Quantitative Easing - Do The Markets Understand It
Japan and the US – Contradictory Reactions to QE
The reactions of the US and Japanese bond markets to announcements about quantitative easing (QE) were inconsistent, to say the least. In Japan, the announcement of a massive new QE program brought about an instant increase in Japanese Government Bond (JGB) yields as rates doubled (to admittedly still paltry levels below one percent.) So in Japan the introduction of QE brought a rise in rates. But in the US things were different. Just a hint from the Fed that QE would be “tapered” also brought an instant rise in rates. (To admittedly still paltry levels of less than 2.7%)
So why these contradictory responses?
Japan’s Last Fling with QE—Did It Make Any Difference?
The Bank of Japan’s (BOJ) first QE program, with encouragement from Milton Friedman, lasted from 2001-2006. The general view, at least until Abenomics came along, was that this first round of QE did not do very much in the way of stimulating the Japanese economy.
Be that as it may, in late 2005 the BOJ announced that QE would be eliminated in 2006. The results were similar to the recent US response. Long rates spiked upward and the Japanese stock market, which had been rallying for the prior three years, suffered a twenty percent decline. The yield on 10 year JGBs spiked from nearly 1.2% in mid-2005 to 2% in May 2006. But these results proved temporary. JGB ten year yields then began an irregular but consistent seven year decline to the pre-Abenomics levels below 50 basis points last seen in early 2013. The Nikkei 225 resumed its rally until the global economic crisis of 2008 intervened.
10 Year JGB Yields
So the simplistic conclusion might be – and sometimes in economics the simplistic conclusion is as good as any – that once the markets figured things out, the withdrawal of QE in Japan in 2006 really did not make that much difference. After a one time panic adjustment, JGB yields continued downward and the stock market resumed its upward trek.
A Close Look at QE
My general conclusion is that, other things equal, introducing QE is stimulative and therefore potentially inflationary. Withdrawing it is contractionary and potentially deflationary. Of course if QE is introduced during a period of substantial economic slack no inflation may be visible. If QE is withdrawn during a period of economic revival, this action’s contractionary effect may not be visible.
In my opinion central banks are not really banks. They are government agencies in charge of printing high powered money (bank reserves plus currency). Depending on the country, central banks also are usually assigned a variety of bank regulatory functions. You constantly read in supposedly sophisticated financial publications how the Fed or some other central bank’s balance sheet is deteriorating. This is nonsense. The Fed’s balance sheet is irrelevant. The Fed can always print high powered money and bail itself out. For historical reasons, the balance sheet and income statements of central banks are not consolidated with the accounts of the central governments. But they should be since from an economic (as opposed to a legal) point of view they are a part of the government even if from a policy perspective they are independent.
Assuming that in economic reality central banks are part of the government, central bank QE affects the economy in three ways – government funding, government spending and the money supply.
Government funding – QE is free funding for the government. No taxes, no borrowing with a need to pay principal and interest. Call it pure expropriation of resources if you want. Keynesians will argue that this is great in periods of substantial economic slack when stimulus is needed. Non-Keynesians are appalled.
Government spending – Without getting into the intricacies of government budget and GDP accounting, the general principle here is that activities like purchasing government bonds would be consolidated out but purchases of private assets would be additive to overall government spending. So if QE goes beyond purchases of government securities and assets that would not be consolidated out of a government budget integrated with that of its central bank, QE is stimulative and adds to aggregate demand. Via QE, central banks as agencies of the government when they add to government spending are actually a part of governments' fiscal policy.
Effect on money supply – By now the markets have become aware that when economists talk about money they mean currency plus some measure of bank liabilities. M2 is one commonly used measure of the money supply. High powered money, i.e. the monetary base or bank reserves plus currency, is not money as economists define it. In “normal” times the ratio of high powered money to say M2 has been relatively constant. So historically this arcane distinction of monetary theorists has been of minor significance. But not since the crisis of 2008. QE has added trillions to the monetary base but the ratio of the base to M2 has collapsed. The Fed prints high powered money and it winds up back in the Fed as an excess bank reserve liability. The effect of this on the financial markets would appear to be limited. In a fractional reserve system, the Fed does not really control the money supply, contrary to popular belief. The borrowing pubic does. The money supply despite QE has not grown at the same pace as the monetary base because of the relative dearth of borrowers.
There is a fundamental question here which nobody can really answer. What would the level of interest rates be today in the absence of QE? Most market observers would instantly answer “higher”.
My own view is that interest rates in the absence of QE would not be much higher than they are today. We are in an age of global deleveraging with China slowing, Europe in recession, Japan just barely reviving and the US in a so-so recovery. At the same time, the powerful deflationary forces of accelerating technology (including fracking and horizontal drilling) and globalization (which is really a product of accelerating technology) underlie the rise in US stocks and offset the precarious state of US government finances.
The investor, who reasons that he or she can earn nothing in short term interest rate assets and opts for so-called “risk-on” assets like stocks and riskier bonds, is making a rational decision. In the risk-on world, US (and Japanese and European) multinational corporations are beneficiaries of technology and globalization and are better able than small companies to deal with byzantine government regulations. The long term risk is an ever larger inefficient and insolvent US government which “eats” more and more of the economy including the US corporations. QE is a part of that government ingestion machine.
There are two immediate investment implications for QE. First in a period of global deleveraging and excess capacity thanks to globalization and the acceleration of technology, QE is stimulative as a tool of fiscal policy even though it has had fairly limited effects in the monetary policy (money creation) area. From the conventional viewpoint of purely fiscal policy, QE should be positive for the stock market but potentially negative for bonds. But the effect on bonds will be muted when there is an overall deficiency in aggregate demand.
Second, there is the question of what the central bank is buying. In most cases, the central banks including the Fed are buying bonds. So even though QE adds to aggregate demand which in theory should be negative for bonds, it is focused on a particular asset class, i.e., bonds. This second effect may outweigh the first. Certainly that was the initial market reaction when the Fed did its taper talk.
The US stock market’s recent reactions to the Fed’s tapering hints seemed confused at best. Given that the market believes QE has brought substantially lower interest rates, it was logical that stock prices initially went down. The withdrawal of QE will be contractionary in a fiscal sense although the Fed’s plan is to only withdraw QE if aggregate demand from other sources is picking up. The bond market’s negative reaction seemed to focus on the withdrawal of Fed buying for government bonds and MBS securities. It ignored the fact that QE withdrawal other things equal would reduce aggregate demand and therefore potentially be good for bonds.
My own view is that the withdrawal of QE if done in an environment of rising aggregate demand will not make that much difference in the intermediate run for either the stock or bond markets. In the long run I believe QE is harmful in that it allocates resources to the least efficient user, i.e., the government. So the sooner it is withdrawn, the better.
When I first started writing my book (along with contributor Michael C S Wong) Investing in the Age of Sovereign Defaults here, I was convinced the US along with the other so-called advanced countries were near the end of their fiscal rope. Authors like David Stockman are definitely of that view. Countries like Greece and Ireland have used up all their rope and required bailouts to avoid bankruptcy. I am now convinced that the US has more rope than I originally thought although eventually fiscal reforms must happen and there will be “defaults” on overly generous entitlements. But the US has this extra rope in part because of its culture of freedom and technological entrepreneurship which is necessary for economic growth. This growth is a necessary ingredient to avoid fiscal catastrophe.
Investing in venture capital puts an investor on the front line of technological progress. Venture capital firms have gobbled up some of the biggest profits on deals like Facebook. But this avenue is not open to most investors. And IPOs have certainly proved to be a mixed bag for the average retail and even institutional investor who does not have the “inside” information of venture capitalists. The large global corporations are the users and beneficiaries of technology. They are “insiders” when choosing new technologies. For the average investor, investing in large global companies may be the only attractive risk-on alternative to the impossible dream of becoming a venture capitalist or IPO maven.
Alibaba – Battle for Financial Capital Supremacy and Global E Commerce Champion
Just a quick note here. According to the financial press, the largest IPO of the year — Hangzhou based Alibaba — is coming. Alibaba is a Chinese e commerce giant, comparable in a general way to Amazon or eBay. Alibaba is a huge user of technology and perhaps on its way to becoming China’s number one global corporate name. Alibaba incidentally is 25% owned by Yahoo which is the only albeit imperfect way for the average investor to buy into Alibaba pre-IPO.
Question – Will the Alibaba IPO, assuming it happens, get done in New York or Hong Kong? Will America, despite Sarbanes Oxley, its hyperactive court system and recent difficulties with getting information on Chinese firms, win this deal? (Of course, it is possible that the deal would, one way or the other, get done in both Hong Kong and New York.) If New York is left out, will policy makers in America even care? Stay tuned.