In the next in a series of guest financial pieces, Mark Tinker from Axa-Framlington discusses the anticipated next round of quantative easing in the US and how the outcome might not fit most current market expectations.
Many people have been scratching their heads about the wisdom behind QE2, seen now as almost a certainty by markets. We know that you need to trade on the basis of what you think will happen, rather than what you think should happen, but even so the logic seems very flawed. To recap, QE1 was effectively the US authorities stepping in to prevent meltdown in the US financial system in 2008. In effect the Fed had to undo the damage caused by the Treasury and the regulators, who in their wisdom had managed to paralyse an entire section of the shadow banking system. By insisting that everyone had to sell so called toxic assets while not allowing anybody to buy them, the politicians created a need for a buyer of last resort. Step forward the Fed. Thus the job of QE1 was effectively to supply liquidity to undervalued but almost totally illiquid assets and the Fed balance sheet expanded by $1.3trillion, almost all of which was mortgage backed securities
QE2 however seems aimed at doing something completely different; buying the most liquid and expensive (as opposed to the least liquid and cheapest) assets in the world; US treasuries. The apparent thinking here is that by reducing the cost of capital (yet) further, the Fed can stimulate growth in the US economy. Now this is dubious on a number of levels. First, for all the politicians Banker bashing, these policies are doing nothing to improve the supply of credit. Credit is what small businesses need to survive and prosper and it comes from the banking system (shadow or otherwise). Making it very cheap to raise money in capital markets is good for large businesses, but they are not the ones that drive employment growth, indeed they continue to shed labour. Equally, making it cheap for banks to borrow at the short end and then encourage them via your “Risk” policies to buy government bonds simply sucks investment capital away from the productive economy.
In reality, all that has happened so far is that as the MBSs run off, largely because they were not at all toxic and have been redeemed at par, but also because the very policy of driving down long rates encouraged refinancing and pre-payment, the Fed has simply rolled that liquidity into other fixed income products (mainly Treasuries) so as not to tighten policy. Somehow, this has been whipped into an hysterical bandwagon (encouraged by uber-keynesians like Krugman) that the Fed should spend $1trilion, $2 trillion or even $3 trillion on buying US Treasuries in order to stimulate the US economy. Never mind that the Leading Indicators are turning positive, never mind that employment is a lagging indicator (which incidentally your own policies are making even more lagging), hurry up and get employment going, encourage inflation, push up asset prices and everybody will be happy!
Now this all seems very strange, not only because it seems to be a repeat of the very asset bubble issues that we swore not to repeat, but because the unintended consequences (if that indeed is what they are) are clearly evident already. Most notably the liquidity is flooding out of the $ and into real assets, notably commodities and emerging markets. The huge binary allocation of expensive bonds (buy with leverage because the Fed will buy them off you at a profit) and expensive emerging market equities (buy with $’s because not only is this where the growth is but the currency is only going one way) had, until recently left the rest of the equity markets looking ridiculously cheap with almost all large cap stocks trading at a dividend yield above their own corporate bond yield. Thus even the talk of QE2 has produced a dramatically weaker $ and risks of a bubble in commodity prices, treasuries and emerging market equities and no discernable effect on employment.
Now generally I prefer cock-up to conspiracy, but for once, let’s give the US authorities a bit of credit. Say you wanted the Chinese to revalue their currency, or even scrap the peg (now we know this is not the reason for the deficit, but we have seen this movie before with the Japanese), suggesting that you will dramatically lower the cost of capital and thus drive their monetary policy is a very credible threat, for as we know from 2007, the liquidity goes straight to Asia via the peg – a smart bomb straight into the heart of Chinese economic policy. Say too that you know from 2007 that a key vehicle for this transmission is the $ itself, a weak $ correlates to high commodity prices and we know that the Chinese are far more sensitive to imported food and energy prices than the US is. But of course this is not one sided, the Chinese have moved to tighten policy and also they can try and offset the weak dollar impact on their export economy by buying Yen and Euro, and then allowing a Yuan appreciation. To do this of course they effectively sell down the $ as well. Now they are not the only players in markets, momentum traders in $ are shorting and shouting, about debauching the currency and the $ as a one way bet. Their equivalents in the commodity markets are also shorting $ to buy oil and metals, particularly gold. Other emerging economies are really struggling with capital inflows and instability is rising everywhere from Indonesia to Brazil.
So maybe these unintended consequences are actually intended. Now that the Yuan has revalued (at least somewhat), maybe the US backs off? Tim Geithner has started to make comments about wanting a stronger $ (something China’s EM competitors would also like) and, interestingly, a number of Fed Chairman from around the country are making increasingly hawkish (ie sensible) noises on QE2, not least concerned with the reality that higher energy prices in the US are a deflationary thing – as essentials they crowd out other disposable income. Come November the 3rd of course, the Fed oversight committee will likely be chaired by a republican $ hawk. But, and here is the final twist, how about Bernanke simply muses that the US might consider selling some of its physical gold reserves? Gold would drop like the proverbial, almost certainly taking other commodities with it, meanwhile the $ would soar, reducing all those unpleasant emerging market tensions and reducing the price of gasoline to boot. Oh and John Paulson would get hosed (which would be nice)
Go on Tim, tell me it’s a plan.