Guy Haselmann: Don't Hold Your Breath for QE4

Cold Turkey

by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM

· Several times today, I was asked if or when I thought the Fed would begin QE4. The answer is ‘never’ (pending a disaster); although I guess the more prudent answer is to say the chances are ‘infinitesimal’. It is counterfactual to know with any certainty what would have happened if the Fed had not done QE3; however, it is easy to make a few observations that suggest QE is a failed policy, or at least a policy that has reached its saturation point. Let’s review a few of them.

· As I mentioned in my note yesterday, QE was intended to spur aggregate demand to deal with over-indebtedness. This implies that, under this metric, successful QE should have decreased debt-to-GDP levels. In fact, sovereign and corporate debt-to-GDP levels have risen substantially. (To be fair, household debt has fallen quite a bit, but that is likely due to demographics. Yet, household debt-to-GDP remains well above the average of the 20^th century.) Large increases in debt will borrow from future growth and act as an economic headwind.

· QE intentionally encouraged asset price inflation with the intent of having ‘the wealth effect’ spill into the broader economy. The plan was to eventually hand off the support for QE-fueled lofty asset prices (and sinking risk premiums) to strong fundamentals backed by robust economic activity. The trouble with markets today is that the latter never materialized and QE is now ending at the same time that perceptions for growth and inflation are ratcheting lower.

o Therefore, prices for risk assets need to adjust downward to meet those new economic expectations. This recalibration is occurring quickly in an environment of crowded trades and poor market liquidity. Therefore, an overshoot to the downside is highly likely and this process has just begun.

· QE policy has also amplified inequality which is a factor that should not be dismissed too quickly. Inequality is an economic headwind. Historically, when it becomes too extreme, very bad things can result. A QE policy that makes the rich richer could not happen at a worse time, given popular dialogue; and combined with the effects of globalization and technological advancements.

o Unfortunately, education and training is currently losing out to technology.

o The difference between QE as a driver of inequality and that of globalization and technological advancements is that the former is a deliberate policy choice. Furthermore, the latter have wonderful qualities that have resulted in lifting tens of millions of people out of poverty. The benefits have arguably done more to collectively improve the human condition than any other development in history.

· The Fed’s policy of financial repression sends the wrong signal. It punishes savers, such as pensions and retirees, while rewarding speculators and debtors. It is like giving my son ice cream after he yells at his mother and punches his brother.

o Counter-intuitively, higher rates might actually increase the velocity of money and increase lending, as it would allow the lender to charge more for their loans.

o In addition, lower rates, coupled with lower equities, significantly damages the funding status of pensions. This could be one of many reasons why the ECB never adopts sovereign QE.

· Forward guidance has reached its ‘sell by’ date. It was initially used as tool to encourage risk-taking by collapsing the risk premium, and in turn, to provide a ‘put’ to risk seekers. However, after a prolonged period of time, investors have become callused. Prices have diverged too far from economic fundamentals. Investor and corporate confidence has become negatively impacted.

o After all, if the Fed is so worried about the economy that they have to keep rates low for a very long time, then how can a corporation have enough confidence to want to begin a capital investment project? Shouldn’t a potential borrower (or consumer) wait to borrow until there is more visibility, knowing that rates will remain low for an ‘extended period’?

· Conclusion: Many Fed policies have been, or have become, counter-productive. Events may certainly force the Fed to be ‘lower for longer’, but expecting some type of new stimulus measure is an exceptionally long way off. Should the Fed resort to ‘new’ measures, based on the comments above, the Fed might wish to veer in an entirely new and creative direction. (see ‘Macro-Prudential’ note from yesterday mentioning direct targeting of subsidized loans to select areas of the economy)

Market Comment

· Fed policies and financial asset prices have recently reached their practical limits.

· Until recently, many risky assets were perceived to be ‘safe’; because volatilities were low, prices seemingly ascended each day, and markets were overly-confident that the Fed would always do whatever was necessary.

· Today, the end of QE, occurring simultaneously with a deteriorating view of the geo-political and economic landscapes, has conspired to call this perspective into question. Valuation and expectation recalibrations must occur accordingly.

o The explosion of market volatility has shaken the foundation of investor psyche.

o The unwind process has far to go.

o Blindly “buying the dip” will be more difficult for equity investors. (Low volatilities have led to greater leverage and position sizes, due to how most risk models are designed.)

o Treasury bonds should maintain an underlying bid. Investors will earn carry, ‘roll-down’, and the optionality of lower yields.

o Liquidity, safety, and high quality bonds will command a premium during the market shakeout.

o Low yields and low inflation means that holding cash has a low opportunity cost and a high optionality value.

o Credit spreads will widen as risk is pared and risk premia rises.

o Fed hikes for 2015 are too far off in the future. With quickly building levels of uncertainty, the market may completely price them out for 2015. Should things change, the market can always quickly price them back in.

“Insanity: doing the same thing over and over again and expecting a different result” – Albert Einstein

Regards,

Guy

Guy Haselmann | Director, Capital Markets Strategy

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Copyright © Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM