青豚的鹿honey:謝國忠 : Twisting in the wind

Here comes QE 3

------------------------

QE 3 is about to be born. Financial market is expecting the Fed to launch 'Operation Twister' in its September meeting. The operation is supposed to bring down long term interest rates through its purchasing of the long-dated treasuries. That expectation has caused the yield on 10Y treasury to drop to 2% and 30Y to 3.3%, about 100 bps below their recent levels. The Fed couldn't afford to disappoint the market and would likely deliver what the market expects. Like QE 2 its primary effect is to stimulate the stock market and, through wealth effect, demand. And, like QE 2, its effect will be short-lived.

The market has partially priced in a slower economy

---------------------------------------------------------------------

By now financial market has priced in a significant slowdown of the global economy. The recent data suggest that major developed economies are either stagnating or contracting slightly. The market has priced that in. But, it isn't clear if the market has priced in a significant slowdown of the emerging economies. The Australian dollar and oil price, the most important indicators for emerging market growth, have been extremely resilient in the August sell-off.

The growth momentum is still negative

---------------------------------------------------

QE 3 is unlikely to reverse the weakening growth in the global economy. In theory monetary stimulus works through stimulating investment by cutting the cost of capital temporarily. That hasn't been the case in the past two decades, as corporations care much more about demand than the cost of capital in investment decisions, especially when they are already sitting on surplus cash.

Hence, if QE works, it needs to work through consumption or export. The later requires a big devaluation. As other major economies are all pursuing loose monetary policy, a big dollar devaluation seems unlikely. Indeed, the ECB and the BoJ may have to be more aggressive in solving their debt problems. The dollar may be quite strong in the next twelve months.

The US household debt has declined by 8.6% in the past three years. The current level at $13.3 trillion is still too high relative to the household income. The deleveraging trend isn't likely to change. Unless the deleveraging is done, it is hard to see how consumption could grow. If the consumption doesn't grow, the corporate sector isn't likely to expand and hire more people. It is a vicious cycle for the US economy. The headwind is too strong for the Fed to overcome.

There is a backlash, both in politics and market, against fiscal deficit around the world. On fiscal side, the whole world is shifting towards tightening. Eurozone is on austerity for some time. The political change in Japan seems to bias it towards fiscal austerity. The US is moving towards austerity too. The Obama Administration is trying to use high unemployment to undermine the deficit cutting plan from the last debt ceiling agreement. I suspect that the Obama Administration won't be able to change the trend. The Republican Party has no incentive to go along.

QE 3 may support stocks

----------------------------------

I always believe that the Fed's policy is to target the stock market. As the treasury yields are so low already, it doesn't make sense to cut a few basis points here and there. The perception that the Fed is doing something inspires market confidence. A higher stock market will improve consumer confidence through the wealth effect. A higher stock market will also support the property market. A weak stock market will push more households to liquidate the properties with negative net value, intensifying the downward spiral. Hence, QE could be used to stop temporarily a vicious spiral.

Inflation is forcing emerging market to slow down

-----------------------------------------------------------------

The emerging market block is still experiencing good growth this year, despite the big slowdown of the developed economies. The reason is the negative real interest rate that inspires investment and speculation. In a way the emerging economies have been running a bubble to sustain growth. It is not a sign that they have decoupled from the developed economies yet. This growth dynamic is challenged when inflation becomes intolerable.

In China and India inflation seems to become too high for political stability. The later has stepped up the pace of increasing interest rate. In addition to the internal constraint, India is also vulnerable externally. It depends on capital inflow to offset its current account deficit. Hard landing in emerging economies is always due to sudden withdrawal of foreign liquidity. That is a confidence issue. Foreign capital in emerging market is usually faddish. Anything could spark panic. Among the BRIC economies India's is most vulnerable to a hard landing.

China has been raising interest rate much more than what it has announced. The money market fund is a new phenomenon that has raised deposit rate by two percentage points above the policy rates. At the same time the banks have increased lending rates to at least 30% above the policy rates or about two percentage points.

China's hard target is to keep M2 growth rate at 16% or lower. It is four percentage points below the level in recent years. It is causing liquidity tightness in many segments of the economy, the property sector especially. The economic impact is limited so far as most players still expect the central government to loosen policy in the second half of the year. As it becomes clear that it won't happen, local governments and property developers have to cut projects. This change seems to be taking place now.

The low volatility bubble may return

-----------------------------------------------

With so many weaknesses in the global economy one would expect volatility to be high. However, until the recent selloff, the volatility index was below average. This reflects the behavior of the financial industry rather than reality. Most traders on Wall Street make a living by selling volatility. It is like borrowing money to buy a higher risk and high interest rate bond. The profit is the interest rate difference. It works if the high risk bond doesn't fall apart.

The trade could be self-fulfilling in the short term. The short volatility trade boosts the prices of risk assets, which increases liquidity flow into high risk areas and covers up their shortcomings for the time being. But, when something happens, the cumulated pressure is released in the form of a big selloff. The short volatility trade, hence, increases risk in the long run. It is essentially a bubble.

The low volatility bubble is a recurring phenomenon. After a big selloff, the sell volatility trades will be put on due to bottom fishing. The resulting momentum will lead to more traders piling in. The risk asset prices would rise, which emboldens the short volatility trade. This could happen in the third quarter. I'm not bearish about stocks in the short term for this technical reason.

Slow-cooking savers

-----------------------------

The global economy is in a logjam as the people who want to spend have too much debt and too little income while money is piling up among people who can't spend it all. Some people are just better than others at making money. This difference causes the logjam over time.

One solution is debt forgiveness for the former. Stagflation is basically that. It takes time to achieve the goal. If the real interest rate is -5%, the real debt level is down by 40% over a decade. It takes time to work. This is why stagflation may be with us for a long time.

An alternative is to tax the ones who know how to make money. Warrant Buffett is advocating that. This is politically difficult to achieve. Further, it may solve the internal imbalance, but not the external one. The later is big too, over $1 trillion per annum. One country cannot tax another.

Stagflation indirectly taxes the people with money at home and abroad. Its slow pace fools the people with money into inaction. The victims of this policy are mainly middle class savers, not the super rich. The later are more likely to hide in income earning assets.

When middle class become proletariat, ...

-------------------------------------------------------

Stagflation impoverishes middle class. The super rich gain even more political power. The society by then would be a few against all others. It is fertile ground for revolution. Like in the 1930s and 40s the world is experiencing another era of revolutions.

Absolute poverty is usually considered the cause for revolution. The Maoist Revolution in Nepal and similar revolutions in Central American fall into this category. The most important revolutions are not that. Fairness rather than poverty is a more potent force. The world today rewards those who borrow and spend at the low end and speculators and crony capitalists at the other. The hard working middle class who earn and save get the worst deal. These are highly educated people who keep their society together. When they have nothing to lose, expect nothing less than revolution.