Why it is impossible for the Fed to phase out QE without causing instability

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Qijian Chen's picture

Introduction

Quantitative Easing (QE) has drawn strong reactions from multiple groups of people. Some have lauded it as the bullet that saved us from a depression whereas others have argued that it has produced nothing but “zombie” growth. What most groups can agree on however is that QE has had a huge impact on both the US and global economies around the world since then. Tapering would cause a monumental shift in the economic and financial status quo then.

It is my opinion that in the short run, it is impossible for the Fed to phase out QE without causing financial and economic instability in both the US and its trading partners. For the scope of this essay, we will be focusing on her main trading partners such as the European Union, China and Japan.

This essay will be divided into 3 main parts. The first will seek to establish the context of the Fed’s actions as the effectiveness of monetary policy is very much dependent on the actions of the other players. The second will seek to show what QE has done to the US financial markets as well as the economy. Lastly, with the pointers derived from the first 2 portions I will show why it is impossible for the Fed to phase out QE without causing financial and economic instability domestically and externally.

The Global Macro Environment

While the US Fed has been a monumental player, it is not the only central bank to have engaged in QE. In order to better make sense of the operating context of the taper, here are a few key events that are important.

Bank of Japan (BOJ)

The BOJ with Haruhiko Kuroda has broken tradition from its previous ranks by engaging in unprecedented monetary easing. While the size of its QE is 2/3 of the US, Japan’s economy is only 1/3 the size of the US. Thus we can expect a disproportionate response to the Japanese loosening. Since its easing, the USDJPY exchange rate has changed from 92 to a high of 105.

European Central Bank (ECB)

The ECB has instituted various measures to aid the euro along. All of these actions can be encapsulated in his famous quote last year that the ECB “is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough” Since then, the euro has appreciated from a low of 1.27 to the dollar to 1.37.

People’s Bank of China (PBOC)

Out of all the external global macroeconomic factors, the actions and developments of China is the deciding factor.

While the Fed has injected in about USD 2.5 trillion since Lehman, this pales in comparison to USD 15.4 trillion growth in Chinese bank assets. What is of particular interest is the surge in January’s Total Social Financing which is the widest measure of loan and liquidity growth to about USD 426. This comes at a time when the PBOC has tried to taper credit growth as well as the near default of trust products such as the Credit Equals Gold #1.

 

Impact Of QE

Risk On attitude

Through QE, interest rates have been held low and close to zero. The search for yield has blossomed into a full on “risk on” attitude as stock indexes such as the Dow Jones, S&P500 have soared to new highs.

Even more worrying for the financial community and bulls in particular has been the lack of serious corrections in this strong market. Even the recent 5% pullback to 1740 for the S&P500 has been eradicated as investors “bought the dip”.

Correlations gone crazy

QE has caused traditional correlations to decouple. For example. Historically stocks and bonds have been negatively correlated, recently (as of October 2013), the correlation between the 2 has become positive.

What these means is that the hedges placed by funds can fail and instead exacerbate the situation in a unexpected surprises as evidenced by Bridgewater All Weather Fund falling -5% in the May 2013 selloff. A parallel could be drawn towards the entirely unintended and ironic role of portfolio insurance (by selling S&P futures) during Black Monday.

While it has not been seen yet, it could be entirely conceivable, that QE has caused a shift in the interactions of assets and positive feedback loops could be inherent in such a system to increase its fragility.

Limited economic recovery

There has been much celebration over the recent unemployment figures of 6.6% in the US January 2014 data. While this is certainly an improvement over the figures we had over the past years. There has been much concern that corporate profits and margins have come on the back of cost cutting and the lowering of the unemployment figures have been a result of a lower participation rate as people stop looking for jobs.

What is worrying is that the amount of new hiring in the January 2014 figures have seen a drop at just 113,000. This has sparked new fears about the sustainability of the recovery and therefore it only affirms one certainty; that if this is a recovery, it is one where employment gains have been disappointing and we are still not at the stage where we can ascertain whether those “green shoots” of recovery has taken root.

 

Why Financial and Economic Instability Is To Be Expected

Therefore, the above external and internal factors can be crystalized into 2 main reasons why tapering will bring short term financial and economic instability into the US and its trading partners.

Market adjusted to easy credit

Monetary conditions are looser than ever before. The recent debacle in the emerging markets (Turkish lira) sparked by taper fears have shown one thing; that such money is extremely flighty and will rush for the exit at the drop of a hat.

What is also seemingly perverse to many people is that stock indices were making new highs on the back of below expectations economic data as evidenced in the monthly data release and market reaction last year. In other words, the market preferred weak economic conditions with QE than a stronger economy with QE being tapered off. This signals the reliance of the stock markets towards the easy money that the Fed has provided.

Despite such global risk as pointed out in part 1, the VIX sits at 13.57, a record low since 2007. This illustrates the sheer amount of complacency that investors have within the entire financial system. With broken correlations and the possible subsequent increased fragility in the system, it could imply a rise in hidden systemic risk.

Therefore, a stronger sustained tapering would then without doubt throw off the entire paradigm that markets have been adjusting to in the past 3 years and cause short term instabilities as market participants adjust. What is worrying would be the magnitude of the move as the adjustment takes place.

Moreover, as the selloff in January has shown us, a move in the US stock market has generated significant movements in overseas markets as they follow the lead. Of particular interest is the Nikkei which has made wide swings. Thus a stronger sustained tapering could cause financial instabilities for the trading partners of the US.

Global monetary conditions

Moreover, as the global market has gotten used to the easy monetary conditions. A tapering by the Fed could force foreign central banks to increase the scope of their QE to keep their economy flowing along.

Japan’s brave monetary policy could face the risk of implosion if not managed correctly. With the tax revenues as it is, if bond yields on the JGBs rise to 4%, all revenues would only be enough to cover the interest payments. Through the Fed tapering, if Japan mis-manages their own QE, it could mean an increase in the JGB yield demanded and subsequent pain.

However, the real risk lies in China.

As George Soros has pointed out, the performance in 2014 is very much dependent on the state of the Chinese economy and banking system. While the taper might not have a clear cut impact on the Chinese economy, it is feared that the gunpowder for a crisis has already been laid by the latent instability and leverage inside the system. The taper could merely play the role of being the spark in the months to come.

 

Conclusion

We are in interesting times and chickens do come home to roost. As policy makers take on leaps of faith to conjure up economic growth, there is a cost to such easy monetary policy that may be invisible to us yet.

However we should all be duly worried if the only way we are solving our problems is to kick the can down the road and to plaster it down with printed money. Phasing out QE might bring about short term instabilities onto the US and its trading partners, however it is better to bite the bullet now than to postpone the pain.

References: 

Bibliography

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Koh Gui Qing, China january lending soars to 4 year high, Reuters, Web, 16/2/2014

Lu Jianxin and Pete Sweeney, Total social financing indicator, Reuters, Web, 16/2/2014

William Pesek, Did Soros predict a China crash, Bloomberg Opinion, Web, 16/2/2014

Sam Mamudi and Whitney Kisling, Volatility Spurs Volume Boon, Bloomberg News, Web, 16/2/2014

Yahoo Finance VIX, Web, 16/2/2014