Monday, 24 September 2018

A QE rally in search of Main Street confirmation

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While we may want to enjoy the quantitative easing-fuelled rally while it runs, it is probably best to remember that sometime, perhaps soon, a bull market will depend on improvement in the real economy.

James Saft, Reuters Columnist

We’ve had our fun, and central banks globally have actually achieved a lot, but there are good reasons to believe that this time QE will have even more trouble creating carry-through in the world outside financial markets.

The Fed’s pledge to buy US$40 billion a month in mortgage debt until morale improves is just part of the picture, undergirding a rally which is getting support from central banks around the world.

Perhaps the biggest help has been from the ECB, which has said it will buy debt from euro zone countries, a move interpreted as taking a euro breakup off the table, at least temporarily. And the Bank of Japan this week weighed in with another US$1 trillion or so in planned asset purchases.

That’s driven the recent rally, and more significantly, the anticipatory climb in risky assets we’ve enjoyed in recent months.

The key question then is whether there is something special about the Fed’s commitment being open-ended. Will that give investors more faith, so that if the economy still looks sluggish in December they don’t sell stocks?

“Equity markets have closely tracked economic growth indicators in this cycle; however, over the last few months this relationship has started to break down as equities have rallied substantially despite continued weak macro data,” Graham Secker, a strategist at Morgan Stanley in London writes in a note to clients.

“Much of this divergence is likely due to investors’ hopes for monetary policy intervention, which has duly been delivered by the Fed and ECB. While the latter provides scope for a tactical rally, its sustainability depends on an improving economic growth outlook,” the note said.

Secker argues that, though circumstances are quite different now from other recent episodes of QE, the initial response may be similar. Price/earnings multiples may expand, investor sentiment will improve, bond yields fall and perhaps, despite recent movements in oil, commodities prices will rise.

To be sure, there is evidence that past extraordinary Fed interventions did actually result in better economic data, with an unusually slight lag, including better labour market conditions, improvement in manufacturing surveys and better consumer confidence.

Two important concerns arise: first, those improvements didn’t sustain themselves, and second, conditions are considerably different this time.

Different this time

One important area is financial conditions. Consider the VIX, an indicator of expectations of volatility on financial markets.

Investors hate high VIX readings because volatility scares them and can cost them money. Just by reducing the VIX by calming investors during the height of the crisis, the Fed was able to have a big impact on markets and potentially the real economy. When the Fed took extraordinary measures in 2008 and 09, the VIX was first in the 60s and then in the 40s, exceptionally high levels historically. It stands today at 14, about at the level you might find in a coma ward, so expecting much bang for the Fed’s buck from that quarter is unwise.

Similarly, with mortgage rates already near record lows before the Fed announced its plan, it is hard to say financial conditions in the U.S. were tight. Some borrowers clearly will get a benefit, but many who couldn’t borrow before because of balance sheet issues will still be in the same position. As well, a very flat yield curve may mean banks have a perverse incentive not to make loans, which will not be terribly profitable, but instead to speculate in financial markets.

Finally, equities were rallying well ahead of the Fed’s move, meaning that there won’t be the same kind of shock and benefit that can come from turning markets around.

Everyone has learned, well, how to play the Fed easing game, and I’d say that the rule is not, as in the old days, “Don’t fight the Fed” but rather “Get in early and then get out.”

If we don’t see improvement in the underlying economy those expanded stock market multiples will begin to look pretty stretched. None of this is to say that that improvement can’t or won’t come, but it really looks as if counting on it is expecting the QE to work better this time, because it will be operating in an environment in which there is less panic and easier conditions.

The key question then is whether there is something special about the Fed’s commitment being open-ended. Will that give investors more faith, so that if the economy still looks sluggish in December they don’t sell stocks?

Possibly, but at that point we might have to accept that the law of diminishing returns still applies if you keep doing the thing which works less and less well.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at

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