So rather than get into the details of why central
bank policy is hollowing out underlying economies, let’s just worry about …
The Short-Term Consequences
Fed Chairman Ben Bernanke’s comments early this week drove risk appetite higher. But in comments a few weeks prior, his lack of clarity on the subject of quantitative easing made some (me included) assume that the Federal Reserve would be sitting on its hands for a while to see how things in the economy played out.
Yes, I know what happens when you assume!
Bernanke made it clear this week that should risks arise and call into question the structural solidity of improved U.S. employment figures, the Fed would not hesitate to take additional action.
Moreover, we cannot yet be sure that the recent pace of improvement in the labor market will be sustained. The decline in the unemployment rate may reflect, at least in part, a reversal of the unusually large layoffs that occurred during late 2008 and over 2009.
To the extent that this reversal has been completed, further significant improvements in the unemployment rate will likely require a more-rapid expansion of production and demand from consumers and businesses … a process that can be supported by continued accommodative policies.
One of three things could explain this flip-flop policy:
- Bernanke is worried the economy is set to lose its recovery momentum,
- Bernanke is worried the markets are set to lose their QE momentum, or
- Bernanke is worried the government is set to lose its borrowing momentum.
Let’s focus on the first two, because …
Bad News for the Economy Has Meant Good News for Markets
So if the economy loses its recovery momentum and the Fed steps back in, is more QE an overall bullish force for the markets? Or if the economy doesn’t lose its recovery momentum and jobs are not qualified as being in structural decline and the Fed doesn’t feel the need to step back in, is economic recovery still an overall bullish force for the markets?
Bad news for the economy (implying officials must take action) has meant good news for markets. It sounds perverse, but it has very much characterized investor perception in the era of quantitative easing and stimulus.
From there you might then assume good news for the economy (implying officials stand down) means bad news for the markets. It could, but odds are you’d be wrong with that assumption. Improvement in the economy might alter the speculative nature of the markets, but economic growth is ultimately supportive of the markets.
Is It Really a Win-Win Scenario? It Seems Like It
Honestly, considering how things have played out since the credit crunch, the way markets have behaved despite constant and significant economic risk, it’s hard to build a scenario where stock markets, or risk assets in general, fall.
Global central banks wouldn’t have it any other way. It’s as if they can do no wrong.
This week we learned about the nature of the latest European Central Bank funding. Specifically, the money from the ECB that’s been pushed to the banks has not made its way into the real economy in the form of loans to businesses and households. The only thing new here are the updated figures; we’ve known for some time that stimulus and accommodation have been about shoring up insolvent banks and stabilizing periphery debt. After all, bond yields have been a major driver of European markets and a crucial gauge of investor sentiment.
And though it appears the lack of credit in the real economy is a problem, since the euro zone is already faced with insurmountable risks to growth, the markets could continue to ignore the growth factor in favor of monetary accommodation via the ECB, firewalls, the ESM, and whatever other bailout concoctions are in play.
Again, as bad as everyone realizes things could get, the only thing that seems to matter is that something (regardless of its efficacy) will be done about it.
If I had to develop a scenario where markets perform poorly for a protracted period of time, it would contain some combination of these elements:
1. An environment characterized by unsustainable debt. More specifically, it would be an environment where investors actually become worried about unsustainable debt particularly in the U.S. or China (since the euro zone’s unsustainable debt is pretty much old news). Recognition by the public of unsustainable debt, and only this recognition, could put a stigma on further monetary accommodation, rendering it ineffective in its stated and unstated goal. After all, global debt is outpacing global growth with ease:
And as shown below, central banks are very over leveraged at this point:
2. A blow-up of global derivatives. The 2008 financial crisis was pinned very much on the systemic nature of global derivatives, i.e. banks exposed to questionable financial assets created a severe counterparty risk that left other banks and financial institutions exposed in a big way. The top four biggest banks in the U.S. hold roughly 95 percent of $250 TRILLION in U.S. derivatives exposure.As of the most recent report from the Bank of International Settlements, global derivatives rose to a record $707 trillion in 1H 2011. Back to the U.S. banks, their exposure to Europe is key here: The BIS reports that U.S. banks hold $641 billion in loan exposure to the European periphery nations.
Who, at this point, barring a major concern from something as just described above, isn’t going to side with the gravity-defying forces of quantitative easing?
Assuming accommodation from central banks remains on the table, it’s going to take a major shift in monetary policy or global growth expectations before investors start fleeing risk assets in a significant and lasting way. We saw some softness across markets this week. It’s possible we get a playable move lower in currencies, partly technical-driven and partly overdue.
But without a substantial fundamental catalyst, it will probably amount to nothing more than a new buying opportunity if you are playing along with central banks.