Last week we noted that with the start of Q€ just around the corner, the ECB finds itself in a rather absurd situation. In what we called the ultimate easy money paradox (or, alternatively, the ultimate Keynesian boondoggle), Mario Draghi and crew are doomed to trip over their own policies as they (literally) attempt to monetize twice the net supply of eurozone fixed income this year.
The problem is two-fold: 1) the central bank’s adventures in NIRP-dom mean anyone willing to sell their EGBs would face the truly silly prospect of sending the proceeds right back where they came from, except at a cost of 20 bps (negative deposit facility rate), and 2) because the central bank’s easy money policies have compressed credit spreads, sellers who wanted to reinvest the cash they would theoretically receive for their EGBs would have to do so at ridiculously low rates, a scenario that would compound QE’s already negative effect on NIM for banks and would be absolutely untenable for insurers. So what we have “is one deflation-fighting policy stymying another [and] the central bank’s previous efforts to drive down rates thwarting its current plans to … drive down rates.”
Now, courtesy of Citi’s Matt King, it’s our distinct pleasure to present yet another wonderfully ridiculous paradox inadvertently created by central banks who apparently aren’t capable of understanding when they’re just pushing on a string: manufactured deflation or, more poignantly, just what the doctor did not order. Here’s Citi:
It’s that linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5tn of global QE, which saw corporate bond yields in both $ and € fall to all-time lows, didn’t prompt a wave of investment, what do we think a sixth trillion is going to do?
Another client put it more strongly still. “By lowering the cost of borrowing, QE has lowered the risk of default. This has led to overcapacity (see highly leveraged shale companies). Overcapacity leads to deflation. With QE, are central banks manufacturing what they are trying to defeat?”
Ultimately, the question is whether the ceaseless printing of money is actually creating any demand, and for King, the answer is pretty clearly “no”:
QE, and stimulus generally, is supposed to create new demand, improving capacity utilization, not reducing it. But ... it feels ever more as though central bank easing is just shifting demand from one place to another, not augmenting it.
This point is nicely illustrated by Citi in the following two charts (from a previous note) showing the evolution of inflation expectations over the last several years:
And so, stuck as we are in what looks like a chronic condition of oversupply and as it increasingly appears, in King’s words, that “the decoupling between EM GDP growth and global trade growth over the past decade [now looks] less like a benign shift away from exports to domestic consumption, and more like a world where GDP was temporarily boosted by a surge in credit, where suppliers ramped up capacity in anticipation of 10% nominal EM/Chinese demand growth continuing indefinitely, but where the limits of such credit-fuelled demand are suddenly being exposed,” more QE simply won’t move inflation expectations and certainly can’t do much to further stimulate aggregate demand (assuming it’s done anything in that regard thus far).
In other words, we’ve reached the limit of what can be accomplished and with NIRP creating new market perversions on an almost daily basis, the unintended consequences of continuing to delve deeper into the new paranormal are making the game ever more dangerous as we now have central banks accidentally creating deflation while simultaneously embedding enormous amounts of risk in fixed income markets by sapping every last vestige of liquidity.
Soon enough, expect the rest of the world’s central banks to one by one meet their own Waterloos just as the SNB did in January. In fact, the ECB is on its way there now as it appears everyone is coming to realize that Q€ simply cannot work as designed. On that note, we’ll give the last (rather depressing) word to King:
By definition, races to the bottom are not very positive affairs. And as the sell-off in commodities shows, at some point they can lead to casualties. But the lower yields go, the longer even previously unsustainable debt burdens can be sustained – just look at Japan. Competitive easing may do little to improve long-term growth prospects, but it should make the hunt for yield more powerful still. Even if QE does prove deflationary, until we start running into actual defaults, it is hard to see what stops this.