From Scotiabank's Guy Haselmann
QE-Infinity Sends Experiment Awry
In the comedic movie Young Frankenstein with Gene Wilder, a brilliant experiment went awry by an unexpected mistake. When Igor fetched the 'genius brain’, he accidentally dropped it, so he simply got another one. Only when the creature turned into an uncontrollable monster did Dr. Frankenstein ask Igor whose brain it was. Igor's response was "Abby-someone". Logically, Dr. Frankenstein asked, "Abby who?" Igor replied, "Abby Normal."
The Fed’s well-intentioned experiment to bring life to the dead economy is analogous to this movie with QE-Infinity analogous to the “Abby-normal” brain.
For the sake of argument, let’s assume ZIRP (Zero Interest Rate Policy), Operation Twist, QE1 and QE2 were necessary to stabilize financial markets, arrest deflation, and/or help jumpstart the economy. For the moment, let’s reserve judgment on QE-Infinity.
QE-Infinity is dissimilar to the earlier QE actions for three very important reasons: 1) it began under different economic conditions; 2) its’ open-ended time frame hijacked the market’s typical price discover mechanism; and 3) it originated subsequent to earlier actions that had already changed investor behavior. I will address each of these factors.
#1- When QE-Infinity was announced in September of 2012, the economy was healing and progress was being made toward the Fed’s dual mandates. The FOMC was already providing extraordinary accommodation through two policy actions, ZIRP and forward guidance. At the time, the unemployment rate was headed in the right direction having fallen from 10% to 8.2%. The equity market was higher by 15% YTD and had more than doubled from its low in March 2009. And, core CPI inflation was steady and near target.
Yet, Dr. Bernanke was dissatisfied with the pace of the recovery, so he consulted his Great Depression reference guide prior to altering and intensifying the patient’s medicine to QE-Infinity. Unfortunately, I believe this decision has resulted in a toxic combination of drugs that could ultimately lead to the patient’s overdose (which I explain below).
#2 - Price discovery became distorted by QE1 and QE2, but it was QE-Infinity that demolished it completely. Remember, financial assets are valued simply by aggregating the discounted value of future cash flows. Yet, when QE was not given an end date, the market had to accept ZIRP as extending infinitely into the future. Thus, the discount rate used to value those cash flows was assumed to be zero in perpetuity. Dividing a number by zero equals the empty-set. This triggered talk of markets “melting up”.
It was only when QE was viewed as actually having an end-date during ‘tapertalk’ in May that a forward increase in interest rates was priced into the discount rate mechanism. It is for this reason that the market adjusted accordingly after May, thus leading to an increase in bond yields. (100+ bps).
Furthermore, QE-infinity destroyed the foundations of the Capital Asset Pricing Model by flipping the capital structure upside-down. Interest rates had been forced to such artificially low levels that risk/return characteristics became too skewed. In other words, an asymmetric distribution existed, the closer interest rates and credit spreads got to the zero-bond. Government bonds (the risk free rate), which converge to par, offered limited upside potential, but great downside risk. Equities became the preferred asset class, simply because it provided uncapped upside price appreciation that bonds did not. Many asset managers even moved into dividend paying stocks as a substitute for their fixed income exposures. This shift in perception has had a material impact on asset allocation models, and has significantly increased systemic risk.
#3 - The situation is magnified since the QE-Infinity follows the QE1 and QE2 regimens, which had dramatically changed investor behavior. Fed ‘promises’ since 2009 have provided a market ‘put’ that incentivized risk-taking and search for yield. Investors have been afraid of missing out. Or, they fear underperforming benchmarks, competitors, or inflation. Investors have imprudently been chasing the ‘least-bad’ relative return not wanting to ‘fight the Fed’. Fed policies have fostered a herd mentality; an embedded and complacent psychology of bullishness.
Once tapering actually occurs, the discount re-adjustment equation will rise away from zero, making stock and bond valuations less attractive. Prices will ultimately have to be supported by their fundamental values, so a large price adjustment process will almost certainly occur. More importantly, a volatile over-shoot in equity and fixed income markets is likely, because investors will shift current positions from one of accepting the Fed’s ‘easy candy’ toward pricing in the Fed’s new final destination.
FOMC members will not be able to micro-manage that transition as they have suggested. Changing its already complex message and ‘tapering the taper’ seem to be revealing an FOMC vacillating between over-confidence and fear.
Investors, for their part, may be trapped in a ‘greater fool theory’ in thinking they can all unwind risk at the same time. Over-regulation, shrinking bank balance sheets, and fewer market makers mean that market liquidity is challenged. Retracting Fed dollars is always far more difficult than creating them, particularly in the current environment.
In summary, the FOMC scientists have been working in their lab tweaking models to assess marginal benefits, but it is blinding them from seeing the underlying risks that are building. They openly ask what signs of troubles are evident, but the morphine drip has been in use for so long that they can’t see that the current calm may be replaced with an uncontrollable monster unleashed when the sedation fades.