The Greenspan/Bernanke legacy: a grave policy dilemma Article of BT Finance SA published in June 2014 in Dennaris, The Swiss magazine of independent asset managers (ASG/VSV). While most investors expect further QE tapering, this may not be so. Deeply-imbedded deflationary forces, possibly unleashed by tapering itself, may ironically force an abrupt end to monetary tapering and the renewed balance-sheet expansion of both the Federal Reserve and other key central banks. This ominous prospect holds important implications for portfolio management. Tapering by the Federal Reserve recently has been a key driver of global financial markets. Given the modest policy adjustment so far, indeed even some prospects for a policy reversal (i.e., un-tapering), it is likely this issue will remain a key driver of financial markets for some time to come. Hence, we explore the likelihood of further tapering versus the prospect for a return to even more aggressive quantitative easing (QE). We assess the likelihood of these two, key scenarios based on both fundamentals and related politics which have influenced since inception this unorthodox and controversial monetary policy. After three rounds of QE over five years, it is quite clear that it has had limited positive impact on the real sector (employment and growth); rather, it has primarily benefitted large banks that have off-loaded impaired securities to the Fed (i.e., US taxpayer) at par and profited from a ‘risk-free’ carry trade: funding longer-duration US Treasuries, MBS and other financial securities with virtually cost-free borrowing at the Fed window. Additionally, with the Fed paying 25bps for deposits, it is little wonder that free reserves at the money center banks have swelled to record levels while lending to the private-sector has stagnated. However, the big banks’ recapitalization and return to profitability has allowed them to capture greater US market share in deposits and loan concentration despite the country’s ongoing credit crunch and liquidity trap. The enormous expansion of the Fed’s balance sheet would normally raise fears of incipient inflation. While the Fed’s core inflation has remained well behaved, arguably, there has been asset price inflation. In particular, prices of Treasuries, certain foreign government bonds and US equities have rarely been more expensive. Yet the wealth effect from these higher financial prices has not much benefitted economic growth and employment as the Fed anticipated, owing to concentrated holdings. Perhaps it is not surprising that there is an erosion of political support for continued QE given the fairly narrow dispersion of QE benefits across the economy. The sustainability of continued QE could also be limited based on financial market valuations and the increased probability of black swan events as key foreign creditors become increasingly concerned about money printing and the devaluation of their US Treasury holdings. So it seems that further tapering is not only politically expedient but also perhaps induced by lofty financial market valuations and increasing creditor resistance to rapid money printing. Well….not so fast. Lack of a strong inflationary impulse given the unprecedented US base money supply explosion/Fed balance sheet expansion is not only due to the limited circulation of money flows (lack of credit creation). It is also because there are strong countervailing deflationary forces which have yet to be dissipated. Let us explain. During the eight years prior to the onset of the crisis in 2008, there was a dramatic rise in the ‘shadow banking system’ by which we mean credit growth generated in unorthodox ways. The lending and re-lending of marketable securities from one financial counterparty to the next (i.e., rehypothecation) sometimes many times over was the source of tremendous credit expansion. This occurred not just with government and corporate bonds and equities but also with MBS, structured notes, bullion, etc. With the onset of the crisis in 2008 and the demise of Lehmann Brothers and Bear Stearns, fears of counterparty risk quite naturally spiked and, while since having somewhat receded, are by no means normalized. Hence, multiple re-lending of a host of financial securities and assets remains a small fraction of what it had been prior to 2008. Given that this source of credit growth contributed as much as 50% of total credit growth between 2000 and 2008, it is clear that the collapse of this source of credit growth retains a strong deflationary grip on the overall economy and a grave risk to the onset of a renewed crisis. It is this lingering yet extant deflationary pressure which limits the ability of the Fed and other central banks to aggressively taper and indeed creates a real prospect for an abandonment of tapering and an even more aggressive return to money printing. Were the Federal Reserve to return to expanding QE, foreign creditors may resist further US Treasury exposure and stagflation could well result. After five years of benefitting from the ‘Fed put’, certain financial market valuations are so stretched that a one-way bet on financial prices (“buy on dips”) can no longer be relied upon. In this milieu, one should construct a portfolio which barbells assets that would hedge both scenarios of deflation and stagflation, while also being particularly cognizant of counterparty risk. Until monetary and financial policies find a stronger footing, one which benefits all stakeholders not just a select few, financial markets will remain on Occam’s razor. Dr. Ronald Solberg Advisor to BT Finance SA Bruce Goodwin Advisor to BT Finance SA Copyright: BT Finance SA
Posted on: Wed, 18 Jun 2014 08:12:11 +0000
Trending Topics
Recently Viewed Topics
© 2015