable future inflationary spiral and concurrent dollar collapse.

QE2 will not be followed by yet another ill-advised sequel, in our opinion. Nor will it result in immediately and dramatically higher interest rates or a pronounced economic decline. Rather, we believe that momentum in the underlying economy is sufficient to withstand newfound restraint on the part of the Fed. From the beginning, Bernanke told everyone exactly how much the Fed would buy and exactly when they would stop buying. Financial markets, corporate managers, and heads of households have had seven months to prepare for the end of QE2, and it is unlikely that bond yields and economic data will show more than a slight ripple as the program expires.


If the Fed’s liquidity push did not translate into hiring or faster growth, as we suspect it did not, but rather flowed like a rising tide into commodities markets, the lack of another round of QE should at least stem the tide. The positive impact of a relatively tighter Fed might just be less inflation — a benefit for corporations and consumers. Since the formal announcement of QE2, prices of all types of raw materials have soared — from energy to metals to agriculture. Households have been paying more for clothing, food, and gasoline. Notably, during the latest round of quarterly conference calls, a wide swath of companies directly emphasized higher input costs as a growing challenge.

Fed Chairman Bernanke, in his first ever post-meeting press conference, addressed inflation concerns by calling the recent commodity price increases “transitory.” We at Peloton are optimists, who overwhelmingly believe in the American capitalistic system and the operational potential of American corporations. As such, we would like nothing more than to back the Chairman’s assessment, but it strikes us immediately that all things are eventually “transitory.” Bernanke is a smart and thoughtful economist, and he has developed considerable skill dealing with the financial media. There is no doubt he chooses his words wisely. While no one believes that “transitory” is a particularly insightful assessment of the environment, we think is as close as he could come to actually saying QE3 is not in the cards.

If we’re right, the Chairman likely shares our view that most of the recent rise in raw materials prices was due to extraordinary Fed action, not building structural inflationary forces. There is a very simple relationship between surplus dollars and higher commodity prices. Too much money chasing too few goods creates upward price pressure. So it seems Chairman Bernanke would be more likely to make a call on inflationary concerns if he felt like he had a level of direct control (or cause) of what we have experienced recently. High structural inflation, which is the spiral everyone fears, is more complicated and will not materialize until wages and rents (two huge corporate costs components) inflate — and few see either ramping up soon.

At present, underlying economic fundamentals are improving, and demand for commodity inputs is growing worldwide. Such an environment argues for modestly increasing prices for the things used to build and produce finished goods. Skyrocketing prices of oil and silver, particularly, and incredible speculative volatility in many other commodities suggest that non-fundamental forces are also influencing prices.


Time and again, speculative excesses lead to bubbles, which end in tears. But before they collapse, bubble prices inflate to unimaginable levels, often rationalized by new, creative valuation methodologies or altogether new paradigms which perfectly explain why “it’s different this time.” Mass speculation can lead to bubbles in virtually anything. In Holland in the 1630’s, it was tulip bulbs. In 1720, The South Sea Company bubble gripped England. More recently: Japanese stocks in the 1980’s; dot com stocks in the late 1990’s; and residential real estate in the 2000’s.

Every bubble has unique nuances and contributing factors. The NASDAQ dot com bubble in the 90’s was fueled by an emerging technology that seemed to have limitless reach, and a perfectly logical new valuation method for the companies jockeying at the internet’s vanguard: eyeballs. Not revenues, not earnings, not cash flow, but eyeballs. Speculators threw money at the stocks of companies that could attract the most page views on internet, whether or not they had a plan for converting eyeballs into profits, or even sales for that matter. Research reports promoted a number of companies poised to conquer the world — enduring corporate icons like eToys.3

In addition to bubble-specific events, several building blocks are universal. First, money is plentiful. Second, credit is readily available. Third, a “market” brings buyers and sellers together. Fourth, any level of price appreciation seems plausible when the new paradigm is articulately explained. And finally, by the time everyone has been lured in by the prospect of easy gains, it is time to watch out. Wall Street calls this a “crowded trade.” It is analogous to putting too many people on one side of a boat, or shouting “FIRE!” at a Justin Bieber concert. When the overwhelming consensus is packed “in” a trade, getting out is often calamitous.

With regard to Fed-induced mini-bubbles in commodities, QE2 satisfies both liquidity criteria, and with all the major commodities already trading in developed markets via futures and options contracts, the mechanical elements are in place. The emergence of China and her 1.6 billion people provides the paradigm shifting rationale to dispel all conflicting data.

Oil prices have been inflating despite inventory data indicating more-than-ample supply. Geopolitical concerns are real, but they do not support the magnitude of the run-up. Virtually everyone has succumbed to the notion that $100 oil is a new fact of life, so the oil trade had become crowded. On April 29, the price of oil topped $113 per barrel. The next trading day, new CFTC margin requirements went into effect — making it more difficult to speculate with borrowed funds. Prices corrected 15% very quickly, pushing oil definitively back below $100 per barrel. Most significantly, nothing changed fundamentally.

Since QE2, silver has garnered significant new interest. By the end of April, silver prices had gained 60% year-to-date and have doubled since QE2 was announced in November. At $49.19/ounce, silver was within a whisper of the all-time high price of $49.45 last seen when the Hunt brothers tried to corner the market in 1980. Silver, unlike gold, is primarily an industrial metal, so the price should more closely track supply and economic demand expectations. But not even the most optimistic economist can make the fundamental case for silver’s quadrupling in two years. More likely it has become a gold-like hedge for speculators betting on dollar weakness. When margin requirements increased for oil traders, tighter margin limits also went into effect for silver, and its price plunged 34% over the ensuing 10 trading sessions.

Two more crowded trades we consider today are 1) bearish calls on bonds and 2) forecasts for a weak US dollar. We disagree with the consensus call on the dollar because we believe the end of QE2 allow interest rates to drift higher, supporting the dollar. A stable or stronger dollar will also tamp down commodities prices, which will boost corporate earnings and relieve pressure on consumers. Likewise, ending QE will effectively close the liquidity spigot. Gradually, the conditions that fostered commodity spikes will reverse, including highly levered speculative positions. If the economy is strong enough to grow without QE2, merely allowing the program to quietly expire on schedule will help stabilize the system. We welcome the end of the Fed’s latest masterpiece — primarily because it should have been left on the cutting room floor in the first place.

The Peloton Position is a compilation of original insights and writings by Peloton Wealth Strategists. This issue features articles by Matthew K. Bradley, Executive Director and Chief Investment Officer.

  1. Peloton Position, “QE-2 Much?”, November 2010
  2. See Peloton blog, April 25, 2011, European Central Bank Raises Rates, Stokes U.S. Inflation Concerns
  3. eToys priced its initial public offering in 1999 at $20 per share. The stock almost quadrupled on its first day of trading. Less than two years later most of its assets were purchased out of bankruptcy by KB Toys, the parent of which went on to file for bankruptcy in 2008.