The economy and financial markets remain in the grips of the most easiest monetary policy the world has ever seen.
The balance sheets at the Fed and the BOJ continue to expand at record pace and global real rates have been negative for over 3 years now. Negative real rates create tremendous incentives for borrowers to lever up and often create asset bubbles in debt, equity and property.
The irony is it was these conditions that enabled the build-up of debt of questionable quality – and unsaddled asset prices to ever more fanciful valuations – that led to the financial crisis in the first place. Policymakers seem to believe that the poison and the remedy are one and the same. More worryingly, with the market moving up or down on every comment by politicians and central bankers, policy makers are growing complacent in their ability to micro-manage the markets.
Such complacency is dangerous in our view. We certainly symphatize with Nordea’s Chief Economist Annika Winsth suggesting that maybe it was time for central banks to scale back the barrage of communication, forward guidance, guidance on tapering etc.
The Riksbank says that it’s the world’s most transparent central bank, but I normally tell them being transparent is not the same as being clear,” Annika Winsth, chief economist at Nordea in Stockholm, said in a phone interview. “We’re getting a bit too much information. We’re running after all the signals they send, but things become very unclear.”
Quote, Bloomberg October 15th
Since 2008, the original Masters of the Universe epitomized by the swashbuckling investment banker and adrenaline powered prop trader have seen their wings clipped by regulation. They have been forced to eat a measure of humble pie. Not so for politicians and central banks who have emerged as the post-crisis saviors from whose every hint, comment and opinion is acted upon by the market.
Maybe, this is about to change however. A common refrain is that if monetary conditions are not about to tighten as soon as was originally thought, then the long risk-asset trade is back on. We are inclined to disagree. One of the problems of QE was always likely to be its efficacy would peter out the longer it was in existence. There have been many now clichéd analogies of QE and heroin-addiction. But clichés are useful because they have a grain of truth. And this much is true with QE: the longer it goes on, the greater the ‘dose’ needed to give the same ‘hit’.
We can see this is we look at the correlation between the change in the size of the Fed’s balance sheet (now $3.75 trillion) and the simple return of the S&P. In previous episodes of QE, the policy succeeded in keeping the correlation mostly positive. Once the policy was complete, the correlation fell very quickly. This time around, however, we are still in the midst of an incarnation of QE with still no defined end date or total size, and yet the rolling correlation has been negative for several months, ie the effect of the Fed’s growing balance sheet on US large-cap equities is diminishing.
This is a trend which, if it continues, will create a big headache for the Fed as it would show that one of the main mechanisms through which QE is supposed to operate – the portfolio channel – is in effect broken.