Dear Diary,
QE, we hardly knew ye…
Hang the black crepe. Get out the whiskey. Say goodbye. And try to keep the tears from your eyes.
The Dow rose back above 17,000 points yesterday, near its all-time high. Higher stock prices should settle nerves at the Fed’s FOMC meeting. It should leave the central bankers free to let their emergency bond-buying program die in peace.
The Financial Times announced the end even before it happened. On Monday, its headline read: “RIP QE: The quiet death of a radical US monetary policy.”
But the Fed has to be careful. If it announces that QE is truly dead, it is likely to set off some untoward scenes of wailing and keening in the stock market. Investors will feel a deep sense of loss.
Is the Party Over?
The trouble with death is it is permanent. The dead stay dead. And if investors believe QE will never rise again, they may be disheartened. Or even feel betrayed.
Remember, the central bank was the life of the party. It was central banks that brought the booze… leading to the big run-up in US stock prices over the last five years.
If QE is history, most likely so is the bull market on Wall Street. The party is over. Stock prices are likely to put on their coats and hats and go back whence they came.
The Fed has already given out the word that, although QE may be breathing its last breath, its offspring will live on.
The Fed will not be selling its roughly $4.5 trillion portfolio of bonds… or even allowing it to expire of natural causes.
In the normal course of events, these bonds would mature and then – as all of us will – disappear. But Janet Yellen tells us it will be reinvesting the funds from maturing bonds in new issues. In other words, it will continue to soak up new bonds, helping to keep a lid on yields.
We doubt that will be enough…
An economy that depends on debt needs more and more of it to get the same buzz going. The first time you pump a lot of credit into an economy’s veins you get quite a rush. It’s only later that the shakes begin.
As debt grows, it becomes harder for the economy to grow. Because the resources needed by the future have already been claimed by the past.
Ultra-low interest rates disguise the problem and postpone the reckoning, but they can’t put it off forever. A man who buys a cup of coffee today on his credit card has created an obligation that will eat into some of tomorrow’s income.
If he allows the interest on that debt to compound, he could still be paying for that cup of coffee 10 or 20 years from now.
Debt Is a Drag
This debt drag has been explored in a number of economic studies. According to Van Hoisington and Dr. Lacy Hunt of Hoisington Investment Management:
A country’s growth rate will lose about 25% of its normal-experience growth rate when total debt reaches a “critical” level of 250% to 275% of GDP. Currently, it’s 334% in the US.
If you borrow to invest in a productive undertaking, the stream of income you receive from that undertaking may be enough to pay off the debt and even give you a profit.
But if you borrow – for Obamacare… for war in the Middle East… or for Wall Street bonuses – you’re not in a better position to pay off your debt; you’re in a worse position.
That is the conclusion of a rather dense paper by a quartet of Ph.D.s laboring for banking think tank the International Center for Monetary and Banking Studies.
Their paper – “Deleveraging? What Deleveraging?” – shows us that the world’s debt load is still increasing. It also tells us that “an excessive level of debt poses both acute and chronic risks.”
Nothing surprising about that…
But add in slow growth, and it puts you into a “vicious loop” in which you can’t pay down debt. The authorities try to stimulate growth. They run deficits… and lower interest rates to encourage borrowing… believing that these things will make it possible to “work our way out of debt.”
Instead, we just dig a deeper hole – increasing the risk of default, depression and deflation.
Which is why we wouldn’t be so quick to throw dirt on QE’s face. It might not be entirely dead.
And come the first alarm in the headlines – that the stock market has cracked… or the economy is sinking – we will likely see a resurrection.
Regards,
Bill
The World’s Tallest Midget
No one chart can ever give you a complete picture of what’s going on in the markets.
But the one below of the US Dollar Index going back to the start of the year comes pretty darn close.
Source: StockCharts.com
When it’s rising, it means the dollar is strengthening versus its currency rivals. When it’s falling, it means the dollar is weakening versus its rivals.
This year, the index has been on a tear. It’s up more than 8% from its 52-week low. And it is up nearly 20% over the past three and a half years – a huge move higher.
This is partly a reflection of a better US economy, which grew at a rate of 4.6% in the second quarter. But mostly it’s about weakness overseas. As former Merrill Lynch economist David Rosenberg recently put it, “America is receiving the trophy for being the world’s tallest midget.”
Look around the world and you see deflation and recession risk in Europe… a slowdown in China… debt and demographics issues in Japan… and lots of political uncertainty in the big emerging markets (Russia and Brazil being two notable examples).
This has caused capital to flow stateside… lifting the dollar with it.
Add in the winding down of QE in the US… and the continuation of money printing in the euro zone and Japan… and you have all the ingredients for a sustained dollar rally.
This has a number of important implications for investors. My top three are:
1) Foreign stocks will struggle – When the dollar is strong, earnings in relatively weak foreign currencies are worth less in dollar terms.
2) Emerging-market bonds will come under pressure – Dollar strength means US investors won’t have to invest in what are still widely seen as “riskier” emerging markets for returns. Emerging-market bonds are particularly vulnerable, as the positive currency effect of stronger emerging market currencies is now becoming a drag on returns.
3) Commodities are in trouble – Commodities are priced in US dollars. That means a rise in the dollar tends to correspond to a fall in commodity prices – one of the reasons crude oil has fallen by about -25% since April 2011. This is net positive for the US economy, which will see the cost of energy inputs fall… and where imports exceed exports by about 20%. It’s bad news, on the other hand, for big commodity exporters such as Russia and Brazil.
If you’re based in the US, this is also a great time to book a foreign vacation. Hotels, car hire, dining out – all will be cheaper for you in dollar terms.
Make the most of it while it lasts…