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"We Should Have Known Something Was Wrong"

Remember when stuff such as the following was written exclusively on "conspiracy" tin-foil blogs by deranged lunatics who could not appreciate the brilliance of the neo-Keynesian system and central-planning by academics, in all its glory? Good times.

Here is Bank of America's Athanasios Vamvakidis channeling Tyler Durden circa 2009

The real cost of QE

QE was not a free lunch after all

If only it was that easy to print our way out of a global crisis. Eight years after the crisis, we are still debating about whether the recovery has gained enough of a momentum to allow exit from crisis-driven policies and start hiking rates from zero. The world economy has actually lost momentum this year (Chart 1), deflation risks have increased (Chart 2), and EM indicators and overall market volatility have reached crisis levels (see Chart 3). All this is despite unprecedented expansion of central bank balance sheets (Chart 4). Things may have been worse otherwise, but in hindsight we believe relying too much on unconventional monetary policies was not a free lunch after all.

We should have known something was wrong

The Fed “taper tantrum” could have been the first warning that QE had gone too far. The Fed’s announcement in June 2013 that they would consider tapering QE, contingent upon continued positive data, triggered a sharp market sell-off, particularly in EM. The aggressive search for yield, which intensified after the Fed announced QE3—or QE infinity as markets called it—came to a sudden stop. QE was not for infinity after all. The Fed tried to reassure markets that QE tapering was still policy easing and that its end would not imply rate hikes immediately, but the markets apparently thought otherwise. A key takeaway was not that QE had already gone too far, but that announcing its tapering may have been a mistake. The Fed waited until December to start tapering, although the market had already priced its beginning in September.

The second warning sign may have been the across-the-board EM sell-off that started in mid-2014, as QE tapering was coming to an end and the market started pricing Fed tightening, a sell-off that intensified substantially this year. EM FX tends to underperform when the Fed tightens and the USD strengthens, but by early 2015 the EM FX index had reached a level below that during the global financial crisis (Chart 3). China’s devaluation made things worse in August, but the EM sell-off started much earlier. Risk assets more broadly have reached oversold levels. The market has been anxious about Fed hikes, despite pricing a very slow tightening and expecting interest rates to remain historically very low for years to come.

The point when things started going wrong

The Fed and other major central banks were the first to act when the global crisis started, and we believe their actions helped avoid another great depression. Political disagreement and brinkmanship led to a messy fiscal policy in the US and a neverending Eurozone crisis. The Fed and the ECB, successfully, came to the rescue a number of times in recent years. In Japan, the BoJ has delivered the strongest arrow from the three arrows in Abenomics, with mixed progress in the arrow on structural reforms and no progress in the arrow on fiscal sustainability. However, monetary easing is not the solution to every problem and risk in an economy – and we believe that using it when other polices may have been better used has its own costs.

At some point during Fed QE, the markets started reacting positively to bad news. In our view, this is when things started going wrong. Bad news became good news for asset prices, as markets expected more QE by the Fed. Asset prices were increasingly deviating from fundamentals, as the markets were trading the Fed instead of the economic reality. This was clearly not sustainable.

We believe QE1 by the Fed (Nov 2008) was a necessity. Without it, the world economy was heading to a new global depression. The Fed, led by the world’s expert on the great depression, did what needed to be done. The ECB took the opposite approach, avoiding QE and even hiking rates in the midst of the global crisis and again in the midst of the Eurozone crisis. The crisis got worse, the Eurozone economy still had the largest output gap in the Q10 group, and deflation forced the ECB to finally start QE this year. We are more skeptical about QE2 (mid 2011). The world had avoided a second great depression by that point. The justification was to address deflation risks and support the recovery during deleveraging. It was not clear cut—US inflation was above 2% and core inflation only slightly below—but one could see the Fed’s point taking into account the risks and empirical evidence that recoveries from balance sheet recessions are very slow. QE2 was not trying to address depression risks, but to avoid a Japan scenario. As such, we think QE2 was needed, albeit less so than QE1.

However, we are less sure about QE3. We believe this round was intended to support asset prices, with the idea that high asset prices would lead to a stronger recovery. Instead, Wall Street was increasingly deviating from Main Street, inflating asset prices. Equity prices started pointing towards a strong recovery, while bond prices were flagging a Japan scenario for the next decade. Both could not be right, and both turned out to be wrong. The recent sell-off suggests to us that the Fed underestimated the risks from strong EM inflows because of QE.

While we will of course never know what would have been had other policies been pursued, we believe that excessive reliance on unconventional monetary policies in recent years has had side effects. The recent market turmoil has shown that macroprudential measures have limited ability to deal with such side effects. Indeed, despite continued central bank balance sheet expansion (Chart 4) and further easing by most G10 central banks from already historically low policy rates (Chart 5), monetary conditions have tightened in most G10 economies (Chart 6) and global liquidity conditions have worsened this year (Chart 7). No macro-prudential measures could prevent this from happening, in our view.

We wouldn’t necessarily look at QE as the root of these issues. Less QE might have been necessary if US fiscal policy wasn’t so fractious, Europe had been faster to respond to the crisis, global policy coordination was stronger, and governments worldwide had grasped the “opportunity” of the crisis to implement structural reforms and progress in trade agreements. As the IMF has warned, we believe the world put too much burden on monetary policy. We have started seeing the consequences this year.

The above has lessons for both the Eurozone and Japan looking forward:

  • ECB QE has led to historically low periphery yields, which are not pricing sovereign risks—just think where Greek yields are going to be if the ECB starts buying GGBs. When at some point in the (likely distant) future the ECB stops QE, the adjustment in the periphery yields is unlikely to be smooth, particularly if the countries in the region have not taken advantage of the ECB easing to implement reforms. These concerns would not justify stopping ECB QE early, but we believe they do point to consequences when central bank policies force markets to ignore risks for too long and governments are not addressing these risks in the meantime—recent reform progress in Italy is encouraging from this point of view.
  • Japan could face challenges if delivery of the non-monetary “arrows” in Abenomics remains so weak. In our opinion, Japan needs structural reforms to grow and a credible long-term fiscal consolidation plan to ensure debt sustainability. We believe aggressive BoJ QE is currently kicking the can down the road, but these problems could eventually come back to haunt Japan.

Now what?

The story of the year so far may be that of a negative feedback loop leading to a bad equilibrium. First, risk assets sold-off expecting the Fed to tighten. Then, the sell-off went too far and started affecting the real economy, including in the US. Now, the Fed is not tightening as a result. However, postponing Fed tightening does not necessarily increase the demand for risk assets. We are oversimplifying, and there are certainly many other things going on, but it helps make the point.

This appears to be a new regime, in which bad news is bad news, as we wrote a year ago and reiterated recently. Fed QE does not appear to be coming to the rescue anymore. The Fed staying on hold can support risk assets in the short term, but is not as strong as QE. This is an environment with high market volatility, as the so-called central bank put is less powerful without Fed QE. ECB and BOJ QE apparently cannot do the trick. Bad news is supposed to be bad news and this should be a healthier market than before, but the adjustment back to normal has not been, and in our view is not going to be, easy.

Risk-on recommendations are only tactical. If the US data improves in the months ahead, the Fed will likely tighten and risk assets could sell-off again. If the US data remains weak, or weaken even further, we would expect risk aversion to increase, as the threshold for QE4 by the Fed appears high—and more QE may not be as effective anymore.

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And that, dear Janet Yellen, is how you trapped yourself in reflexivity from which there is no way out. Now if only someone could have possibly foreseen all of this years ago...