To follow-up on last week's newsletter on the unprecedented size of balance sheet expansions (i.e. QE) undertaken by the 8 major central banks, I now focus on looking at the impact of QE on asset markets and the economy. There is considerable debate on this issue, much of it clouded by ideological biases and pre-(mis)conceptions (as seems to be the norm nowadays in an increasingly polarised world!), so it is helpful to consider research which relies on data analysis to draw conclusions (i.e. a deductive rather than an inductive approach). With that aim in mind, I summarise below an insightful note by the economist and financial advisor Gavyn Davies in his FT blog (http://blogs.ft.com/gavyndavies/2012/01/25/asset-market-returns-in-a-liquidity-trap/#axzz1lbDioV8Z ):
-The weight of empirical evidence since QE started in 2008 supports the current view that QE has a positive impact on reducing long term bond yields, increasing real GDP growth and asset prices.
-Estimates on the reduction in long-term bond yields vary, with the BIS on one end estimating the impact to be a reduction of 0.25%, while the BOE and several studies in the US conclude that the reduction is 1.0% or more. The graphs below illustrate this relationship clearly and demonstrate that yield curves have flattened substantially since QE began, supporting the latter view.
-This empirical evidence refutes the traditional view that under a zero interest rate environment, investors should be indifferent to holding cash or bonds – with bond prices moving substantially higher it is clear that investors have a strong preference for holding longer term bonds which provide some return.
-However, there is a lower limit to bond yields, as suggested by the Keynesian liquidity trap. Japanese experience suggest this to be 1.3%, in which case US treasury bonds with maturities up to 5 years have already reached their lower limit- leaving the longer maturities for the Fed to focus its efforts on. In addition, the Fed could purchase mortgages and private securities to push down their spreads.
-In a QE environment, with the central bank balance sheets taking on more risk, the private sector attempts to restore its asset portfolio risk levels to those prevailing prior to the start of the crisis by purchasing riskier assets like equities. The BOE study suggests that equity prices have moved up by 20% in response to QE in the UK.
-Various studies (by the Bank of Italy and others) also suggests that QE has had a positive impact on the real economy – boosting GDP growth by 1.5% in the UK and 0.6-3.0% in the US. In addition, inflation rose (as desired by central banks) by 1.0%.
-However, the evidence also seems to indicate that the initial bout of QE had the maximum impact on bond yields, and subsequent doses produced smaller declines. This is likely to continue being the case going forward. In addition, the long-term positive correlation between central bank balance sheets and inflation is worrisome.
-In conclusion, central bankers are in general agreement that their experiment with QE has worked so far, providing a far better result than what might have been the alternative.
An interesting note, which provides ample evidence that QE does work. Martin Feldstein (not quite a supporter of Keynesian policies I might add!) had also written a note which analysed clearly the specific positive impact of QE on the fourth quarter GDP growth in 2010 (http://www.project-syndicate.org/commentary/feldstein33/English ). Yes, there are likely to be unintended consequences (higher commodity prices, currency wars to name a few) but it is clearly the lesser of the evils once the alternative scenario ( a depression) is considered. As the noted economist Irving Fisher noted in his classic study of "Debt-Deflation Theory of Depressions " in 1933 (an analysis of various depressions over the previous century ) to make a point on why a reflationary policy should be pursued in the face of a severe economic downturn: "it is silly and immoral to let nature take her course as it is for a physician to ignore a case of pneumonia". To extend that thought further – a new drug to treat a patient suffering from a serious illness, is preferable (despite its potential side-effects) than letting nature takes its course and risking far more serious consequences!
So what size of further QEs can we expect from the Fed over the next few years? – I came across an interesting chart (from Casey Research) which totals the QE to date which has been required to keep short-term rates at zero, and extrapolates that number to estimate that $2 trillion of further QE could be required to keep them at zero until 2014 (which is the current stated goal of the Fed).
A very early Stock market indicator? (from Tom McClellan market report via Pragmatic Capitalist):
An intriguing chart below which looks at the Commitment of Traders (COT) data on eurodollar (interest rate deposit) futures to predict stock market movements a year in advance. Sceptical?! Read the following quotes from two reports – Feb 8, 2012 and May, 2011:
Feb 8, 2012:
-"For almost a year, we have known that a top was due to arrive in February 2012".
- "The next 3 months show a sideways to downward structure in the eurodollar COT data, and the implication is that the steep price advance that we have been seeing should transition to a more sideways market".
-" The next major inflection point is due in early June, when this leading indication says that a big multi-month rally is due to begin. By then, all of the bullishness that investors are expressing now in the various sentiment indications should have turned to frustration and pessimism, creating the right setup for a big new uptrend. The hard task will be to remain patient until then, waiting for conditions to be right again".
May 27, 2011:
-"The reason I picked this chart to show this week is that it is shouting to us now that something big is coming up for the stock market between June and October. In June 2010, the commercial eurodollar futures traders had gotten all the way up to a neutral position overall. Then between June and October 2010, they moved back to a big net short position."
-"The good news for the bullish case is that once that October low is put in, this eurodollar leading indication says we should see a really strong rally into the end of the year."
-"Commercial eurodollar traders seem to "know" a year in advance what the stock market is going to do. It is not a perfect correlation, but it is a darned good one. I'm not sure what makes this work, but I have seen that it has worked great since about 1997. It may help to understand that the commercial traders of eurodollar futures are typically the big banks, who are using these futures contracts to manage their assets and fund flows. So what we are seeing in their futures trading are responses to immediate banking liquidity conditions, and those actions give us a glimpse of future liquidity conditions for the stock market. These liquidity conditions are revealed first in the banking system, and then the liquidity waves travel through the stock market a year later."
-The weight of empirical evidence since QE started in 2008 supports the current view that QE has a positive impact on reducing long term bond yields, increasing real GDP growth and asset prices.
-Estimates on the reduction in long-term bond yields vary, with the BIS on one end estimating the impact to be a reduction of 0.25%, while the BOE and several studies in the US conclude that the reduction is 1.0% or more. The graphs below illustrate this relationship clearly and demonstrate that yield curves have flattened substantially since QE began, supporting the latter view.
-This empirical evidence refutes the traditional view that under a zero interest rate environment, investors should be indifferent to holding cash or bonds – with bond prices moving substantially higher it is clear that investors have a strong preference for holding longer term bonds which provide some return.
-However, there is a lower limit to bond yields, as suggested by the Keynesian liquidity trap. Japanese experience suggest this to be 1.3%, in which case US treasury bonds with maturities up to 5 years have already reached their lower limit- leaving the longer maturities for the Fed to focus its efforts on. In addition, the Fed could purchase mortgages and private securities to push down their spreads.
-In a QE environment, with the central bank balance sheets taking on more risk, the private sector attempts to restore its asset portfolio risk levels to those prevailing prior to the start of the crisis by purchasing riskier assets like equities. The BOE study suggests that equity prices have moved up by 20% in response to QE in the UK.
-Various studies (by the Bank of Italy and others) also suggests that QE has had a positive impact on the real economy – boosting GDP growth by 1.5% in the UK and 0.6-3.0% in the US. In addition, inflation rose (as desired by central banks) by 1.0%.
-However, the evidence also seems to indicate that the initial bout of QE had the maximum impact on bond yields, and subsequent doses produced smaller declines. This is likely to continue being the case going forward. In addition, the long-term positive correlation between central bank balance sheets and inflation is worrisome.
-In conclusion, central bankers are in general agreement that their experiment with QE has worked so far, providing a far better result than what might have been the alternative.
An interesting note, which provides ample evidence that QE does work. Martin Feldstein (not quite a supporter of Keynesian policies I might add!) had also written a note which analysed clearly the specific positive impact of QE on the fourth quarter GDP growth in 2010 (http://www.project-syndicate.org/commentary/feldstein33/English ). Yes, there are likely to be unintended consequences (higher commodity prices, currency wars to name a few) but it is clearly the lesser of the evils once the alternative scenario ( a depression) is considered. As the noted economist Irving Fisher noted in his classic study of "Debt-Deflation Theory of Depressions " in 1933 (an analysis of various depressions over the previous century ) to make a point on why a reflationary policy should be pursued in the face of a severe economic downturn: "it is silly and immoral to let nature take her course as it is for a physician to ignore a case of pneumonia". To extend that thought further – a new drug to treat a patient suffering from a serious illness, is preferable (despite its potential side-effects) than letting nature takes its course and risking far more serious consequences!
So what size of further QEs can we expect from the Fed over the next few years? – I came across an interesting chart (from Casey Research) which totals the QE to date which has been required to keep short-term rates at zero, and extrapolates that number to estimate that $2 trillion of further QE could be required to keep them at zero until 2014 (which is the current stated goal of the Fed).
A very early Stock market indicator? (from Tom McClellan market report via Pragmatic Capitalist):
An intriguing chart below which looks at the Commitment of Traders (COT) data on eurodollar (interest rate deposit) futures to predict stock market movements a year in advance. Sceptical?! Read the following quotes from two reports – Feb 8, 2012 and May, 2011:
Feb 8, 2012:
-"For almost a year, we have known that a top was due to arrive in February 2012".
- "The next 3 months show a sideways to downward structure in the eurodollar COT data, and the implication is that the steep price advance that we have been seeing should transition to a more sideways market".
-" The next major inflection point is due in early June, when this leading indication says that a big multi-month rally is due to begin. By then, all of the bullishness that investors are expressing now in the various sentiment indications should have turned to frustration and pessimism, creating the right setup for a big new uptrend. The hard task will be to remain patient until then, waiting for conditions to be right again".
May 27, 2011:
-"The reason I picked this chart to show this week is that it is shouting to us now that something big is coming up for the stock market between June and October. In June 2010, the commercial eurodollar futures traders had gotten all the way up to a neutral position overall. Then between June and October 2010, they moved back to a big net short position."
-"The good news for the bullish case is that once that October low is put in, this eurodollar leading indication says we should see a really strong rally into the end of the year."
-"Commercial eurodollar traders seem to "know" a year in advance what the stock market is going to do. It is not a perfect correlation, but it is a darned good one. I'm not sure what makes this work, but I have seen that it has worked great since about 1997. It may help to understand that the commercial traders of eurodollar futures are typically the big banks, who are using these futures contracts to manage their assets and fund flows. So what we are seeing in their futures trading are responses to immediate banking liquidity conditions, and those actions give us a glimpse of future liquidity conditions for the stock market. These liquidity conditions are revealed first in the banking system, and then the liquidity waves travel through the stock market a year later."
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