As a geeky young teenager I spent way too many hours with my nose deep in Tolkien’s Lord of the Rings. I thought I was a bit of a fan until I googled the main plot hole that many have criticized Tolkien for not addressing. Upon researching, I realized that there are people who take their devotion to LOTR to another level. I am not going to do the plot hole justice, but the gist of the complaint is that the eagles could have either carried the ring and dropped it in Mt. Doom, or at the very least, carried Frodo part of the way. Even Tolkien knew that the eagles were a potential problem. In a letter written by Tolkien he warned:
“The Eagles are a dangerous ‘machine’. I have used them sparingly, and that is the absolute limit of their credibility or usefulness. “
But have no fear, LOTR fans have an answer to this problem. I found a terrific post on Reddit (complete with maps) that fills in the plot hole. Obviously I wasn’t the only geeky teenager that spent too long thinking about Lord of the Rings instead of getting up the nerve to talk to girls.
Even with this explanation, it is hard to dispute had the eagles gotten involved earlier, the whole saga would have been a lot easier for the fellowship.
And I can’t help but think about the similarities between the eagles and the ECB. Instead of waiting until the last possible point to execute their QE program, the ECB could have realized this logical conclusion and implemented the program a year earlier. But no, they had to drag it out. And there is no excuse, it’s not like they had three books to write…
But here we are today at the beginning of March, with the ECB starting their balance sheet expansion. I know that it is tempting to say, “oh great, now the ECB finally shows up.” This development is easy to dismiss after we have had months of debating, talking about it, and beating it to death. Now that it is here, no one cares.
Yet they should. It is fashionable to argue that balance sheet expansions don’t affect the real economy. I know the prevalent attitude is that QE just sits in the banking system and is largely ineffectual.
I don’t believe this for one second. I will acknowledge that QE becomes less effective as it is prolonged and expanded. The velocity of money definitely decreases as the liquidity is stuffed into the system.
But QE programs affect both the real economy and market prices. There is no doubt in my mind. I have sat on a trading desk for too long watching the days that the Fed executed their Permanent Open Market Operations (POMO) cause the stock market to rise.
Here is an old chart I dug up that shows the S&P 500 return on POMO days versus non-POMO days.
When a Central Bank executes permanent open market operations it affects markets. Full stop. Period. Ignore all the pundits who tell you otherwise.
Yes, the degree to which they affect markets depends on many factors. But if you think that the ECB’s program will be a non-event, then you are sorely mistaken.
But you wouldn’t be alone in your skepticism. Have a look at the chart of the EU 5 year forward 5 year break even inflation expectation level (a favourite Central Banker rate to watch for long run inflation expectations):
The rate has been steadily falling since last summer. Every hopeful turn has proven to be only a temporary rally. Even the actual announcement of the QE program caused only a short lived spike.
I think the reason for this pessimism is that no one believes the ECB will be irresponsible enough to create inflation. Here is a tweet from the very shrewd “Two and Twenty” trader:
I respectfully disagree with Two and Twenty. I acknowledge the ECB’s lack of credibility for being “reckless” has so far kept inflation expectations contained, but the QE program has not even started.
This will be a situation where the market will not move until the actual flows enter the system.
Quantitative Easing programs work – at least in influencing asset prices and inflation expectations. Whether they are successful in the long run is open to debate, but I don’t think anyone who has watched markets can argue that the Fed or the BoJ’s balance sheet expansion didn’t have an immediate and obvious effect on prices.
Therefore as we begin European QE, I am trying to not overthink it. At the margin European stocks will continue to out perform, the Euro will be offered and European bonds will go down. This last prediction is one that always gets the most push back. Everyone thinks that because the ECB is buying bonds, they must rise in price. Don’t forget that QE programs are designed to be inflationary, and inflation is a sovereign bond holder’s worst enemy. Therefore if the ECB is successful with their QE program, bond prices should go down, not up.
Expectations that European balance sheet expansion will create inflation are low. Investors have been bombarded with disappointment after disappointment from the ECB. The layers of bureaucracy and delay from the ECB has been maddening. But don’t forget that the eagles eventually saved Frodo and Sam from certain death, and I fully expect that the ECB will equally successful (although it sure would have been better if the ECB had simply done this a year ago when it was obvious to everyone what the end result was going to be).
I like your model…
For those who think that QE programs don’t affect stock prices, I thought I would post this twitter exchange that made me laugh. $hane Obata was responding to @Not_Jim_Cramer and I found his comment quite witty.
He was of course implying that the Fed’s balance sheet expansion is all that has mattered over the past five years. The ratio of the S&P 500 to the Fed’s balance sheet has basically gone sideways since the start of the first QE program.
Over the next year or so the ECB is set to increase their balance sheet by a trillion euros. Those who think that this will not affect market prices assume that this relationship that is so clear in the US, will not be applicable in Europe.
I will take the other side of that bet…
Thanks for reading,