Thursday, 7 October 2010

A sweet sport ... followed by?

Renowned Fed hawks believe it is necessary to expand and extend the Quantitative Easing programs in the US. Bank of Japan is doing it already. Bank of England is being strongly recommended by business leaders to do the same. And in continental Europe it is all quiet. I must admit that some of what I hear makes me rather apprehensive. Apparently there are strong worries that the current slow growth phase will last long enough to spur deflation. And deflation is the thing we do not want. At all!

In the past months we have seen some broad trends: Stronger stock markets, strong bond markets, weaker dollar, weaker yen, Stronger EUR, stronger EM currencies and EM stock markets. Market risk indicators are coming down. Credit spreads are falling.

Plainly, some of it does not make sense. I am afraid that we are setting ourselves up for a new round of market turmoil, maybe even at the level of what we experienced in May.

Since the outset of the crisis, the central banks have worked to reflate, and the asset prices have indeed recovered much of the lost ground. The loss of paper wealth should not be a major obstacle to growth. But now we have arrived at another critical junction. It is marked by a slew of new growth forecasts for 2011 from various institutions – they all represent downward revisions of growth forecasts.

The Great Recession was triggered by a huge increase in debt, mainly by households in the Western world. Households are now involved in a gigantic cleaning up of their own balance sheets. Meanwhile, the sharp recession undermined government revenue, leading to huge government deficits. Governments are now cutting back on expenditure and increasing tax revenue to fill the coffers.

Some had hoped for business investment to step in as a driver. But in terms of volume, investments do not match neither consumption nor public spending. And we have already seen an inventory rebuilding. New business investment is being delayed as final demand appears sluggish.

It means that attention turns to the original purpose of monetary policy, namely to stimulate the economy. But we are in a “liquidity trap” where pouring more money into the economy has very little effect on economic activity, since banks to not increase lending. As Keynes would have put it, we are trying to push on a string.

Several central banks have taken the step of introducing Quantitative Easing. Instead of massaging the money market they buy securities (various bonds) directly in the market, pushing money into the pockets of banks and other corporations. But the question is whether that has any effect on the economy. If we look at traditional measures, there are no significant signs that it is actually moving the economy forward. So what happens is quite simply that the reflation of the financial assets takes another step forward.

It all looks like a replay of the events following Internet bubble. This time it is not different. It is more of the same, just on a grander scale. Stocks move up, bond yields fall, commodities prices increase. We are in a liquidity driven sweet spot. It all goes well until it becomes clear that the underlying reality does not correspond to the current market perceptions.

Given that the stock markets have not yet taken to heart that growth will be slow because of the ongoing attempts to repair public and household balance sheets, this is where things may go wrong, maybe sometime in 2011. Until then, the markets look set to have quite a good time.

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