We have quite vehemently reminded readers of the dismal drop in US (and global) macro data over the past few months. These disappointing economic surprises and the ensuing global growth weakness will, Morgan Stanley believes, lead to a global policy response (rate cuts where rates can be cut and QE where they can't) and while they expect this monetary policy to work in many important emerging economies, they are doubtful as to whether it will make a material difference to growth in developed economies. Certainly, there are obvious risks to growth (Euro rupture and US fiscal cliff) that could counteract any QE effect but they rather critically note that unconventional policy is effective when the issue is systemic stress; it is less so when growth is the concern. The QE2 rally was largely due to better macro data, which coincidentally started right after Bernanke hinted at QE2. If macro data stays weak, they expect any 'Pavlovian' QE3 rally to last hours or days, not weeks or months. The bull case for a tradable rally is one of simple observation that prior central bank action has coincided with important market turning points but the more skeptical MS strategists suspect this more correlation than causation as they point to the muted effect monetary policy has in an extended deleveraging to stimulate activity.
Morgan Stanley - Pavlovian Policy or 'Doggy' Markets
Global macro weakness seems set to trigger another round of global monetary easing. Prior aggressive policy action has coincided with risk asset rallies. However, those policy actions also corresponded with improving macro data, which we think was the critical factor. There will be a Pavlovian reaction from markets if we get further easing, particularly QE3 from the Fed. But if macro stays weak, expect any QE3 rally to last hours or days, not weeks or months.
Macro news is falling short of expectations almost everywhere
Our sense is that investors are split on the significance of this, but many see monetary easing as a potential catalyst for a tradable rally, even if they – like us – doubt its ability to significantly improve the macro outlook. The bull case is based in part on the simple observation that prior central bank action has coincided with important market turning points (Exhibit 2).
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Fed balance sheet expansion and US equities were, for a while, correlated (Exhibit 3).
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Other central banks’ balance sheets and equity indices show little correlation.
Our view is that the apparent effect of policy easing was more correlation than causation. However, note two qualifications:
- First, policy easing has a much greater chance of working in EM, where credit systems still function and the economies are not burdened by the structural baggage now weighing on developed economies.
- Second, we are not arguing that monetary policy has been unimportant over the past few years. Unconventional policy has been, at several points, critical to avoiding systemic stress leading to systemic collapse. Central bank liquidity can lubricate a private sector in seizure. This was most obvious after the collapse of Lehman’s. The ECB’s long term repo operation was also important last year. When risk assets, rightly, were affected by the tail risk of systemic implosion, reducing that risk triggers (and warrants) a risk rally.
What’s at issue now is whether unconventional policy either works to stimulate activity, or can directly boost risk asset prices. We’re skeptical on the first point. Deleveraging cycles mute the effect of monetary policy on growth. Unconventional monetary policy may be an effective shield – can defend against systemic breakdown – but not a good sword: broadly unable to encourage a return to normal credit creation, where monetary policy can work to stimulate growth.
Having said that, the important issue for many investors is whether further unconventional easing can trigger a tradable rally in risk assets, even if there is little or no effect on the macro outlook. We’re doubtful. When growth is the concern, as now, tradable rallies require better macro news.
That macro was critical in the QE2 rally is most obvious from looking at bond markets. Whatever else QE2 did, buying bonds should have affected Treasuries - but as the chart shows, the commencement of QE2 – as with QE1 (large scale asset purchases) and operation twist – coincided with rising Treasury yields. And, as an aside, Fed selling Treasuries (as it did in late 2007) coincided with falling yields.
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Of course, we don’t know what would have happened otherwise – perhaps yields would have moved even higher. But that is beside the point. If the Fed’s action were designed to encourage a shift to risky assets by lowering the yield on safe assets, the point is that its actions coincided with rising yields. Moreover, yields fell as LSAP and QE2 ended.
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This shows that not even the Fed can dominate the pricing of the world’s largest, most liquid, asset market. What explains the seemingly perverse reaction of Treasury markets to the Fed’s actions? Simple: it was the swing in macro data (Exhibit 5). The swing in macro likewise explains much of the swing in equities through the past few years, as suggested by Exhibit 6. We think Mr. Bernanke got lucky with QE2: macro data improved almost from the moment it was flagged at Jackson Hole in August 2010. That improvement, not QE2, was in our view the key to the subsequent rally.
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Growth concerns, not systemic risk, are now unsettling markets. Investors, rightly in our view, are increasingly skeptical about the ability of unconventional policy to boost growth in developed economies. Certainly, it seems unlikely to counteract fiscal tightening, now under way in Europe and UK, and in prospect in the US. Further easing may trigger an initial market response – there are too many investors who think it works to think otherwise. But without macro improvement, that risk asset rally will be short-lived, in our view.