Many economists have recently noted the declining efficacy of quantitative easing (QE) and other extreme monetary policies like NIRP. For example, Larry Summers ( www.voxeu.org) has pointed to the failure of QE and NIRP to close the output gap or stop the slide in productivity in Japan and the Eurozone. The Japanese have little to show for all of their massive market interventions under both their QQE (Chart 1) and NIRP (Chart 2) programs. As I pointed out recently, "…the Japanese have just about run out of options, as they are caught in a liquidity trap. Their cumulative QQE purchases will mean they own over 50% of the JGB market by next year, and they already own over 50% of the Japanese equity ETF market. Their debt is enormous and their deficit is already being partially monetized by the QQE program."
Chart 1: QE Programs Have Boosted Central Bank Assets But Left Economies Weak
Chart 2: JGB Yield Curve Negative to 30 Yr., Jan.-Mar. 2016
I would add that since essentially all of Japan's bonds have negative yields, QQE cannot really go on much longer; however, this is not necessarily a problem if helicopter money (monetary finance) is used instead. I further pointed out recently that, "Europe is also very close to having to make a decision on helicopter money, according to [analyst and author] Russell Napier. He thinks that German Chancellor Angela Merkel will be forced to decide between helicopters and the end of the EU dream, since the financial crisis in Europe is so dire. It is a binary type of decision that will either cause a huge rally (helicopters) or a huge crash (nein), and probably fairly soon. The Finnish government has already separately decided to explore monetary finance, with a November deadline for a formal proposal, according to the Zero Hedge blog. Finland has been locked in a depression for years on end, and they are desperate to get things moving again."
Note that the ECB's QE program has already started to hit a wall in spite of being much smaller than Japan's (as a percentage of GDP). This is in part because most of the government bonds in demand (e.g., German bunds; Chart 3) have yields that are too low for legal use in the QE program, according to Anooja Debnath Anoojad at Bloomberg. Many of the government bonds in France, the Netherlands, Austria, and Belgium are also too low-yielding to be bought in the QE program, according to Paul Hickey of Bespoke Investment Group. It is true however, that since the ECB is now buying corporate bonds as well, that this could extend QE in Europe for some time. The quality of corporate bonds being purchased ranges from AA+ to NR, with many BBB's being bought recently. Bespoke Investment Group suggests that this will put a bid under junk bonds in both Europe and the US. If so, this would involve a very disruptive decoupling of bond market prices from underlying fundamentals (not that this would bother the eggheads at the ECB).
Chart 3: QE Must End in the Eurozone
In any case, it would likely be no more effective than all the other ECB interventions. Indeed, lending standards are now tightening and loan demand has recently been falling again in spite of the extremely low rates across the entire credit universe (cf. Chart 4). This suggests that if there is any benefit, markets will again move up at the expense of the economy. When political pressure rises high enough, perhaps ECB President Mario Draghi will conclude that the ECB, like Japan, would not be precluded from the eventual use of helicopter money. The problem that should most concern central bankers is what will happen if a major downturn is triggered by Brexit or a Chinese devaluation, before rates can be normalized, i.e., before the system rises from the Zero Bound. Then their options would be very few, and they would be stuck with reacting to market turmoil instead of leading market speculative surges.
Chart 4: EU Lending Activity Weak Since 2010
At some point relatively soon, even the true believers at the ECB and the BOJ will be forced to admit that both QE and NIRP have failed, and that one of their unintended consequences has been the further weakening of the already weak European banking system. Let's assume that any European banking crisis would simply speed up the process without changing the result. Then the standard choices for central banks fighting deflation, stagnation, or economic collapse (at the Zero Bound) are: 1) currency devaluations (ruled out for the EU unless it breaks up, but possible for Japan); or 2) money printing that may or may not induce hyperinflation (i.e., the most likely but not inevitable outcome in the wake of any helicopter money drops). A third option, austerity, can only be used if no crisis intervenes, and is more effective when coupled with a major devaluation (cf. C. Roxburgh et al., 2012, "Debt and Deleveraging: Uneven Progress on the Path to Growth," www.mckinsey.com/Insights). It seems to me that helicopter money (monetary finance) will be the extreme measure du jour, and that this could be associated with different short term and long term responses from the markets.
What will the consequences be if either the ECB's or the BOJ's QE and/or NIRP programs are abandoned in favor of either devaluation or helicopter money in the next few months? First, a look at history might serve us well. As I wrote a few months ago: "Two examples, Finland and Sweden in the early 1990s, involved strong recoveries from financial crises and recessions following major currency devaluations and austerity. In each country, an initial deleveraging phase was followed by substantial bank reforms and structural government spending reforms. Both countries ended up cutting their annual deficits, and then their government debt significantly within a single decade. For still another example, we can examine what happened in the US during the inter-recession growth recovery between 1933 and 1937 (during the Great Depression but before the big savings surge of the 1940s). This huge surge in GDP to an average of 7% growth annually was caused in part by a 60% devaluation of the currency when we went off the gold standard." The reaction of the Swedish stock market to the October, 1992 devaluation and associated bank nationalizations was very strongly positive (Chart 5).
Chart 5: Swedish Markets Surged After Late 1992 Devaluation
As I have mentioned elsewhere, during World War II the US federal government borrowed 9% of GDP annually over five years using Federal Reserve financing (note that this was effectively debt monetization or helicopter money). Although there was an inflation surge when it was over (as one might expect), it was contained, according to Adair Turner in an interview published this year by Goldman Sachs. The stock market could have cared less, and this was in spite of a world war going on simultaneously. The S & P 500 rose steadily throughout the 1942-1946 period of debt monetization (Chart 6).
Chart 6: Treasuries Held By Fed (Red Dashed) vs. SPX (Red Line) During Debt Monetization, 1942-1946
During the Great Depression, Japanese Finance Minister Korekiyo Takahashi devalued the yen following the abandonment of the gold standard, and then used a well-disciplined version of monetary finance to help Japan recover, without triggering hyperinflation. The Japanese stock market responded very strongly in the wake of these policy measures (Chart 7).
Chart 7: Japanese Market Response to Devaluation and Debt Monetization During the Great Depression
It is important to note that in all of these examples a major bear market was already ongoing before the devaluations and/or monetary finance steps began. Therefore the rallies were in part a reaction to the bottom being put in as a result of extreme central bank and treasury department policy changes. I think that this same pattern, i.e., a bear market followed by a strong bull market, will occur this time around. However, perhaps the time sequence will be compressed compared to the historical examples because extreme policy measures have already been in place for years. Once the markets figure out that QE and NIRP are dead in either Europe or Japan, they will violently contract in my opinion. Stock buybacks and IPOs, the main drivers of demand in the US markets, will essentially cease and uncertainty about what the new policies will mean will probably take hold for a while. I believe this will happen because the central banks will not take such a huge step as debt monetization or monetary finance without first being pushed into it by a market meltdown.
My advice to investors is therefore to stay defensive until the writing is on the wall with respect to monetary finance. Once it is, the bottom will likely be near and a strong offensive stance will make sense, if history serves as a guide at all (and of course, it may not for reasons as yet unknown). Trades of interest in this environment would include the purchase of long treasuries (Vanguard Extended Duration Treasury Bond ETF (NYSEARCA:EDV), Vanguard Long Term Government Bond ETF (NASDAQ:VGLT), I-Shares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), and Vanguard Intermediate Term Bond Fund (NYSEARCA:BIV)), defensive dividend growth funds (SPDR S & P High Yield Dividend Aristocrat ETF (NYSEARCA:SDY)), liquid alternatives (Otter Creek Prof. Managed Portfolio (MUTF:OTCRX), AQR Long/Short Fund (MUTF:QLENX), and AQR Equity Market Neutral Fund (MUTF:QMNIX)), and sophisticated hedge-like strategies (Nuveen S & P 500 Buy-Write Income Fund [BXMX]). After the deluge, indexing with the Vanguard S & P 500 Index ETF (NYSEARCA:VOO), or using a factor ETF like O'Shares FTSE US Quality Dividend ETF (NYSEARCA:OUSA) may help one to track the bull rally that follows rather well.
Disclosure: I am/we are long SDY, OTCRX, QLENX, QMNIX, BXMX, BIV.
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