Over the past few weeks my working theory has been that until the three other major Central Banks blink, risk assets will be for sale.
Many market pundits are hoping for the Federal Reserve to ease up on the tapering of Quantitative Easing. Of course anything can happen, but I view that as low probability bet. The Federal Reserve wants to wind down QE. There has been absolutely no signals to expect anything different.
As the Fed winds down QE, the rest of the world suffers from the decrease in the rate of increase in liquidity. Yes, you read that right. The Fed is not withdrawing liquidity. They are merely slowing down the rate at which they expanding.
The fact that this slowing down of the expansion of liquidity is enough to cause risk assets to perform poorly demonstrates how reliant the world economy is on these QE programs.
There is no doubt in my mind that absent the Fed and the other Central Banks’ aggressive QE programs, the world would be experiencing deflation. Over the life of the 70 year credit super cycle there has been so much debt piled on that absent a very aggressive monetary policy, the natural tendency is for credit to contract. The Central Banks are continually fighting the tendency for the private sector to destroy credit.
The real danger is that the Central Banks eventually push so hard, they unhinge inflation expectations. Contrary to recent conventional wisdom, Central Banks are not powerless to create inflation – it simply takes larger and larger stimulus. As the size of required stimulus increases, the consequences of a mistake in either direction intensify.
This whole chess game is all the more complicated by the fact that most of the developed world has borrowed themselves into the same situation. There is no easy fix by devaluing against your neighbour and stealing growth.
Over the last 5 years the Fed has led the charge in providing the world economy’s needed liquidity. At times other Central Banks have been more aggressive (Europe when their sovereign debt crisis hit or Japan’s recent war on deflation), but the Federal Reserve has been the most consistently expansionary Central Bank.
The trouble is that the Federal Reserve is getting cold feet. Even though the CPI is not showing any signs of inflation creeping up, the Fed is concerned about the size of their balance sheet:
CPI (white line) vs Fed’s Total Balance Sheet (yellow line)</a> </div></p>
The Fed realizes that their QE programs are not being as effective as they would wish, and that at the margin they might even be contributing to the increasing inequality problem. They are taking the opportunity to wind down the QE program while the economy is performing decently. The logic being that the QE program was supposed to be an emergency program and the emergency is long past.
This leaves us with an interesting set of questions. Does the Fed need to be actively expanding their balance sheet to offset the private sector contraction, or will simply holding it at elevated levels be enough? Prior to 2008 economists believed that simply holding the expanded balance sheet constant would be inflationary, but the past 5 years has shocked most into questioning the whole stock versus flow argument. My personal belief is that the decline in the velocity of money was so severe that it has temporarily distorted all the normal monetary relationships. Therefore the answer to this question is unknown. If the velocity of money were to stabilize and even return to moderately normal levels, then the Fed’s expanded balance sheet would be highly inflationary. However if the decline in the velocity of money continues (it might be a demographic long term trend that is not easily reversed), then the expanded balance sheet would do very little to combat the deflationary tendencies.
This is why the Fed is in such a difficult situation. Their ability to keep the economy at the nice 2% inflation target is severely hampered by the fact that there is so much debt. The mechanisms needed to influence the economy are so large that it is quite frightening.
You can argue all you want about whether the Fed should have or should not have engaged in QE, but you need to step back and realize that they are mandated by Congress for a very specific task. Their goal is to keep inflation stable at around 2% while maximizing economic growth. It is hard to argue that their QE programs have not been somewhat effective at achieving their goals. There has been no massive uptick in inflation as the result of their balance sheet expansion, and the employment situation is slowly improving. If you want to place the blame on someone about the foolishness of this short sighted path, then you should place it on Congress. They are the ones who have mandated the Fed’s goals.
Back to the current environment. Now that the economy is slowly improving, the Fed is reducing the rate at which they are supplying liquidity. Unfortunately the world economy seems to be suffering.
This will most likely continue until the other three major Central Banks blink.
Over the last couple of months, the ECB has talked a big game in terms of potentially expanding their QE programs – but so far it is nothing but talk. Their balance sheet continues to shrink:
ECB Total Balance Sheet</a> </div>
The ECB is not only refusing to expand, but they are even continually withdrawing liquidity. This is causing the Euro currency to appreciate and will ultimately cause another European liquidity crunch. Their economy cannot handle the lack of monetary expansion.
The Chinese are in a different boat. They are attempting to rebalance their economy away from the export / infrastructure driven growth model. This rebalancing is causing some pain and their economy seems to be slowing rapidly. It is a delicate balancing act that the Chinese government is trying to pull off. Rebalance too quickly and the whole economy might slow to a crawl. But as it slows, there is a desire to fix it with the easy solution that has worked so well in the past – aggressive stimulus programs. However, if they do that it will simply put off the inevitable rebalancing into the future when it might be all the more painful. There is no doubt that the Chinese government’s rebalancing plan has slowed down the economy, but to what extent is very difficult to ascertain.
And finally Japan. They have been the most aggressive over the last year with their massive monetary stimulus. However that stimulus is wearing off. Their currency is no longer falling and the much hoped for inflationary/growth virtuous circle has not yet taken hold.
As the Fed withdraws liquidity, these three major economies feel the pinch.
Many market pundits are hoping for the Fed to put their foot back on the monetary accelerator. I think that they are watching the wrong Central Bank.
The time for the Fed to lead the charge in monetary expansion is behind us. The US economy is one of the worlds’ better performing economies and the Fed is right to slow down the pace of their balance sheet expansion. Given the massive lag in monetary policy, they still might have dramatically overshot their target.
The monetary stimulus policy baton has to be picked up by these three other Central Banks. The real clues for where global risk assets are headed will be in how quickly these three blink. Without a change in policy, then expect risk assets to at the margin be for sale.
Getting more short in the next couple of days
I have been easing into a short Nasdaq position over the past week. My initial sales proved lucky and we have drifted lower during the past few days.
My goal was to be fully short by the first week of May and to hold it as a somewhat longer term position into the start of the summer.
Today is the first day of the two day FOMC meeting. I have found that this is often a positive couple of days as market participants position themselves for a dovish Fed.
I am going to wait until the end of today, and assuming it is higher, I am going to short a little more into the close.
And then, assuming the pattern continues, I will short a little more late tomorrow morning before the announcement.