Short of a “psychological meltdown,” the current crisis in financial markets greatly enhances the chance of a U.S. economic recovery, says CIBC World Markets managing director Peter Gibson in a recent report to clients. How can that be?
For one thing, panic selling and a slowdown in the global economic activity creates conditions for launching a third round of quantitative easing (QE3) by the U.S. Federal Reserve. For another, yields on 10-year U.S. Treasury bonds have plunged below 2.5%, which pulls down mortgage rates and boosts purchases of housing and durable goods. And oil prices are crumbling, which leaves more purchasing power in the pockets of consumers.
“Altogether this is the best and perhaps last chance to save the U.S. economy and get some economic traction,” declares Gibson—the market and quantitative analyst who has won No. 1 rankings multiple times in the Brendan Wood International survey of Canadian analysts. “Therefore, it would imply that … it is time to start re-establishing ‘good positions’ in equities,” he adds.
At the moment, there is the danger of fear feeding on itself, which is why a coordinated policy response is necessary to stop the panic sell-off and change investor psychology. “We would expect,” declares Gibson, “all of the following: QE3 in some form, plunge protection, China buys more treasuries since the implied U.S. dollar crisis is a threat to China’s export markets, the use of the European stabilization fund and the issuance of European debt with the centralization of the European debt market.”
The reference by Gibson to “plunge protection” is of particular interest. After the market crash of 1987, the U.S. Government created the President's Working Group on Financial Markets to recommend solutions for enhancing U.S. financial markets and maintaining investor confidence. Known colloquially as the Plunge Protection Team, many observers believe that it will intervene to reverse market crashes. Supposedly, it can do this through either “moral suasion” aimed at convincing banks to buy stock index futures, or by having the Federal Reserve do the buying.
Gibson’s comment on European debt and centralization of its debt market is also noteworthy. It is likely a reference to a need for the eurozone to move closer to fiscal union.
Something akin to Canada’s fiscal union, with its equalization payments intended to keep regions from falling too far behind, would at this stage be likely unfeasible for the eurozone. The more politically expedient option may be to have the European Central Bank (ECB) buy up the bonds of ailing members while issuing “Eurobonds” of its own to finance those purchases.
What about the threat of inflation posed by central banks “printing” so much money to buy up bonds in U.S., Europe and elsewhere? It’s a non-issue, as far as Gibson is concerned.
Central banks do have the means to rein in the money they have created—one way is to mop it up by issuing bonds, or selling the bonds they previously purchased. This they can be expected to do, in measured manner (to keep the "bond vigilantes" dormant), as the economy gains traction.
Indeed, Gibson says the time has come for investors to realize that inflating away debt is not an option with government and consumer debt at record levels. Bond holders will sell en masse if they become worried about the real value of their holdings eroding. And the weight of the selling would send interest rates soaring—which, in turn, would collapse the world economy.
Gibson advocates a different solution:
“Rather, the goal must be to hold a very low level of U.S. bond yields for a very long time and hope that the U.S. economy can find the productivity growth it needs to grow out of its debt levels over the next couple of decades.”