The Complete Cost-Benefit Analysis Of QE2, And How To Best Hedge For Federal Reserve "Fat Tail" Risks
At least Bank of America is honest as to why it continues to recommend investors pursue risk assets: "Liquidity-friendly global central bank policies remain the lynchpin of our constructive view on risk assets...Our economics team believes that QE2 will come in the form of purchases of Treasury securities of $500bn - $750bn every six months until the economy reaccelerates." In other words, this is precisely what Morgan Stanley's Jim Caron said on Friday when he confirmed that in this market nothing else matters, except what side of the bed Ben Bernanke wakes up on: "Investment decisions across many asset classes today are tantamount to an educated guess on what the Fed decides to do regarding QE. In the near-term this trumps fundamentals, valuations and almost everything else. Thus the risk in the market is man-made, not freely determined by the market. In general, this is not a good thing because it may invite greater risks in the future." To be sure, the market is now trading nothing less than QE news, but with that comes the added uncertainty of how the world's central banks will react to this latest dollar debasement episode: while QE1 was crucial and needed by the entire world to prevent the collapse of the system, things this time around are far less clear cut. Yet it is so difficult to fight the tape: as the attached chart demonstrates, for the duration of QE1 (3/5/2009 through 3/31/2010), global equities surged 80.5% while since April 2010, and without the benefit of the Fed's generosity, global equities have only generated 0.8% in returns. Furthermore, Jim Caron points out that unlike QE1, there is a very distinct possibility QE2 will fail miserably (all fans of buying what David Tepper is selling would be wise to be very weary). Luckily, just like in the Morgan Stanley case, BofA now highlights that there is a distinct possibility of "fat tail" risks and advises clients how best to position against these.
But first: here is why the "market" is nothing less than a euphemism for liquidity overflow actuions by the Federal Reserve now.
It is thus painfully obvious that there is nothing in the economy that drives stocks: all risk assets do is correlate with near unity to what the Fed is doing or will do in the immediate future. In other words, stocks no longer discount the natural growth of the economy, but are merely an excess-liquidity discounting mechanism.
BofA's Jeffrey Rosenberg agrees that only those who believe in a November QE2 event should be involved in stocks:
Fourth Quarter Investment Drivers
The key drivers of our constructive fourth quarter tactical asset allocation are:
- Our expectation that both liquidity-friendly global central bank policies and the absence of deflation or a double-dip in the economy will encourage a cautious consensus to reduce cash
- Low growth and low rates will cause liquidity to narrowly flow to assets that offer growth, yield, and quality, such as emerging markets. Stronger-than expected growth is required to broaden the rally in risk into areas such as the global financial stocks and the energy complex in commodities
- Our continuing belief that while we favor risk assets, the probability of “tail risks” is higher-than-normal and recommend multiple hedging solutions
In the beginning there was QE…
Liquidity-friendly global central bank policies remain the lynchpin of our constructive view on risk assets. The impact of Quantitative Easing (QE), the central bank policy of purchasing financial assets, has been profound on asset price performance. Buying risk assets when the first QE program was announced on March 5, 2009 and selling risk assets when QE programs were ended on March 31, 2010, yielded handsome returns (Table 3). Industrial metals (+98%), equities (+81%) and high yield bonds (+73%) were big winners during this period.
…then the “Japanification” of rates…
In contrast, since the end of QE, asset price returns have been more modest (see Table 3) with the exception of the “fear” trade of precious metals (+18%) and the “safety” trade of government bonds (+9%). Between the end of QE in March 2010 and the eve of Bernanke's "proactive" speech (26 August 2010) 10-year yields declined 100bps in the US, UK, Australia & Germany (see Table 4). The collapse in interest rates towards Japanese levels was encouraged by stagnant summer markets in both US labor and housing as well as a deceleration in global lead indicators. The “Japanification” of interest rates in developed markets further reduced the incentive for investors to hold cash.
…and now “Growth at Any Price”
But since late August, the absence of deflation and data to support a double-dip, coupled with the new promises of fresh liquidity injections from the Fed and the Bank of Japan, has caused a melt-up in certain asset prices. Within equities, investors seem prepared to invest in “Growth at Any Price” as a wave of liquidity hits emerging markets (with the notable exception of China), creating a classic situation of "too much money is chasing too few goods". Stocks in India, Indonesia, Korea and Turkey have soared. Similarly, commodities such as sugar, corn, silver have also seen recent dramatic gains in price.
High liquidity, low growth
We believe policy will ensure that ample liquidity remains in the financial system and this will be supportive of asset prices. The sources of fresh liquidity are the Fed and the Bank of Japan. In the immediate future we believe liquidity is likely to be particularly supportive of assets that offer growth, yield, and quality, and our allocation is skewed towards emerging markets and spread products in fixed income. The 4Q risk trade should be aided and abetted by upgrades to Chinese growth, one reason to raise commodity weightings. Stronger-than-expected data on US labor and housing markets is required to broaden the rally in risk into areas such as the global financial stocks and the energy complex in commodities.
The Fed promises more liquidity
Central banks want inflation and we believe the Fed has both the will and the ammunition to step up to the plate if the data begins to threaten deflation. We expect that the Fed will announce a new program of Quantitative Easing if the economic fundamentals deteriorate further over the next three months. Our economics team believes that QE2 will come in the form of purchases of Treasury securities of $500bn - $750bn every six months until the economy reaccelerates.
These purchases would not only keep the Fed balance sheet steadily growing, but would likely provide a “shock and awe” catalyst for financial markets. The implicit promise of QE2 has clearly caused investors to close short positions in September and may eventually mean that QE2 is not necessary after all.
The Bank of Japan has added liquidity
Meanwhile the August “crash” in the JGB market caused a surge in the Japanese yen, ultimately forcing the Bank of Japan to intervene in currency markets for the first time since 2004. The intervention was unsterilized and if sustained will cause Japan to finally expand their balance sheet in line with recent Fed and ECB actions (Chart 5). Note Japan has intervened to buy US dollars on three occasions over the past 20 years (‘94-‘95 ¥9trillion; ‘99-‘00 ¥10trillion; ‘03-‘04 ¥35 trillion) and on all three occasions, the Japanese successfully widened rate differentials and weakened the yen (though in 2002-2004 it took time to work).
Yet even wild-eyed optimists such as David Tepper who are betting the ranch (or at least giving those that will buy Tepper's stocks and bonds that impression) that QE will be a resounding QE1-like success will have the be careful: as Jim Caron follows up his Friday observations, there is no guarantee at all that doing "more of the same" will either help the economy (for a change), or have the same impact on risk assets.
QE2 May Not Be a Panacea
However, it is not a foregone conclusion that QE2 is either necessary or effective for the following reasons:
QE2 will not necessarily lead to higher growth: Purchases of private sector assets or government bonds (Greece) can be useful when markets malfunction. However, when they result in sub-equilibrium levels of risk-free yields and/or artificially depressed risk premia on other assets, QE can result in further asset mispricing and misallocation of capital. The result could be another decade of poor quality economic growth, both in the US (zombie companies are allowed to survive) and globally (EM boom-bust bubbles);
Corporate and household borrowing costs are already appropriately low: Partly due to past QE measures, Treasury yields and 30y mortgage rates are already near historical lows in both nominal and real terms – see Exhibit 1, which shows 30y mortgage rates deflated by year-on-year changes in personal incomes and the core PCE deflator. QE(2) cannot by itself resolve the various factors – e.g., capacity, legal constraints or poor credit profiles − which have hampered a reduction in effective levels of mortgage rates paid due to a lack of mortgage refinancing options. Likewise, real corporate borrowing costs are not onerously high in either nominal or real terms (see Exhibit 2);
Deflation risks are modest: Although low levels of core CPI have raised Japanese-style debt deflation concerns, recent IMF research1 suggests that while economies with significant negative output gaps tend to post similar percentage declines in inflation (disinflation), outright declines in prices (deflation) – such as experienced in Japan − are very rare due to stickiness of prices and wages (see Exhibit 3).
Recent year-on-year increases in producer prices of finished goods, of core PCE and GDP deflators and signs of increases in rents and owner-equivalent rents also suggest a pick-up in core CPI in coming months, as also expected by Morgan Stanley economics (see Exhibits 4 and 5); and
QE imposes a carry tax on the banking system: As a result of Fed purchases, higher-yielding, low-risk Treasuries and mortgages on deposit bank balance sheets have been replaced by US$1,991 billion of current account balances of banks with the Fed remunerated at only 0.15%. Besides depriving deposit banks of higher yielding risk-free assets, this has imposed a tax on the banking system, making it more difficult for the banks to boost their capital ratios. In turn, we believe that QE could actually impede, rather than stimulate bank lending, which – besides credit issues – is hampered by a shortage of bank capital instead of bank liquidity.
Caron's daming conclusion is that the best the Fed may hope for is to retain the status quo rather than to generate any incremental improvement in assorted financial indicators, let along the economy. If correct, this is a sad summation, as it means that soon the Fed will be forced to intervene more and more often merely to preserve existing gains in risk assets, instead of achieving any new headway in the road to Dow 36,000.
Perhaps the best the Fed could hope to achieve is to cap any potential rise in US Treasury yields and/or realised Treasury volatility through additional purchases of US Treasuries in the event of significant further USD weakness. Certainly, the Fed’s QE measures already appear to have their desired effects in healing US/global credit markets. By contrast, a resumption of bank lending and/or a reduction in effective mortgage rates paid by households are more likely to be driven by a resolution of various structural factors (household/corporate deleveraging, easing of mortgage origination/refinancing constraints, etc.) than by additional QE measures.
And if there is one chart Mr. Tepper should look at, it is the following:
So should investors sit paralyzed at this point, now that QE2 is not the definitive catalyst for a surge in stocks that Tepper expects? Not at all - in fact it may be time to go all Taleb on Bernanke's ass. Here are the best ways to hedge risk according to Bank of America, along the 6 key verticals of the unknown which are summarized as: 1) negative growth shock, 2) positive G7 growth shock, 3) risk shock, 4) G7 deflation, 5) inflation, and surprised #6 being no surprise.
1) Cross-asset correlations remain high: use it to your advantage. Substituting another asset class as a hedge may be helpful, as we remain in a riskon/ risk-off world (Chart 13). For example, between April and June the Australian dollar fell almost as much as the S&P 500 despite put options being much cheaper.
2) Finding good hedges is easier than figuring out what will go wrong. Successful hedging involves identifying assets that predictably react to the most number of risk-off events. Equities, industrial commodities, credit and certain FX crosses have been consistently reacting to risk-off events. Hedging with rates may be more appropriate for specific tail risks.
3) The cheapest crash hedges remain in Asian equities and FX such as AUD. Chart 14 illustrates the relative cost of hedging with out-of-the money puts on various assets vs. hedging with a S&P 500 put. Assuming a market decline back to 2008 lows, NIFTY, TWSE, HSI and HSCEI provide similar protection to S&P but at much lower costs (NIFTY is 56% of the cost for the same level of protection). Australian dollar puts offer crash protection at 80% of the cost. Most of these hedges also performed well during the sell-off in April/May this year when the S&P 500 fell 14% as they delivered greater protection at lower cost (For further details on how our favorite tail hedges performed during the risk-off events of 2010, see “Global Equity Derivatives Insights”, 21 September 2010.).
4) Sell expensive tail protection, and exchange for cheap. With tail hedging growing in popularity some obvious tail hedges such out of the money Eurostoxx 50 and S&P 500 options are still historically very expensive. Selling this protection through put spreads captures this premium to reduce the cost of hedging against modest declines. Cheaper tail protection can then be purchased elsewhere such as in AUD or Asian equity markets.
5) Hedging with credit remains expensive vs. hedging with equity options. With equity volatility normalizing faster than credit spreads, hedging with equity options is cheaper than buying protection on major credit indices. Option hedging also benefits from total hedge costs being known up front, versus credit hedging where hedge costs increase as spreads tighten (We are not considering credit options, as we believe they are even more expensive than hedging with credit).
Table 5 compares the cost of buying a one-year put option on the S&P 500 and Eurostoxx 50 to buying protection on major US and European credit indices. The hedge ratios are determined to provide the same protection if both credit and equities re-traced to their stress levels of 2008/09. Buying protection on U.S. HY credit appears the most attractive credit hedge, as it costs 67% of a 1 year at-themoney S&P put. However, we believe HY would only widen to ‘09 crisis lows in a major Sovereign scare, and would be less stressed in most other risk-off events, reducing the value of credit as a hedge. Also, our 1 year forecast for HY spreads of 440bps would increase the cost of a HY hedge beyond that of an S&P put.
6) VIX puts still a good way to pay for hedges if nothing bad happens. With shorter-dated equity volatility falling faster than other asset classes, the term-structure of S&P volatility is again approaching its steepest levels in 20 years. This allows puts on the VIX to roll down the term structure and provide a positive pay-out is nothing bad happens. The profits from these trades can then be used to fund other hedges that expired worthless and can be an effective way to reduce the overall cost of a hedging plan. The most efficient implementation is through VIX put spreads currently, rather than outright puts.
It is without doubt that QE2 will shape the face of risk assets over the next two years. And all those who naively have bought stocks in anticipation of a Tepper-endorsed outcome of a stock surge, may be wise to recognize that not only is there a distinct possibility that the Appaloosa founder is not only wrong, but currently on the other side of the trade. To all these, we highly recommend applying a basket of fat tail protection trades as suggested above. After all, the prevailing groupthink is that the Fed will succeed now as it always has (compare last week's CFTC COT data to see just how little debate there is on the topic). Should the crowd be proven wrong once again, as always eventually happens, watch out below.