US Fed & Quantitative Easing: Will It work?
The US Federal Reserve has just announced a new programme that would expand its balance sheet by another US$600 billion over and above the present US$1.7 trillion. The Programme announced by the US Fed attempts to reinvigorate the US economy by buying bonds from now till about June 2011. The stated amount is expected to about US$75 billion a month.
There are a number of interesting aspects in this decision. At first thought, the Fed seems to have gone beyond the market expectation, but on a closer scrutiny it may not be as widely off the mark as the initial indications seems to imply. Before the decision, it was commonly expected that the US Fed would buy about US$100 billion of US Treasuries a month till about March 2010.
This round of quantitative easing has raised a number of questions (in fact there are now more questions than answers and more questions now than before the actual decision). The most important questions may be summarised as below:
1. What is the impact of this round of QE2 going to be on the US Economy, especially unemployment and housing?
2. What is the outlook for Inflation in the USA and the rest of the world?
3. What is the outlook on the US Dollar?
4. What is its impact going to be on different asset classes (including currencies, bonds, commodities and equities)?
5. Will it lead to currency wars due to competitive debasement of currencies by national states?
6. Will this lead to asset bubbles in different parts of the world?
Era of Rotating Sovereign Crisis & Rotating Quantitative Easing
We are probably living in unique times. There are a number of eerily historic similarities. The reaction of policy makers to different historic crisis over the past century has been somewhat similar. Most of the current policy makers believe that monetary policy can actually provide the solutions without actually undertaking a dramatic overhaul of the system. Infact, one would be tempted to believe that the policymakers in the US between 1890 to 1930 were actually more amenable to taking up drastic structural overhaul that actually laid the foundations for the emergence of the USA as a major power. Unlike those regulators the current regulators seem to believe that policy tinkering is sufficient to reinvigorate the US economy, despite the magnitude of the problem that we have had to face.
The easiest questions to answer are those related to bubbles and competitive debasement. It is beyond doubt this round as well as forthcoming quantitative easing by different countries will lead to new rounds of easing in UK, Japan and even the EU, if not other parts of the world. Cumulatively these rounds of easing will invariably create gigantic bubbles in almost all the countries. The only difference is that now we have entered into an era of not only rotating sovereign debt crisis but also an era of rotating quantitative easing – at least for the next 18 months if not beyond.
The most obvious impact is the new round of easing is that it is now clear that the interest rates are going to remain low well into the middle of 2012, if not beyond. I was one of those who was very clear that we are going to live with low interest rates at least well into 2011, if not beyond. It is clear that inflationary pressures in the USA and Europe will not go beyond the targeted levels till at least the end of 2012.
The more tricky questions about the possible impact of QE2 are in the arenas related to lending, employment and housing. These are analysed in greater details in the following pages.
Bernanke believes that resuming large scale asset purchases will boost economic growth by way of lower borrowing costs and higher asset prices. The justification is that this has been the case in the past and is likely to be the case in the present. Undoubtedly sound logic – at to some extent. The peculiarity of the logic is that the US, Europe and Japan have had low interest rates and abundant liquidity for nearly 2 years. If we were to believe the logic propounded by the US Fed then it the question is for how long? It is imperative to ask a pertinent question: If they actually did reduce the borrowing costs and increase growth then what led to growth tapering off over the past six months, despite all the government bailouts and all the abundance of liquidity? The rationale for the present form of QE2 seems to be on weak ground as growth as continued only as long as we have government transfers. The fact that the unemployment rate has been hovering at nearly ten percent despite nearly 2 years of near zero interest rates seems to indicate that the effectiveness of monetary easing is overstated. It is not the case of a lack of funds in the banking system. The problem seems to be that banks are not interested in lending as they are quite sure that the economic situation is such that borrowers may not be able to repay the loans and hence the believe that being prudent is likely to be more profitable than being brave.
Banks are unlikely to lend unless they foresee a long-term improvement in the business landscape, which they current do not foresee. What is likely to cause the banks to actually foresee a semblance of change? While it would be difficult to pin point the reasons, the banks (as well as Wall Street) would first like the US Administration to take up a much more pro-business environment and roll back some of the diluted regulatory measures that the present administration has now put in place. In other words, business would like the government to go back into the previous administration’s policy of back-to-business and policy non-intervention so that they can unleash their speculative fervour.
Interestingly, I would argue that the policy and regulatory regime is actually very conducive for a complete roll back of even the most diluted norms. A conspiracy theorist would argue that these deliberative measures of the banks are intentional and are an attempt to privatise profits and socialise losses.
What is the impact of QE2 likely on unemployment?
The short-answer would be that QE2 will have only marginal impact on its potential to create employment. The issue is not the availability of liquidity in the system. Infact since the inauguration of the credit crisis, it has never been a direct problem related to liquidity. It is more of a solvency issue, which has now morphed into a more conventional crisis. Banks have abundant liquidity; the only important factor is that they are not willing to lend money to non-institutional borrowers (especially individuals). Nothing in the present QE2 could change that attitude. The nature of a banker is stated to be dominated by a behaviour where they lend only when they perceive that there is a high probability that the loan will be repaid. The state of the global economy in a number of sectors does not induce that confidence from a banker’s point of view. The lack of pricing power, lack of demand and the collapse in the margins due to currency and commodity volatility means that the risks far outweigh the profits of lending. Little wonder that they are not lending to small and medium enterprises and consumers. Most of the lending goes to financial speculators or the very large corporations. As long as the banks are not willing to lend to small and medium enterprises there will be no meaningful gains in employment. This is because even in a economy such as the USA, about 50% of the job creation is by small and medium enterprises. Since they are starved of capital, it would be impossible for employment to climb in the present circumstances. Big corporations will face absolutely no problems for raising funds. This advantage for the large companies means that they are now willing to take larger risks, as can be seen from their big forays into the emerging markets and the huge jump in large acquisitions that they have proposed. It is because of this structural change that a US$10 billion acquisition barely makes a ripple in the world of finance.
Considering the fact that the US needs to create nearly 200,000 jobs each month, unfortunately it is still losing jobs. So it would hard to see what would lead to a large spurt in job creation. Unfortunately, the US Economy is still losing jobs. A very interesting illustration by the New York Times is indicative of the long road ahead for US jobs (see graphic below).
There are a number of interesting aspects in this decision. At first thought, the Fed seems to have gone beyond the market expectation, but on a closer scrutiny it may not be as widely off the mark as the initial indications seems to imply. Before the decision, it was commonly expected that the US Fed would buy about US$100 billion of US Treasuries a month till about March 2010.
This round of quantitative easing has raised a number of questions (in fact there are now more questions than answers and more questions now than before the actual decision). The most important questions may be summarised as below:
1. What is the impact of this round of QE2 going to be on the US Economy, especially unemployment and housing?
2. What is the outlook for Inflation in the USA and the rest of the world?
3. What is the outlook on the US Dollar?
4. What is its impact going to be on different asset classes (including currencies, bonds, commodities and equities)?
5. Will it lead to currency wars due to competitive debasement of currencies by national states?
6. Will this lead to asset bubbles in different parts of the world?
Era of Rotating Sovereign Crisis & Rotating Quantitative Easing
We are probably living in unique times. There are a number of eerily historic similarities. The reaction of policy makers to different historic crisis over the past century has been somewhat similar. Most of the current policy makers believe that monetary policy can actually provide the solutions without actually undertaking a dramatic overhaul of the system. Infact, one would be tempted to believe that the policymakers in the US between 1890 to 1930 were actually more amenable to taking up drastic structural overhaul that actually laid the foundations for the emergence of the USA as a major power. Unlike those regulators the current regulators seem to believe that policy tinkering is sufficient to reinvigorate the US economy, despite the magnitude of the problem that we have had to face.
The easiest questions to answer are those related to bubbles and competitive debasement. It is beyond doubt this round as well as forthcoming quantitative easing by different countries will lead to new rounds of easing in UK, Japan and even the EU, if not other parts of the world. Cumulatively these rounds of easing will invariably create gigantic bubbles in almost all the countries. The only difference is that now we have entered into an era of not only rotating sovereign debt crisis but also an era of rotating quantitative easing – at least for the next 18 months if not beyond.
The most obvious impact is the new round of easing is that it is now clear that the interest rates are going to remain low well into the middle of 2012, if not beyond. I was one of those who was very clear that we are going to live with low interest rates at least well into 2011, if not beyond. It is clear that inflationary pressures in the USA and Europe will not go beyond the targeted levels till at least the end of 2012.
The more tricky questions about the possible impact of QE2 are in the arenas related to lending, employment and housing. These are analysed in greater details in the following pages.
Bernanke believes that resuming large scale asset purchases will boost economic growth by way of lower borrowing costs and higher asset prices. The justification is that this has been the case in the past and is likely to be the case in the present. Undoubtedly sound logic – at to some extent. The peculiarity of the logic is that the US, Europe and Japan have had low interest rates and abundant liquidity for nearly 2 years. If we were to believe the logic propounded by the US Fed then it the question is for how long? It is imperative to ask a pertinent question: If they actually did reduce the borrowing costs and increase growth then what led to growth tapering off over the past six months, despite all the government bailouts and all the abundance of liquidity? The rationale for the present form of QE2 seems to be on weak ground as growth as continued only as long as we have government transfers. The fact that the unemployment rate has been hovering at nearly ten percent despite nearly 2 years of near zero interest rates seems to indicate that the effectiveness of monetary easing is overstated. It is not the case of a lack of funds in the banking system. The problem seems to be that banks are not interested in lending as they are quite sure that the economic situation is such that borrowers may not be able to repay the loans and hence the believe that being prudent is likely to be more profitable than being brave.
Banks are unlikely to lend unless they foresee a long-term improvement in the business landscape, which they current do not foresee. What is likely to cause the banks to actually foresee a semblance of change? While it would be difficult to pin point the reasons, the banks (as well as Wall Street) would first like the US Administration to take up a much more pro-business environment and roll back some of the diluted regulatory measures that the present administration has now put in place. In other words, business would like the government to go back into the previous administration’s policy of back-to-business and policy non-intervention so that they can unleash their speculative fervour.
Interestingly, I would argue that the policy and regulatory regime is actually very conducive for a complete roll back of even the most diluted norms. A conspiracy theorist would argue that these deliberative measures of the banks are intentional and are an attempt to privatise profits and socialise losses.
What is the impact of QE2 likely on unemployment?
The short-answer would be that QE2 will have only marginal impact on its potential to create employment. The issue is not the availability of liquidity in the system. Infact since the inauguration of the credit crisis, it has never been a direct problem related to liquidity. It is more of a solvency issue, which has now morphed into a more conventional crisis. Banks have abundant liquidity; the only important factor is that they are not willing to lend money to non-institutional borrowers (especially individuals). Nothing in the present QE2 could change that attitude. The nature of a banker is stated to be dominated by a behaviour where they lend only when they perceive that there is a high probability that the loan will be repaid. The state of the global economy in a number of sectors does not induce that confidence from a banker’s point of view. The lack of pricing power, lack of demand and the collapse in the margins due to currency and commodity volatility means that the risks far outweigh the profits of lending. Little wonder that they are not lending to small and medium enterprises and consumers. Most of the lending goes to financial speculators or the very large corporations. As long as the banks are not willing to lend to small and medium enterprises there will be no meaningful gains in employment. This is because even in a economy such as the USA, about 50% of the job creation is by small and medium enterprises. Since they are starved of capital, it would be impossible for employment to climb in the present circumstances. Big corporations will face absolutely no problems for raising funds. This advantage for the large companies means that they are now willing to take larger risks, as can be seen from their big forays into the emerging markets and the huge jump in large acquisitions that they have proposed. It is because of this structural change that a US$10 billion acquisition barely makes a ripple in the world of finance.
Considering the fact that the US needs to create nearly 200,000 jobs each month, unfortunately it is still losing jobs. So it would hard to see what would lead to a large spurt in job creation. Unfortunately, the US Economy is still losing jobs. A very interesting illustration by the New York Times
The present pace of job creation in the USA seems to indicate that it could take till about 2019 to recoup the jobs lost in the past recession, leave alone creating jobs that would be required to accommodate new entrants from the younger generation.
The two diagrams below are an excellent graphical illustration about the state of the current US economy. Major important segments that contributed to the GDP that are unlikely to remain while going ahead, including inventories and Federal government spending-though for different purposes. Federal Government spending is unlikely due to the recent victory of the Republicans.
The two diagrams below are an excellent graphical illustration about the state of the current US economy. Major important segments that contributed to the GDP that are unlikely to remain while going ahead, including inventories and Federal government spending-though for different purposes. Federal Government spending is unlikely due to the recent victory of the Republicans.
Source: Gluskin Sheff
Impact on Different Asset Markets
Bernanke’s logic that low interest rates could lead to higher asset prices is indeed correct, though there is a high probability that he is likely to stoke another bubble (extreme scenario). At a more optimistic scenario stocks are likely to be range bound, as they have been since August 2009. The S&P 500 has been in a range of 1000-1200 and there are very few reasons why this could change dramatically. However, they could deteriorate dramatically if perceptions change. It is pertinent to keep in mind that in the financial markets, perceptions change very rapidly – the year is quite emblematic: in January 2010, everybody was very optimistic and by September QE2 was already a compulsion.
The two important perceptions that could lead to a decline are: (1) if inflationary pressure rise over the next six months, and more importantly (2) it becomes apparent that QE2 is not working, which is likely by May-June. The other major issue that could upset the apple cart of the whole asset prices is volatility on the currency markets, which is likely to be compounded due these factors. There are no inflationary pressures in the US economy. The current marginal uptick in the prices has more to do with the rise in commodity prices (a large part of it has to do with speculative trading demand) rather than due to demand/supply factors. The rise in inflation marginally in the USA and EU may have more to do with the rise in costs rather than inflation caused by the rise in inflation. If the commodity prices do reduce then the actual deflationary pressures in the USA that have been caused by the collapsing demand may actually create panic – surely something that Bernanke would like to avoid and hence the need for QE2. Among the commodity prices, the price of food and oil has been largely responsible for the rise in inflation. There has been no improvement in the capacity utilisation in the USA since the start of the credit crisis. Considering the fact that the capacity utilisation has been helped by the inventory restocking, going forward we are unlikely to see capacity utilisation remain at the current levels. The inflationary pressures are likely to be exported: to the emerging markets, which are basically the commodity producers.
It is pertinent to note that inflation however, need not be concern for the next one year (at least), where the deflationary pressures are likely to plague the US economy. The reasons for this are more due to the nature of the global economy, where those with excess capital are likely to seek different types of investment opportunities. The nature of investments is likely to sharply divided and the debate about the direction of the asset classes is likely to increase rather than decrease. I believe that money is likely to flow into US Treasuries, commodities and as well as emerging markets (over the very short-term). Money will flow into US Treasuries for two reasons: US bonds continue to be under--owned among the US households, especially considering the US demographics. Moreover, profits from present portfolios are likely to be added incentive as to why investors may continue to hold bonds. Deflationary pressures mean that the interest rates are unlikely to rise and hence the high level of comfort for the bond investors. Moreover, those who continue to be risk averse may be more keen to stay in the USA rather than rush into emerging market bonds, where the chances for tightening in the monetary policy have just increased.
The commodity markets are expected to be beneficiaries for three reasons. One the fact that the commodity markets actually are thinly traded means that any incremental increase in the rise in money moving into them may actually have an impact on prices that is far in excess of what is desired. The last two years are instructive. New money flows of approximately US500 billion into the commodity markets over the past two years has led to a sharp jump (almost doubling) of prices in most of the commodities.
A second more important reason for the rise in the commodity prices may have more to do China demand. China which is sitting on nearly US$2.65 trillion of reserves (which is expected to reach US$3 trillion by early next year) has reinvented the economy over the past 25 years as the workshop of the world that needs to consume huge amounts of commodities just to survive. QE2 will debase the dollar and therefore demand a rethink by China on its reserves. Andy Xie has pointed out that only about half of China’s reserves are capital surplus with the remaining being mostly hot money from expatriate Chinese. China would find it more profitable to gradually increase its stockpiles of Commodities so that their manufactures continue to have some bargaining power (economically as well as geopolitically). There is however, a catch: Chinese are extremely savvy market players and hence they are unlikely to be in a hurry to ramp up. Instead they are clearly aware of the bargaining power that their purchases have, hence they are likely to be buyers of commodities in case of panics – as the past two years have shown. Hence it is likely that the commodity markets are bound to remain range bound or at best increase in sync with the increase in monetary easing rather than simply shoot up.
A third factor that may actually increase the demand for some commodity markets is likely to occur due to an increase in the rise in investment demand from exchange traded funds and other institutional investors. This is likely to be the most important source of demand. This increased demand is likely to occur only because of the debasement in fiat currencies of the world. The case of the gold and silver markets are instructive. The rise of physical Copper ETFs and silver ETFs should be closely watched. Further quantitative easing from UK, EU and Japan may actually lead to change in the demand dynamics for commodities, especially the precious metals market. Hence, I believe that investors should be open to the idea of accumulating precious metals on declines.
While the above analysis is more fundamentally oriented, on a technical basis, most of the commodity markets need to be approached with abundant caution. They are ripe for a bout of profit booking once the initial euphoria about QE2 abates. However, over the next few years commodities, especially precious metals, should become a part of ones portfolio as they are probably one of the few hedges against debasement.
A directional call on the equity markets has become more difficult. The interesting aspect of the stock market movement has been that investors have been actually withdrawing money. ICI numbers in the USA. They have pulled out nearly US$89.4 billion out of equity funds, while the S&P 500 has gone up by 45%. There has been a substantial withdrawal of money from Money market mutual funds, which seems to indicate the liquidity upsurge in the emerging market funds and the bond funds.
If money is moving out of equity market and going into bond funds, what would explain the sharp jump in commodities? Infact one would be tempted to ask where is all the money that is going into bond funds, commodity funds, as well exchange traded funds coming from? The only possible explanation for the source of such large sums of money are (a) the central banks of the world and more importantly (b) money coming out of the US money market accounts. Investors who fled all the markets in the aftermath of Lehman and placed their money in money market funds have started withdrawing the money. In the beginning of 2009 the total amount of money in money market funds in USA was about US$3.922 trillion. It now stands at US$2.806 trillion (4 November 2010). This may be one of the main answer to the rise in the commodity markets. In the case of the equity markets, the fact that there has been huge short covering (along with some investment buying) along with large scale programme trading by the big banks may provide some of the answers.
Bernanke’s logic that low interest rates could lead to higher asset prices is indeed correct, though there is a high probability that he is likely to stoke another bubble (extreme scenario). At a more optimistic scenario stocks are likely to be range bound, as they have been since August 2009. The S&P 500 has been in a range of 1000-1200 and there are very few reasons why this could change dramatically. However, they could deteriorate dramatically if perceptions change. It is pertinent to keep in mind that in the financial markets, perceptions change very rapidly – the year is quite emblematic: in January 2010, everybody was very optimistic and by September QE2 was already a compulsion.
The two important perceptions that could lead to a decline are: (1) if inflationary pressure rise over the next six months, and more importantly (2) it becomes apparent that QE2 is not working, which is likely by May-June. The other major issue that could upset the apple cart of the whole asset prices is volatility on the currency markets, which is likely to be compounded due these factors. There are no inflationary pressures in the US economy. The current marginal uptick in the prices has more to do with the rise in commodity prices (a large part of it has to do with speculative trading demand) rather than due to demand/supply factors. The rise in inflation marginally in the USA and EU may have more to do with the rise in costs rather than inflation caused by the rise in inflation. If the commodity prices do reduce then the actual deflationary pressures in the USA that have been caused by the collapsing demand may actually create panic – surely something that Bernanke would like to avoid and hence the need for QE2. Among the commodity prices, the price of food and oil has been largely responsible for the rise in inflation. There has been no improvement in the capacity utilisation in the USA since the start of the credit crisis. Considering the fact that the capacity utilisation has been helped by the inventory restocking, going forward we are unlikely to see capacity utilisation remain at the current levels. The inflationary pressures are likely to be exported: to the emerging markets, which are basically the commodity producers.
It is pertinent to note that inflation however, need not be concern for the next one year (at least), where the deflationary pressures are likely to plague the US economy. The reasons for this are more due to the nature of the global economy, where those with excess capital are likely to seek different types of investment opportunities. The nature of investments is likely to sharply divided and the debate about the direction of the asset classes is likely to increase rather than decrease. I believe that money is likely to flow into US Treasuries, commodities and as well as emerging markets (over the very short-term). Money will flow into US Treasuries for two reasons: US bonds continue to be under--owned among the US households, especially considering the US demographics. Moreover, profits from present portfolios are likely to be added incentive as to why investors may continue to hold bonds. Deflationary pressures mean that the interest rates are unlikely to rise and hence the high level of comfort for the bond investors. Moreover, those who continue to be risk averse may be more keen to stay in the USA rather than rush into emerging market bonds, where the chances for tightening in the monetary policy have just increased.
The commodity markets are expected to be beneficiaries for three reasons. One the fact that the commodity markets actually are thinly traded means that any incremental increase in the rise in money moving into them may actually have an impact on prices that is far in excess of what is desired. The last two years are instructive. New money flows of approximately US500 billion into the commodity markets over the past two years has led to a sharp jump (almost doubling) of prices in most of the commodities.
A second more important reason for the rise in the commodity prices may have more to do China demand. China which is sitting on nearly US$2.65 trillion of reserves (which is expected to reach US$3 trillion by early next year) has reinvented the economy over the past 25 years as the workshop of the world that needs to consume huge amounts of commodities just to survive. QE2 will debase the dollar and therefore demand a rethink by China on its reserves. Andy Xie has pointed out that only about half of China’s reserves are capital surplus with the remaining being mostly hot money from expatriate Chinese. China would find it more profitable to gradually increase its stockpiles of Commodities so that their manufactures continue to have some bargaining power (economically as well as geopolitically). There is however, a catch: Chinese are extremely savvy market players and hence they are unlikely to be in a hurry to ramp up. Instead they are clearly aware of the bargaining power that their purchases have, hence they are likely to be buyers of commodities in case of panics – as the past two years have shown. Hence it is likely that the commodity markets are bound to remain range bound or at best increase in sync with the increase in monetary easing rather than simply shoot up.
A third factor that may actually increase the demand for some commodity markets is likely to occur due to an increase in the rise in investment demand from exchange traded funds and other institutional investors. This is likely to be the most important source of demand. This increased demand is likely to occur only because of the debasement in fiat currencies of the world. The case of the gold and silver markets are instructive. The rise of physical Copper ETFs and silver ETFs should be closely watched. Further quantitative easing from UK, EU and Japan may actually lead to change in the demand dynamics for commodities, especially the precious metals market. Hence, I believe that investors should be open to the idea of accumulating precious metals on declines.
While the above analysis is more fundamentally oriented, on a technical basis, most of the commodity markets need to be approached with abundant caution. They are ripe for a bout of profit booking once the initial euphoria about QE2 abates. However, over the next few years commodities, especially precious metals, should become a part of ones portfolio as they are probably one of the few hedges against debasement.
A directional call on the equity markets has become more difficult. The interesting aspect of the stock market movement has been that investors have been actually withdrawing money. ICI numbers in the USA. They have pulled out nearly US$89.4 billion out of equity funds, while the S&P 500 has gone up by 45%. There has been a substantial withdrawal of money from Money market mutual funds, which seems to indicate the liquidity upsurge in the emerging market funds and the bond funds.
If money is moving out of equity market and going into bond funds, what would explain the sharp jump in commodities? Infact one would be tempted to ask where is all the money that is going into bond funds, commodity funds, as well exchange traded funds coming from? The only possible explanation for the source of such large sums of money are (a) the central banks of the world and more importantly (b) money coming out of the US money market accounts. Investors who fled all the markets in the aftermath of Lehman and placed their money in money market funds have started withdrawing the money. In the beginning of 2009 the total amount of money in money market funds in USA was about US$3.922 trillion. It now stands at US$2.806 trillion (4 November 2010). This may be one of the main answer to the rise in the commodity markets. In the case of the equity markets, the fact that there has been huge short covering (along with some investment buying) along with large scale programme trading by the big banks may provide some of the answers.
Understanding the euphoria of the equity markets is difficult to digest considering the fact that the structural changes of the past two years is actually detrimental to the long term corporate profitability. It is difficult to fathom how rising commodity prices and declining margins in the midst of a massive debt deleveraging cycle is positive for equity markets. Valuations are quite stretched due to different reasons in different markets of the world. In the case of the USA, the valuations may be high due to the high expected earnings of the companies (which are unlikely to be met) while in the case of the East, especially in countries such as Korea and India, they are stretched due to the sharp run up in the prices. The case of India is illustrative: the price earnings ratio of the BSE Sensex is in excess of 25. Interestingly Indian markets sell at a 29% premium to the Chinese stock markets.Chasing returns in the emerging markets at the present juncture (as on 4th November 2010) is not a good idea and never has it been in the past.
Problems likely in the Currency Markets:
The problems posed by the rotating sovereign quantitative easing is going to immediately impact the currency markets. Over the next two years almost all the currencies will be debased. The only question is when and to what extent. Currencies are likely to be the next arena that is going to lead to friction among the nation states. Unlike in the past, central banks have decided that the best form of devaluation is to simply increase the supply of money. The US is no different. It hopes that it would drive the dollar down and would simply lead to an increase in the exports thereby enabling their companies to increase their profits, which would then enable them to repair their balance sheets and then increase investments. However ironic as it may seem, companies are making profits and repairing their balance sheets, but they are not investing in USA instead they are investing in other countries, especially in the emerging markets, where they are aggressively buying assets. In case of any investment in the USA, they are not investing in green field ventures instead they are simply buying existing assets.
The depreciation of the dollar is actually creating another set of problems namely pressurising the balance sheet of those who are in deep trouble: households. The rising cost of imports means that they have to pay more for food stuff and oil, which is akin to a daily tax on their pockets. Unfortunately, unlike the traditional tax, this does not stay within the national boundaries, but is instead going to the resource producing nations of the world. Their currencies have appreciated over the past one year: they face a problem of plenty. This has led to a dichotomy between the two world: a few countries facing deflation while the others face inflation. Depreciation of the US dollar will destroy the economies of the troubled European countries, especially those which are already troubled. Within six months we are bound have greater pressure on the European Central Bank, the Bank of England the Bank of Japan to start their own easing as their exporters will be trouble. This is bound to set off a chain of competitive devaluations: something that has actually been happening over the past two years. The only countries that cannot afford that are the Emerging Markets.
While the above is a likely scenario, the above scenario may not span out if the problems for Greece, Spain, Ireland and Portugal get out of hand. Therefore the key to the global economic recovery is the bond markets of USA and Europe. If there is a re-run of the sovereign debt problems (there are already murmurs about Ireland needing a bail out within 3 months). That would mean more money printing thereby leading to a fall in the Euro, taking the world economy to square one.
Buy the Rumour, Sell the fact?
However, the technical picture (especially one for the next three months) is completely different. It indicates that only is the dollar close to the bottom and the Euro is close to the levels that should already be setting off pain for their exporters. The long positions for the Euro are the highest point since early 2008, indicating that most of the bad news for the US dollar (over the short-term) may have already been factored into the price. However, if the US Dollar Index were to decline below 74 (Current level as on 4 Nov 2010: about 76) we are likely to witness a new decade low of about 70. However, very early indications are that the US Dollar may be close to a bottom. One need not be very surprised if we have a scenario where traders indulge in the classic buy the rumour and sell the fact, once the initial euphoria of the Fed easing dissipates. Hence the early part of the next week is likely to be a critical time for the financial markets of all hues.
Problems for the East:
The easing by the US Fed is likely to create problems for most of the emerging markets. These problems will be aggravated for those countries that are dependent on natural resources exports. Not only will those with an abundance of natural resources face the Dutch disease, but it will increase hot money flows leading to greater inflationary pressures (already high due to the commodity prices). The rising hot money flow means that the Central banks of the Asia-Pacific region (excluding Japan) will have to take up substantial tightening. RBI governor has clearly stated that inflation will be completely controlled in 2012 only.
There is a extremely high probability (in my view above 75%) that the major emerging markets are likely to witness their largest bubble in history. There are both positives as well as negatives in this: the positive is that it would mean that savvy investors have opportunities to take advantage of the rising tide. The downside is that, policy makers have never been able to deal with a bubble without causing pain. The larger the bubble the greater the pain that these countries have to suffer over the next couple of years. It is likely that the problems for global economy are going to be very similar to those suffered over the 2005-2008 period, though for a variety of other reasons.
Investment Strategy:
It is pertinent to note that there is going to an exponential rise in volatility across different markets and different asset classes. Volatility will only increase rather than decrease. While reflation trade may be back on the centre stage for the next few weeks, be extremely cautious. It would probably make a lot of sense for investors to actually take a serious look at various exchange traded funds (for commodities and currencies) rather than taking a direct route through the futures and options.
Interestingly the net long positions in most of the commodity markets (including gold, copper and other commodity indices) are close to their 3-5 year highs (depending on the commodity). Similarly the net long positions of the non US dollar currencies are close to the highest points they have reached since 2007. This would indicate that there may be limited upside to these asset classes and infact there could be more downside risks over the short term (next two months). The only place where the long positions are not at their all time high’s despite the run up in the price are the US Treasury markets. However, if there is a sharp bout of profit booking, it would be safe for investors to accumulate precious metals. A 10% downside could be a good time to warm up to the precious metals and commodity markets. The bigger the fall, the better.
If QE2 doesnot work (it is unlikely to work beyond a 9 month horizon) be prepared for the bottom to fall out from most of the risk assets. Unfortunately, we will get an indication of that only at the end of the May 2011.
Investment Strategy:
It is pertinent to note that there is going to an exponential rise in volatility across different markets and different asset classes. Volatility will only increase rather than decrease. While reflation trade may be back on the centre stage for the next few weeks, be extremely cautious. It would probably make a lot of sense for investors to actually take a serious look at various exchange traded funds (for commodities and currencies) rather than taking a direct route through the futures and options.
Interestingly the net long positions in most of the commodity markets (including gold, copper and other commodity indices) are close to their 3-5 year highs (depending on the commodity). Similarly the net long positions of the non US dollar currencies are close to the highest points they have reached since 2007. This would indicate that there may be limited upside to these asset classes and infact there could be more downside risks over the short term (next two months). The only place where the long positions are not at their all time high’s despite the run up in the price are the US Treasury markets. However, if there is a sharp bout of profit booking, it would be safe for investors to accumulate precious metals. A 10% downside could be a good time to warm up to the precious metals and commodity markets. The bigger the fall, the better.
If QE2 doesnot work (it is unlikely to work beyond a 9 month horizon) be prepared for the bottom to fall out from most of the risk assets. Unfortunately, we will get an indication of that only at the end of the May 2011.
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