This market analysis examines the current economic environment, global monetary policy, and the outlook for global financial markets from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.
Aftermath of QE3
Anticipation of the “official” ending of QE3 in Oct 2014, monetary easing at the BOJ, and easing rumors at ECB and Riksbank propels USD higher, starting in July 2014 (circle in Chart 1). Correspondingly, commodities plunge, dragging emerging markets along two months later (dashed vertical line in Chart1 and circle in Chart 2). Meanwhile, US equities, partially thanks to brethren central bank liquidity injections (see Market Analysis for July 27 2015), remain resilient, albeit volatile (first half of Chart 3). But, by mid-2015, Fed Chair Yellen’s talk about a rate hike finally takes hold as US equities breakdown through uptrend support (circle in Chart 3). Chair Yellen promises three rate hikes in 2016 and to raise Fed funds rate 300 bps by 2017. Despite intermittent rallies, equities face a decidedly downward journey…or, do they?
Energy Sector Gets Decimated
If a stronger dollar wasn’t bad enough, a slowing Chinese economy, prospect of new energy supplies from Iran, and highly-levered shale oil companies makes shorting energy a trade of a lifetime as crude oil trades below $30/bbl. With bank loans in dire straits (Citigroup $58bn, BoA $43bn, JPMorgan Chase $42bn, Wells Fargo $42bn exposures), energy companies manage to unload new equity offerings despite collapsing oil and share prices. According to Bloomberg, another $9.2bn share offerings have been announced YTD (as of Mar 1). With this as background, beware of bear market rallies…that knife is still falling! But…
The Fed to the Rescue
Despite the rhetoric out of the Eccles Building and deeply-massaged and contorted official unemployment figures, the facts are that oil prices are under $40/bbl. (not good for Russia nor US banks), US equities are trending down and volatile, and a lot of angry American voters are attending Trump rallies. At a 0.25%-0.50% target rate, the Fed is out of traditional ammunition to fight the next economic downturn, which is imminent. Any delay in a rate rise now means that the eventual hike arrives during a weaker economy, thereby triggering recession. With remaining FOMC meetings slated for Apr, Jun, Jul, Sep, and Nov 1 prior to the Nov 8 elections, perhaps, as NY Fed Pres Dudley’s speech on Jan 15 suggests, it’s too late to raise them at all. Like Pavlov’s dog sensing a free meal, financial markets make a swing-low in early Feb as the S&P 500 bounces from 1864 and WTI Futures Apr 16 from around 29.00. So, what next?
Alice in Wonderland Time
Picking up the QE mantle from the Fed, the BOJ (see Market Analysis for Jan 12 and Jul 27 2015), following the election of Prime Minister Shinzo Abe in 2012, unleases its own version of liquidity infusion, triggering the Yen Carry Trade. ..and, just to be sure, officially enacts NIRP on excess bank reserves last month. The ECB, for its part, announces in early 2015 an “expanded asset purchase program” of Euro 60 bn per month, expected to total at least Euro 1.1 trn. On Mar 10, the ECB increases monthly purchases to Euro 80bn, cuts interest rates (including the deposit rate to -0.40%), re-declares inflation target of 2% (despite ECB projections showing sub-2% inflation for next 5 years), and announces a scheme to pay banks to lend. On the latter, don’t be surprised if European banks use this opportunity (gift seems more like it) to generate some lending and broking fees to help eurozone corporates engage in some good ol’ American-style share buybacks to give European equities a boost. Remarkably, in his speech, Pres Draghi all but rules out further interest rate cuts…er, get it while it’s hot? With traditional monetary policy, Quantitative Easing, Qualitative Easing, and ZIRP all failures, global CB focus now rests on NIRP to inflate government and bank debt away. And into the rabbit hole we go…
NIRP: What Could Possibly Go Wrong?
By taking the NIRP route, CBs gamble that banks can withstand the hit on their income as lending rates move below deposit rates. For US banks, not as much a problem as not as relient on deposits for funding, but elsewhere it could cause major dislocations. Judging by collapsing European bank share prices, the gamble is not paying off (Chart 6). Making less money, weak banks cut-back on lending, weakening economies and driving CBs to take rates even lower, thereby inducing a self-inflicted death spiral. A WSJ diagram succinctly sums up the situation (Diagram 1).
As discussed in the previous report, economies currently running into strong deflationary headwinds. To be sure, these headwinds stem from underlying problems from the 2007-2008 Financial Crisis and before (see Case Study: US Bear Market of 2007-2009, Case Study: Dot-Com Bubble, and Case Studies: 1997 Asian Financial Crisis, Part I and Part II)*, which never went away: Too much sovereign, corporate, and mortgage-related/asset-backed debt. Keeping debt off-balance sheet, changing accounting rules, or re-classifying debt did not make the debt disappear. Unable to create gentle, steady inflation with the blunt tools at hand, CBs seem determined to pursue NIRP. But, as shown, secondary and tertiary effects can wreck havoc on NIRP.
Again, as discussed in an earlier report, the markets show early signs of deflation in Sep 2014 (Chart 7), while many pundits and economists focus on lagging indicators that suggest all-is-well. In Jul 2015, markets give another emphatic shout that deflation is now a significant problem. Further incongruous actions of monetary officials and politicians perpetuates extremely loose money policies that will likely push economies past the event horizon and into a deflationary-spiral with a nasty terminus: Hyperinflation. Thus, economies and financial markets find themselves today.
Probability of Hyperinflation?
So, assuming NIRP is enacted on a global scale (BOJ, ECB, Riksbank, DNB, SNB, and, possibly, Fed), the chance that monetary and political authorities can withdraw monies from the banking system before inflation takes-off is exactly nil. Hence, expect double-digit inflation as a result of NIRP. As for hyperinflation (+50% general rise in prices), those economies unable to remove liquidity in rapid order would be staring directly at a Zimbabwe or Weimar Republic hyperinflationary environment. How long do global economies have until the SHTF?
As suspected, this story does not have a happy ending. The CBs, led by the Fed, determine the duration and magnitude of the outcome. Out of traditional bullets, fanciful methods are tried to inject liquidity into economies that simply, like gigantic and tiny Alice, effectively inflate financial market prices temporarily before prices deflate once again, thereby inducing another round of the latest monetary potion – NIRP for now. So, how long does this go on for? Japan has managed to remain whole for two and half decades, while caught in its deflationary spiral. But, as explained, NIRP may change this.
If “The Doom Loop” proves to be moderately accurate, NIRP shall likely be the last kick-of-the-can and weak banks and financial institutions (e.g. insurers and pensions with 6-8% real long-term actuarial investment return assumptions are deluding themselves) will eventually be taken-over by relatively stronger ones, while the weakest, facing bankruptcy, split into “good” and “bad” entities, with “good” ones acquired by the strong and “bad” ones run-off. Of course, major unhinging in economies and financial markets occur, including forceful inflation and, possibly, hyperinflation. But, economists already know the solution: Stop printing money. Hopefully, politicians force the purging of putrid debt, letting several major financial institutions and corporates to go the way of the dodo bird, and, with any luck, setting an example for others, before declaring any moratorium on the painful cleansing. Once again, that barbarous relic gold (silver as well) will prove its usefulness, as it has done, time after time throughout history, as the ultimate safe haven store of value.
* Forthcoming Case Study: 1971-1973 End of Bretton Woods System examines, among others, the role that a reserve currency plays in abetting an economy and local borrowing and the massive build-up of debt (sovereign, corporate, mortgage-related/asset-backed, and personal debt) in the US after the US transitioned to a pure fiat monetary system.