David Tepper has sparked a monster rally today with his comments that the market is a “win win” situation. In essence, he is arguing that any economic weakness will be met with a massive round of QE that will then drive all asset prices higher. Credit Suisse recently came to the same conclusion when they listed four reasons why QE is good for the markets. They said (I’ll agree or disagree with each):
“We believe that large scale QE (asset purchases of $1+trn) would have a positive impact on markets and the economy for the following reasons:
a) It would drive down real bond yields. Each 1% off the real bond yields would add 20% to the fair value of equities on our DCF models, 10% to house prices (to keep affordability stable) and 0.5% to consumption (by lowering the savings ratio by the same amount). Above all, a 1% fall in government bond yields would reduce the amount of tightening governments need to stabilise the government debt to GDP ratio by 0.9%;
James Hamilton of UCSD has found that every $400B in bond purchases results in just 17 bps in rate change. So, if the Fed goes on to purchase, let’s say, $1.2B, we can expect a change of 51 bps. That’s real money saved. These lower rates alleviate debt pressures and certainly act as a buffer in a time of high debt levels. If the Fed can drive rates down 50 bps we can expect that to result in some higher level of risk asset attractiveness.
The problem with this argument is that we’ve been in a historically low rate environment for years now. This no different than what occurred in Japan in the 90’s. The law of diminishing returns has already sunk its teeth into the U.S. economy. In Japan we saw the same thing. Rates tanked, but had a marginal impact on the real economy as debt levels remained high and real growth remained low (REAL GROWTH IS THE KICKER HERE – AND THERE IS NONE). There was a real refinancing effect, but without real underlying economic growth the refinancing effect was essentially nullified. With weak end demand the improvement in risk asset attractiveness is essentially nullified – even if there is a short-term price adjustment in risk assets. This whole argument in favor of QE is ultimately based on this misconception that it somehow improves aggregate demand. There is no evidence of this being the case.
UniCredit recently argued that the impact on yields is likely to be even more muted – just 25 bps:
“There are, however, two factors that suggest the yield effect will be smaller than calculated. When the US central bank began with the first round of the quantitative/credit easing in autumn 2008, the financial markets were still in panic mode. In the wake of the collapse of Lehman Brothers and the escalating economic crisis, a complete collapse of the financial markets even appeared to be a distinct possibility. The risk premiums for all asset classes were correspondingly high at the time – also for Treasuries. Thanks to its resolute intervention, the Fed was able to restore a certain degree of basic confidence on the market. The probability of a collapse was averted, and the risk premium fell dramatically. Today, in contrast, the risk premium is already very low. The possible yield effect of additional quantitative easing would, therefore,come exclusively via the higher demand for Treasuries (portfolio balance effect). The second factor that suggests yields would fell less strongly than suggested by the NY Fed model is the law of diminishing returns: The more Treasury securities the US central bank already holds, the lower the effect of further purchases becomes. Net for net, we therefore assume that even a massive additional program for the purchase of Treasury securities totaling one trillion USD would lower the yield level by only approximately 25 basis points.”
CS continued:
b) The funds flow effect: put simply, a $1trn of QE gives asset allocators a $1trn of money to invest. It is noticeable that equities went up when QE started and then stopped going up when QE stopped.
This is a misleading argument in my opinion. This is a classic case of the “cash on the sidelines” argument. If a bank swaps bonds for cash the net financial assets in the system was not changed. This is the key point that most people seem to miss with regards to QE. Therefore, if that bank were to go out and use that cash to purchase new assets they would have to find a seller of equal size. The price the buyer and seller decide upon has nothing to do with the fact that one has cash and one has another asset. The price they agree upon is based upon which buyer or seller is more eager to allocate funds.
The 2009 argument is a bit misleading in my opinion because the Fed was actually targeting the credit markets with their initial round of QE. We had seen an incredible overshoot to the downside and credit markets were dysfunctional. In a January 2009 speech Ben Bernanke said he was targeting the credit markets. The goal here was simple: alter bank balance sheets, remove the fear, game over. That’s exactly what they did. We are no longer in that environment. There is no mean reversion to be had. There are no credit markets to fix. There are no bank balance sheets to fix. There might be some negligible psychological impact, but history shows that QE has very little impact on the real economy and that is what we need at this point – improvement in the real economy.
This argument also ignores the deflationary impact of QE. When the Fed swaps an interest bearing asset with the private sector they are essentially stealing a source of income. When they bought MBS from the banks last year they essentially said, “give me that 8% paper at XX cents on the dollar and here’s some cash”. With many of these assets experiencing huge rallies in the last year you could make a very serious case that the Fed in fact made a mistake via QE.
c) It would force – via a weaker dollar – other central banks to participate in QE. For if the yen/dollar went to 75, say, the Bank of Japan would be very likely to react with its own form of quantitative easing.
There is no historical evidence showing that QE should result in a weaker domestic currency. This was the case in Japan and it was the case in the USA in 2009/2010. QE does NOT add net new financial assets to the private sector. Therefore, the impact on the dollar is marginal in the long-run.
d) The psychological impact of low bond yields on governments: the lower the level of government bond yields, the less governments would be ‘forced’ to tighten policy.
I assume CS is referring to the idea that lower rates allow the U.S. government to “finance” its operations better with lower rates. This is sheer nonsense. The U.S. government issues bonds to control the overnight rate. It is a monetary tool and not a fiscal financing tool. As of now, the Fed wants loose policy. If the Congress wants to spend more they will tell government employees to walk into a room and type numbers into spreadsheets. The rate on the 10 year bond does not make the government more willing to spend. Policy will remain easy for an extended period. This has been made abundantly clear.
All in all, it’s been proven that QE has little to no impact on the real economy. It does not boost lending and it does not boost aggregate demand. The problems here remain one of the real economy. Ben Bernanke believes he can induce a “wealth effect” by making risk assets more attractive, however, without real underlying improvement in the economy there is no long-term gain to be had here. Investors who buy risk assets based on the misconception that QE will fix the real economy will surely find out that real end demand remains weak regardless of QE intervention. Without real underlying economic improvement any bid in risk assets will certainly be temporary. Thus far, there is very little evidence showing that QE will improve real economic conditions. The Fed continues to tinker with various tools that simply paper over our problems. Inducing a psychological effect on asset prices and keeping prices “higher than they otherwise would be” might make us all feel better in the short-term, but I am highly skeptical that this sort of market intervention will lead to sustainable economic growth. At the end of the day, we must see an increase in aggregate demand that leads to higher corporate revenues that leads to hiring that leads to real economic recovery. If you’re banking on QE to generate real end demand you’re mistaken.
NB – I have, at times, likened QE to a stock buyback. When a corporation purchases shares of outstanding stock they are essentially altering the composition of outstanding financial assets. They are reducing the outstanding shares which leads to higher prices and higher EPS (all else being equal). However, this does not impact the underlying corporation in any substantive manner. Therefore, if real operations are in decline then there is no reason to believe that share buybacks would boost prices. QE works in a similar manner. If the real economy is in decline then there is no reason to believe that QE can bolster asset prices. Of course, this doesn’t mean asset prices can’t rise for other reasons, but QE should not be thought of as the primary cause of rising asset prices. That must come from underlying real improvement in corporate America. And while QE1 likely boosted banks tremendously I do not believe QE will impact the US economy substantively going forward. Therefore, asset prices will have to rise for other reasons if they are to be sustained….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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