Thursday, October 14, 2010

The effects of QEII

Yesterday Karen Maley parroted a newsletter from Hoisington Investment Management that argued that efforts around QEII "...may not prove any more successful than their previous attempts. Even worse, they may prove extremely harmful." According to Maley,
"The authors point out that the most likely outcome is that it fails to boost economic activity: “It should be clear that QE2 and the purchases of additional assets by the Fed will, like previous purchases in QE1, serve only to bloat excess reserves without advancing income, spending, or jobs.”

They argue that the only way that QE2 will work is if succeeds in triggering a new cycle of borrowing and lending, which would result in even more Ponzi-style debt being piled onto an already overleveraged economy. A further increase in debt levels will ultimately lead to economic deterioration, an increase in systemic risk, as well as possible deflation.

“Therefore, at best QE2 can be nothing more than a short-term panacea, exacerbating the serious structural problems facing the United States.”

This blogger both agrees and disagrees with this analysis. Firstly, the raging stock market is surely the new bubble that is underway. It is based largely around emerging market growth and commodity inflation, much as it was in 2008. In this sense, yes, QEII is worsening the US's reliance on asset-inflation, debt and consumption for growth. There is also new movement in the refi index for housing.

However, QEII is clearly also going to have an extraordinary effect on the US external imbalance, according to Martin Wolf of the FT:
To put it crudely, the US wants to inflate the rest of the world, while the latter is trying to deflate the US. The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender: the needed changes in nominal exchange rates and domestic policies around the world.

If you wish to understand how aggressive US policy might become, read a recent speech by William Dudley, president of the Federal Reserve Bank of New York. He notes that “in recent quarters the pace of growth has been disappointing even relative to our modest expectations at the start of the year”. Behind this lies deleveraging by US households, in particular. So what can monetary policy do about it? His answer is that “very low interest rates can help smooth the adjustment process by supporting asset valuations, including making housing more affordable and by allowing some borrowers to reduce debt interest payments. Beyond this ... to the extent that monetary policy can ‘cut off the tail’ of the distribution of potential adverse economic outcomes ... it can help encourage those households and businesses with money to spend to do so”.

Above all, today’s low and falling inflation is potentially calamitous. At worst, the economy might succumb to debt-deflation. US yields and inflation are already following the path of Japan’s in the 1990s (see chart). The Fed wants to stop this trend. That is why another round of quantitative easing seems imminent.

Wolf is arguing that now that it has embarked on this course, the US Fed must, by dint of its reserve currency status, win.

So, if Wolf is right, we have a conundrum. QEII has the US stock market threatening a bubble around emerging market growth and commodity inflation, whilst it is simultaneously ripping away the export advantage of those same markets in a forced rebalancing.

This blogger's favourite Fed observor, Tim Duy of FedWatch, endorses the Wolf view:
Consider the enormity of the situation at hand. The Federal Reserve is poised to crank up the printing press for the sake of satisfying their domestic mandate. One mechanism, perhaps the only mechanism, by which we can expect meaningful, sustained reversal from the current set of imbalances is via a significant depreciation of the dollar. The rest of the world appears prepared to fight the Fed because they know no other path.

Bad things happen when you fight the Fed. You find yourself on the wrong side of a whole bunch of trades. In this case, I suspect it means that Bretton Woods 2 finally collapses in a disorderly mess. There may really be no other way for it to end, because its end yields clear winners and losers. And the losers, in this case largely emerging markets, and not prepared to accept their fate.

Moreover, there is no agreement on what should be the post-Bretton Woods 2 rules of the game for international finance. Is there even a meaningful policy discussion? Perhaps a little hope via Bloomberg:
Suggestions for how to resolve currency differences were vague in Washington, with French Finance Minister Christine Lagarde proposing better coordination and more diversification, while Canada’s Jim Flaherty suggested that new “rules of the road” be outlined.

Of course, in the next sentence hope is dashed:
European Central Bank Executive Board member Lorenzo-Bini Smaghi suggested the G- 20 may be too big to find a compromise.

Unless checked in South Korea, the discord may snap the G- 20’s united front formed to fight the financial crisis and recession.

And don’t expect that the International Monetary Fund is prepared to deal with this crisis:
Unable to find common ground themselves, governments agreed the IMF should serve as currency cop by preparing reports which show how the policies of one economy affect others. The studies will focus on the U.S., China, the U.K. and the euro area.

“The need to have this kind of spillover report has been discussed for months and now it’s part of our toolbox,” IMF Managing Director Dominique Strauss-Kahn said.

Well, thank the Heavens above, the IMF stands ready to produce a report. Now I can sleep easy.

Bottom Line: The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder. The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next. Call me pessimistic, but right now I don't see how this situation gets anything but more ugly.

Bloody hell, you might rightly say.

Assuming these guys are right, and this blogger can think of no reason to gainsay them, most especially because the US economy is going nowhere but sideways to down, how does this play for Australia? Obviously it's an unbelievable flux but I will hazard the following educated guesses:

1. Gold is going to the moon. Perhaps far more quickly than even this blogger imagined. Even if the Fed is, in effect, going to break all currency pegs to the dollar, all of those surpluses aren't going to disappear overnight. The reserves are going to have to go somewhere. And gold looks the likely winner.

2. There is a danger for developed markets outside of the US that the great global rebalancing will begin to raise interest rates. If emerging markets are forced to rebalance then in time ipso facto there will be less capital to export. This could prove a major danger to the Australian banks and, if they don't handle it well, the housing market.

3. That may be offset to a degree by the Michael Pettis scenario outlined in Unpleasant Scenarios a few days ago, which is looking increasingly likely. That is, if the Fed is going to break the currency pegs and destabilise emerging markets export-driven growth, they will face a choice: Growing job losses, or stimulate by easing monetary policy. The latter looks far more likely so we're going to have a world awash with fiat money. Inflation and asset bubbles look a good bet for emerging markets with commodities the likely winner.

4. The high income from commodities should support housing but rising rates will retard it. It looks like flatline at best.

5. The Duy scenario is not one of plain sailing for equities either. Hell no. Total currency chaos will cause severe volatility.

History appears to be moving here.


Anonymous said...

Hi, would you please make a post about the Fitch bank stress test report? It needs a critical eye passed over it, imo.

Bear Feller said...

I've finally finished reading Tim Duy and Martin Wolf this afternoon. My conclusion is that the currency war is M.A.D. - mutually assured destruction.

Let's hope the world doesn't call America's bluff on monetary policy, whether that's at the G-20 in Seoul or at some other forum. If QEII goes ahead it'll be the most doomed vessel since the Titanic.

But while that ship's going down the first thing that's going to spike are Australian equities. Boo-yah.