Will the QE trick continue?

Economist Andrew Hunt has recently visited the United States and reports back on the impact of Quantitive Easing and the conflicting views of when it should end.

Monday, December 9th 2013, 11:59AM

by Andrew Hunt

At the beginning of the year, many analysts and commentators were expecting not only an acceleration in the US’s rate of economic growth but also a significant recovery within the beleaguered Eurozone economies.

Unfortunately, neither of these forecasts have come to pass and even in Japan, in which hopes for this year had also been particularly bright, we have found that the latest growth figures have tended to disappoint rather than excite. In the emerging markets, there have been disappointments – bordering on crises – in several of the currencies and economic growth has suffered in many of the countries as a result.

However, despite these various growth disappointments, global equity markets have in general continued to perform well this year.

We firmly believe that the reason for this dichotomy between the behaviour of the risk markets and the underlying economies continues to reside with the central banks. For example, at present the US Federal Reserve is continuing to purchase more than a trillion dollars of debt securities per annum and in so doing the Fed is implicitly absorbing much of the supply of “high quality” bonds from the markets.

The sellers of these Treasury and mortgage bonds are then left with something of a dilemma as to what to do with their money and their solution has been to purchase modest quantities of equity mutual funds; to invest more in the housing market (the rise in house prices that has occurred is due to a flow of savings into the market rather than an increase in mortgage borrowing); to buy very significant quantities of domestic corporate bonds; and there has also been a sizeable flow by savers into foreign securities (chiefly bonds but also some equities).

In the case in which the investors have moved into foreign asset markets, they have naturally impacted not only asset prices in those countries but also the currencies. Interestingly, we find that these investor inflows have often continued even into some of the countries that have been experiencing weak currencies and a loss of growth momentum, which helps to explain why some of these equity markets have continued to prosper even as their economies have weakened. In some respects, it seems that these QE-inspired fund flows can be quite blind, or at least driven by faith rather than fact...

When the displaced investors from the Treasury bond markets have moved into the US’s domestic corporate bond markets, though, they have created an environment in which many companies could issue huge quantities of corporate bonds almost at will. In theory, the companies concerned could have used the funds that they were raising in the debt markets to finance an increase in their level of capital expenditure in the real economy but in reality the companies used the majority of the funds to either buy in their own equities or to offer their shareholders higher dividends.

This strategy led to upward pressure on the companies’ share prices (and to a useful increase in managements’ employee share option prices) although as we have noted it did relatively little for the US real economy. Hence, economic growth has not lived up to expectations but equity prices have nevertheless come under upwards pressure as the available supply of equity has been reduced.

There is a school of thought – to which we would subscribe and which seems to be gaining prominence amongst some of the staffers and advisors in the Federal Reserve – that believes that Quantitative Easing is making it so “easy” for companies to indulge in this type of “financial engineering” (what the Japanese used to call “zaitech”) that it is implicitly crowding out real investment within the economy, while at the same time it is also encouraging companies to over-gear via the corporate debt markets, something that could impact their long-term financial health and stability.

Therefore, there is a movement within parts of the Federal Reserve System to taper or even end Bernanke’s QE despite the adverse impact that such an event might have on the financial markets in the near term.

This is not, though, a view that is shared by all of the staff or even the Board of the Federal Reserve (FRB).

As we found during our last visit to the US, there are some on the FRB who still believe in the “wealth effect” as a route to an economic recovery and therefore they wish to continue with QE and the impact that this is exerting on asset prices despite any long run costs that this may create within the economy.

For our part, we have long been skeptical about the effectiveness of the wealth effect and suspect that its true impact is relatively negligible unless households can indulge in home equity withdrawal by borrowing more through the housing credit markets than they actually invest in the housing stock itself. At present, there are no signs that home equity withdrawal is occurring in the US (in fact, the reverse is occurring) and hence we suspect that any wealth effects from the impact of QE on equity and even house prices will be quite modest.

A more substantive reason why the Fed may not wish to taper its bond purchases is that as a by-product of the ongoing regulatory tightening in the US (the ultimate extent of which, amazingly enough, is still not clear as a result of the seemingly endless political wrangling) the US commercial banking system is continuing to deleverage and to shrink its balance sheet. This continued deleveraging and balance sheet contraction within the banks is, in effect, destroying liquidity with the result that the Federal Reserve, or more particularly its asset purchase programmes, are now the only source of liquidity growth within the economy. Therefore, it can be argued that if the FRB were to cease its QE, the US would face what we might term a “monetary cliff”.

Quite simply, when we left the US earlier this month, we felt that we had visited a country in which not only were there deep divisions within the political elite over the course of fiscal policy but that there was also some uncertainty over just what the Fed wants to do.

Bernanke and Yellen have seemed quite definite that they wish to continue with QE and forward guidance until employment and indeed inflation pick up and this is probably a predominantly ‘East Coast’ view but, as one moves further West one begins to encounter a different perspective from some of the regional offices of the Fed.

For the financial markets, this increased level of monetary policy uncertainty is not ideal but we suspect that “when push comes to shove”, the Bernanke-Yellen axis will likely prevail and, as a result, any tapering of QE will ultimately occur later rather than sooner (and certainly Bernanke will not want to taper before he officially leaves office) but what we do suspect is that the regional Federal Reserves will from time to time “leak” relatively hawkish stories that could alarm markets on occasions.

We therefore expect the QE-driven rally in financial markets to continue for a while longer, even as global growth continues to disappoint – in part because of the crowding-out effects of QE itself – but markets may from time to time continue to face moments of tapering tantrums.

In the longer term, we must wonder just how long the financial markets can really continue to divorce themselves from economic reality but, as the mid-2000s showed, these “trial separations” can run for years rather than months...

Andrew Hunt International Economist London

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