The Federal Reserve recently announced that it would purchase up to $600 billion of US Treasury bonds in a program known as "quantitative easing", which is a fancy way of saying "printing money". This is actually the second bout of quantitative easing since the financial crisis, and thus this round has earned the nickname "QE2". The policy of printing money is a blunt economic instrument, with wide range of consequences, known and unknown. The announcement of the policy has attracted no shortage of critics, from World Bank President Robert Zoellick, to Sarah Palin, to the leaders of Germany, Japan, China and Brazil. All deride it as inflationary currency manipulation.
The Fed's ultimate goal is to prevent a Japan-like malaise of falling prices and shrinking consumption from infecting the United States. With short-term interest rates at zero, the Fed can't lower short-term rates any further. By printing money to buy longer-dated treasury bonds, the Fed accomplishes two things. First, by increasing the supply of money, it decreases the value of the dollar which helps create positive inflation. Second, by reducing interest rates of "risk-free" investments like cash and treasuries to below the rate of inflation, those investments become money-losers in inflation-adjusted terms. The goal is to bribe savers to shift investments from cash and treasuries into "risky" investments like corporate debt, equities and real estate and also into near term consumption of goods and services.
Pushing on a string in the US
There are three major problems with this policy. Americans are unlikely to increase their consumption markedly, given that they are determined to rebuild their savings after years of under-saving. In addition, real estate suffers from a massive debt overhang and isn't likely to truly recover for years. Businesses will gradually increase their investment, but generally act in their own interest and can't be forced into making investments they wouldn't otherwise make. For these reasons, the Fed's war on domestic savings will not likely be successful. In economics parlance, the Fed is "pushing on a string". Instead, we are seeing a shift of savings from investments that have a negative real rate of return (like cash and bonds) and into those that are considered inflation hedges like precious metals and commodities like oil, wheat and cotton.
Taking the fight to China
The second front in the Fed's war on savings is against the biggest saver in the world: the Chinese government. The Chinese government has systematically manipulated the world trade markets by recycling its export earnings into US dollar-denominated assets instead of into US-dollar imports. By mathematical equation, this results in a trade surplus in China and a trade deficit in the US. In the past decade, China has accumulated over $2 trillion of US-dollar reserves. By increasing the supply of US Treasuries and by holding interest rates below the rate of inflation, the US is essentially taxing Chinese savings. The weak dollar also pushes up the currencies of countries that compete with China, not only those of emerging market economies, but also currencies like the Japanese Yen and the Euro. China, Japan, Brazil, Korea, etc. have all been using export promotion policies like currency suppression to enrich themselves at the expense of exporters from the United States. The Fed is finally saying "Two can play at that game".
The current long-term trend of artificially-suppressed interest rates, a weaker dollar and higher commodities will play out until the world cries "uncle!". No one knows when this will happen, but when it does, the current trends will be reversed.
Economic growth ahead
The Fed has clearly learned the lessons of the Great Depression and of Japan. The TARP and the first round of quantitative easing were designed to prevent a second Great Depression, and were successful. QE2 is designed to prevent a repeat of the past two decades of deflationary malaise in Japan from occurring in the United States. If the Fed is determined to prevent deflation, they will. The downside, because there is no "free lunch" in economics, is a weaker currency on a relative basis (next to other paper currencies), and on an absolute basis (relative to precious metals and commodities). The decline in the dollar pushes up the prices of imported consumer goods and commodity products like food and gas, even while overall inflation may be tame. This hurts low-to-middle income Americans most of all.
Looking at the interest rate complex, we can see that treasury rates are far below their equilibrium levels, with the exception of the 30-year treasury. Treasury Inflation-Protected Securities are showing negative yields right now, which is a sign that investors expect the Fed to be successful at maintaining positive inflation. The 30-year, which is the least manipulated issue on the curve, is expecting inflation to average 2.6% over the next 30 years, which is over the Fed's target range.
Source: Vanguard Funds, Bloomberg Treasury Rate Data, tylernewton.com
These rates are even lower than what prevailed at the time of my last post on July 11, 2010 (when I declared that there was not much more fun to be had in the fixed income markets…oh well).
So while the treasury complex is artificially over-priced, risk assets like corporate bonds, high yield bonds, muni bonds and equities are priced at above-equilibrium "spreads" over treasury rates, even if nominal yields are below equilibrium levels. If you are a long-only investor, it would be better to keep your fixed income investments in less-volatile shorter term maturities. If you are the type of investor that can short the appropriate treasury while going long on corporate, high yield and municipal bonds, you can enjoy better-than-equilibrium returns.
The rise in long-term inflation expectations explains the rise in the equity market since July.
Implied market returns
The implied long term return on equities is 2.4 percentage points higher than the yield on the 30-year treasury, versus an equilibrium spread of 2.3 percentage points. (This equilibrium spread is based on an after-tax equilibrium spread of 4.5 percentage points above the after-tax return on the 30-year treasury. Because equities are more tax efficient than treasury debt, the nominal equilibrium spread shrinks to 2.4 percentage points.) Note that I use a lower spread than the 6% or so often used in valuation textbooks.
Equities are a decent buy at this point if you believe that the Federal Reserve's policy of quantitative easing will be successful at increasing long term inflation expectations, weakening the dollar and supporting economic growth. So far the price of the 30-year treasury bond and equities are telling you that the market thinks that quantitative easing will be successful.
The value of the dollar also shows that the market believes that quantitative easing will be successful.
Major Currencies Index (nominal)
Broad Currencies Index (real)
Both measures of the dollar index are trading at the bottom of their long term ranges, which means that further upside in foreign currency trades may be limited.
Gold and commodities
Both gold and commodities reflect the effects of quantitative easing.
On a relative basis, oil and other commodities are cheap relative to gold.
Source: economy.com, calculations by tylernewton.com
Conclusion: A crowded trade?
In the past week (November 8-12), the QE2 trade has been reversing itself. Treasury yields and the dollar have been rising and gold and stocks have been falling, reflecting a classic "buy the rumor, sell the news" situation. The QE2 rally reflected a liquidity-driven rally, where everything except the dollar (stocks, bonds, commodities, and foreign currencies) goes up, and since November 8, we've had a classic withdrawal of liquidity trade, with everything except the dollar going down. This is different from a crisis trade, during which treasury bonds would also rally.
Possible reasons for the break in the markets this week:
- European debt – In the past week, we've had the glimmerings of a renewal of the European debt crisis, as the yields on bonds of Ireland, Greece, Spain, etc. have returned to records relative to German bonds. If a renewed sense of fear regarding Europe were driving the markets, then we would see treasuries rallying, which we are not.
- China slowdown – Another possibility is fear that QE2-induced inflation in emerging markets, particularly China, is forcing them to take unpredictable actions to slow their economies, fight inflation and/or erect capital controls. This is a distinct possibility, although I would expect such a scenario to lead to a decline in the dollar, which we are not seeing.
- QE2 letdown – The markets may have been disappointed with the size of the QE2 program ("only $600 billion versus $1 trillion or more). This could be true, which would also support the following scenario.
- Just taking a breather – The markets are just taking a breather after a good run.
The balance of risks tells me that the markets are likely transitioning from a liquidity-driven phase to a phase that will discount moderate-to-strengthening economic growth. Such a scenario would favor equities and commodities and support the spreads of risk assets over treasuries. The valuation level of domestic equities is relatively high, however.
QE2 will continue to drive investors into emerging markets, which will likely to blow a bubble in emerging markets stocks and commodities. I don't think emerging markets stocks are cheap, but the "story" will likely stay favorable for some time.
As the current market pullback runs its course, I will likely trim a few of my precious metals (gold and silver) positions and add other commodities (a net neutral change in the commodity weighting for the whole portfolio). I will trim a bit of my foreign bond positions (which I added last quarter) and add foreign stocks. I remain neutral/underweight domestic equities at levels above $1,000 on the S&P 500. I remain neutral on bond duration in the US.
Waiting for "regime change"
I suspect we are in the last phase of "casino capitalism" in the international capital markets. While the leaders of the G-20 couldn't agree to anything last week, it is only a matter of time before the international currency and trade system slams into a wall of nationalism. At that point, international regulation of currencies, trade flows, bank leverage and hedge funds will become widely accepted to save the real economy from the whims of the financial economy. The financial system is meant to serve the real economy, not the other way around. The transition to the new system will be messy, so stay on guard in the meantime. Be conservative in your investment decisions, don't be afraid to hold cash and don't be a hero. I still have a strong suspicion that the best investment opportunity still lies ahead.
I am not a financial advisor, and write these columns for personal enjoyment only. Please consult your own investment advisor before acting on any recommendations you find on the internet.