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Global Markets Weekly - 23rd March 2009

• The Fed broadened and deepened its QE programme...
  Last week, monetary policy measures were once again in the headlines. The US Federal Reserve (Fed) expanded the scale and scope of its quantitative easing (QE) measures, increasing the planned purchases of mortgage-backed securities to around 50% of net issuance over the next 12 months. The Fed also said it would start buying Treasuries.
• ...in a double-pronged effort to drive down mortgage rates.
  The $300 billion of Treasury purchases announced was less than half the size of newly announced mortgage purchases but indicates that the Fed is now pursuing a no-holds barred approach to reducing mortgage rates , driving down mortgage spreads and the risk-free rate underlying the price of these securities.
• As most US mortgages are long-term fixed, a wave of refinancing will be sparked by a key level...
  The Bank of England announced that it would start buying corporate debt as part of its Asset Purchase Scheme on 25th March, though it will be mostly targeted at gilts. This reflects the different structure of the mortgage market in the two countries. With most US mortgage rates fixed for the duration of the loan, movements in Fed policy rates have little impact on household borrowing behaviour. Yet, at any given time, there are critical levels for mortgage rates that will trigger a rise in refinancing activity. Wishing to refinance is not the same as being able to, and the Fed estimates that around 20% of home loans currently have negative equity. This would therefore restrain refinancing activity, but only partly.
• ...currently 4.5%, which the Fed is targeting - reinforcing our bullishness on bonds.
  With mortgage rates at 4.5%, around 90% of US home mortgages could be refinanced. On 20th March, the lowest mortgage deals available from Main Street lenders were around 4.65%. We think the Fed wants mortgage rates at these levels, and it would be a brave investor who stood in their way. We therefore remain positive on Treasuries and investment-grade credit in the short term.
• Inflation concerns look misplaced, as global growth shrinks...
  Investors appear to have focused on the medium-term inflationary implications of QE . Such concerns make for sensational journalism but must be set against the profound deflationary forces facing the world economy over the years ahead. A sustained rise in commodity prices requires increased final demand. The current pace of decline of the global economy is historically consistent with the price falls in commodities over the past year, and any short-term, policy-driven rally in commodities needs to be seen in this context. As the oil market showed in 2008, commodity markets can overshoot, but it is wise to keep a steady eye on underlying demand.
• ...and commercial banks continue to tighten lending standards.
  In order to translate into the hyper-inflation envisaged by some commentators, central banks’ expansion of the monetary base would need to be multiplied by commercial banks. As banks all over the world try to shrink their balance sheets, the opposite is occurring: central banks are creating money, and commercial banks are destroying it by rapidly tightening standards. In the UK, investors had a stark warning of the current deflationary forces when unemployment was reported as rising to a 12-year high in February and wage growth fell to a 40-year low. In the US, capacity utilisation is close to its all-time lows. Investors face a multitude of challenges over the foreseeable future, but inflation spiralling out of control is not one of them.

Indices, Interest rates and Inflation

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