By Mike Whitney
Now that the self sustaining recovery has taken hold, Fed chairman Ben Bernanke can end his bond buying program and allow the markets to return to normal.
As it happens, Bernanke is now signaling that he’ll keep the QE2 feeding-tubes in place so that any unnexpected unpleasantness in the market–like another full-blown crash–can be averted. Here’s the story from Bloomberg:
“Federal Reserve Chairman Ben S. Bernanke may keep reinvesting maturing debt into Treasuries to maintain record stimulus even after making good on a pledge to complete $600 billion in bond purchases by the end of June.
“The Fed chief’s top two lieutenants said this month the economy and inflation are too weak to warrant the start of a monetary-policy reversal. Investors and economists including David Kelly at JPMorgan Funds see that as a signal the Fed will keep its balance sheet at current levels by replacing about $17 billion a month in maturing mortgage debt with Treasuries.
“Ending the reinvestment policy and the $600 billion program at the same time would be like quitting stimulus “cold turkey,” said Kelly, who is based in New York and helps oversee $400 billion as chief market strategist at JPMorgan.” (“Bernanke May Sustain Stimulus to Avoid ‘Cold Turkey’ End to Aid”, Bloomberg)
Ahhh, so the ventilator will stay in place, after all. What a surprise. Shall we call this QE3 as Bernanke’s critics have suggested?
It’s revealing that economists at the big banks, like JPM’s Kelly, are now comparing the so-called free market to a drug addict who can’t cope without his liquidity “fix” from the central bank. That seems like a fitting metaphor, but it also illustrates the shortcomings of QE2. For example, the program was never intended to lower unemployment, stimulate demand or trigger a rebound in the real economy. It was merely another multi-billion dollar subsidy to the investor class so they could make the payments on the Jaguar or add another Chagall to their art collection. So, now Wall Street is hopelessly “hooked” and any disruption in the flow of liquidity would mean that G-Sax employees would have to take home less than the $591,299 average compensation they do now. We can’t let that happen, now can we?
So, what’s the final word on QE2; has it been net-positive or a dead-loss? Here’s an answer from Nomura’s global macro strategist Bob Janjuah:
“I strongly believe QE2 added over 250 points to the S&P based on where it closed the year….We think QE1 and QE2 have failed the real economy in the US at the expense of pushing up asset prices in financial markets. (eg house prices vs. stocks) Most American families own a home, but most Americans do not own a meaningful amount of stocks. Bernanke’s solution seems to rely on the US public buying into another round of bubble blowing and on the idea of trickledown economics.
“…We think QE3 will be both unavoidable and a grave policy mistake in the hard landing outcome. We think it (QE3) is unavoidable because under this outcome, where we expect a significant slowdown in global growth in H2, driven by an EM (Emerging Market) slowdown and an end to the global super-cycle in manufacturing, it is the only “stimulative‟ policy option left, and Bernanke and Obama both seem fixated with stimulus, at any cost it seems….
“… We find it extremely worrying that over the mid-February to mid-March global equity sell-off, where the drivers of the sell-off were not particularly US-centric, the US dollar nonetheless sold off over this period. This is the exact opposite of what has been seen for more than the past two years, and not what the market expected. We worry that it may reflect growing concerns about the US sovereign and US policymakers who may now be turning into the central risk. If this is the case, and, as a result of QE3 the US dollar and US Treasuries become unanchored and are no longer seen as the world‟s risk-free assets nor as the ultimate stores of value, then the entire foundations for valuations in financial markets could be at risk.” (“Bob Janjuah – told you so America”, Ft Alphaville)
Janjuah is not alone in his criticism of QE2. While most economists admit that it’s added a bit more helium to equities, few seem to think that it helped workers or strengthened the broader economy. Here’s an excerpt from an article by Professor Alan Nasser on CounterPunch that sums it up pretty well:
“Ben Bernanke’s second round of bond buying, QE2, has been a grand flop. Housing sales and prices are falling at an unhealthy clip, foreclosures and bankruptcies continue to mount and QE2 has had no measurable impact on the dismal employment picture. Nor should we expect it to. A study by the highly reliable Macroeconomic Advisors indicates that even an additional $1.5 trillion bond purchase by the Fed would reduce unemployment by a mere two tenths of one percent. (J. Hilsenrath, “Fed Fires $660 Billion Stimulus Shot”, Wall Street Journal, November 4, 2010)…” (“Putting People to Work”, Alan Nasser, Counterpunch)
See? QE2 was never intended to lower unemployment. Bernanke has been pulling the wool over our eyes from the get go. The real goal was to buoy stocks with the hope that inflated asset prices would increase the “wealth effect” and trigger another credit expansion. But that hasn’t happened because consumers are deleveraging and are still up to their eyeballs in debt. So, QE2 has just turned out to be more corporate welfare for Wall Street; another handout to the folks who blew up the financial system.
Still, as Janjuah points out, there are risks to the Fed’s policy, and those risks have become more worrisome now that Standard & Poor’s has changed its outlook on US sovereign credit from “stable” to “negative”. The change was a reaction to the nation’s bulging trillion dollar budget deficits which S&P sees as a threat to the US’s AAA rating. Even so, if Bernanke’s “credit easing” strategy fails to resuscitate the economy, revenues will continue to plunge adding to the ballooning deficits. So, the rating change is as much a statement on Fed policy as it is on the political gridlock that prevents Congress from agreeing on a course of action. The bottom line: If Bernanke doesn’t figure out a way to kick-start the economy pronto, it’s going to cost considerably more to fund the government.
But firing up the economy is a tall order, especially since Bernanke’s policies have failed to generate the gargantuan Zeppelins that they have in the past. Only recently have the Fed’s zero rates and liquidity injections started to produce the erratic spike in prices that one expects from Bubblenomics. For example, according to BusinessWeek: “Robert Shiller calculates that the Standard & Poor’s 500-stock index is trading at 23 times earnings normalized over the past 10 years, compared with a historical average of 16.” (“The Granddaddy of All Bubbles?”, Peter Coy and Roben Farzad, BusinessWeek)
And then there’s this from Marketwatch:
“There have been only four other occasions over the last century when equity valuations were as high as they are now, according to a variant of the price-earnings ratio that has a wide following in academic circles. Stocks on each of those four occasions would soon suffer big declines.” (“History bodes ill for stock market”, Mark Hulbert, Marketwatch)
Stocks are not overvalued because the economy is doing well, but because the Fed’s bond buying binge has ignited a flurry of speculation that’s pumped up prices. The uptick in margin debt–which is presently at its highest level since 2008–is particularly disturbing. It means that the big banks and hedge funds have been increasing their debt-load to buy equities, confident that QE2 will continue to suppress volatility. But that’s a strategy that can backfire if the market drops suddenly and over-extended investors are sent scrambling for the exits. An article on Seeking Alpha explains what’s going on:
“The Fed’s artificially low volatility (QE2 reduces volatility) may contribute to a dangerous build up in systemic risk. Many investment banks and hedge funds use volatility as an input to determine leverage capacity. When the Fed artificially depresses spot volatility it produces a feedback loop whereby large banks can increase their appetite for risk, increasing asset prices, and further lowering volatility. It should be no surprise that NYSE margin debt is at its highest level since July of 2008 in a direct negative correlation with volatility. Unfortunately for investors the effects of this leverage can unravel quickly and dangerously.” (“Volatility on a Leash: The VIX Index and the End of QE2”, Seeking Alpha)
Get it? When the Fed suppresses volatility, it sends the big players an “All’s Clear” sign, so they up the ante on their investments. Unfortunately, this increases the probability that the markets will get clobbered when Bernanke finally pulls the plug on QE2. Here’s how Gluskin Sheff’s David Rosenberg sums it up in a post over at Pragmatic Capitalism:
“If there is one sure way to tell that the Fed has managed to create and nurture a speculative-led rally in the equity market, look no further than what is happening to investor-based leverage growth – it’s exploding off the page. Yes, that’s right. Debit balances at margin accounts skyrocketed $20.7 billion in February. Only two other times historically have we seen leverage rise so much so fast and both times it was during a manic phase – during the tech bubble of the late 1990s and the credit bubble just a short four years ago.
To put that $20.7 billion incremental leverage in on month into proper perspective, it represents a 7.2 per cent jump, or an increase of no less than 129 per cent at an annual rate. And, it’s not just February – the rising use of credit to buy stocks has zoomed ahead at a 64 per cent annual rate in the past three months. If and when the markets breaks, the problem in trying to contain the downside momentum is that there are no short left to cover, which actually helps as a shock absorber.” (“Surging margin debt and the instability QE2 has created”, Pragmatic Capitalism)
The situation could deteriorate very fast. A sudden decline in stock prices could quickly turn into a full-blown rout as margin calls send investors racing for cover and debt deflation dynamics pull the economy back into another slump.
Nothing is certain, but the chances of a hard landing are greater now than they have been since 2008.