One month ago we presented to readers that in the first official "serious" mention of "Helicopter Money" as the next (and final) form of monetary stimulus, Australia's Macquarie Bank said that there is now about 12-18 months before this "unorthodox" policy is implemented. We also predicted that now that the seal has been broken, other banks would quickly jump on board with an idea that is the only possible endgame to 8 years of monetary lunacy, and sure enough, both Citigroup and Deutsche Bank within days brought up the Fed's monetary paradrop as the up and coming form of monetary policy.
So while the rest of the street is undergoing revulsion therapy, as it cracks its "the Fed will hike rates any minute" cognitive dissonance and is finally asking, as Morgan Stanley did last week, whether the Fed will first do QE4 or NIRP (something we have said since January), here is what is really coming down the line, with the heretic thought experiment of the endgame once again coming from an unexpected, if increasingly credibly source, Australia's Macquarie bank.
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Would more QE make a difference? Have to move to different types of QE or allow nature to take its course
It seems that over the last week investor consensus swung from expecting Fed tightening and some form of normalization of monetary policy to delaying expectation of any tightening until 2016 and possibly beyond whilst discussion of a possibility of QE4 has gone mainstream.
Although “QE forever” and no tightening has been our base case for at least the last 12-18 months, we also tend to emphasize the diminishing impact of conventional QE policies. As the latest Fed paper (San Francisco) highlighted, “There is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed-inflation and real economic activity. Indeed, casual evidence suggests that QE has been ineffective in increasing inflation”.
Whilst one could apply the same for BoJ and ECB QE policies, the above quote perhaps underestimates what could have happened to inflation if there was no QE. In other words, whilst it is true that both real GDP and inflation rates are undershooting CBs’ targets and have been lower than consensus expectations, would the global economies have undergone a severe case of deflation in the absence of QE? The answer is probably in the affirmative.
However, the challenge is that ongoing flow of QEs prevents rationalization of excess capacity (in turn created through the process of preceding three decades of leveraging) whilst also precluding acceleration of demand (both household and corporate), as private sector visibility declines. Hence declining velocity of money requires an ever rising level of monetary stimulus, which further depresses velocity of money, and requiring even further QEs. Also as countries compete in a diminishing pool by discounting currencies, global demand compresses, as current account surpluses in these countries rise not because of exports growing faster than imports but because imports decline faster than exports. This implies less demand for the global economy.
If the above fairly “bleak” picture is correct, then how much incremental QE do we need to arrest (at least temporarily) the decline in global liquidity and ensure that overall liquidity grows by at least ~10%+ to enable continuing leveraging? In the context of 2016, the numbers would suggest that we would require incremental QEs to the tune of at least US$700bn to replace declining FX reserves. However, if we were to aim for 10%+ rise in overall liquidity, incremental QEs need to be at least US$1.5-2 trillion, rising annually into perpetuity. As QEs rise, their efficacy would continue to drop.
Hence, there is an urgent need to either allow nature to take its course (i.e. re-set the business cycle by either closing excess capacity or writing down debt) or re-assess the nature and type of QEs used. We maintain our view that it is highly unlikely that CBs would be prepared to accept the inevitable and stop “managing business cycles”. If nothing else the consequences of re-setting the cycle (either demand or supply) are perceived to be socially and politically unacceptable.
We believe that the path of least resistance would be to effectively ban capitalism and by-pass banking and capital markets altogether. We gave this policy change several names (such as “Cuba alternative”, “British Leyland”) but the essence of the new form of QE would be using central banks and public instrumentalities to directly inject “heroin into blood stream” rather than relying on system of incentives to drive investor behaviour.
Instead of capital markets, it would be governments that would decide on capital allocation, its direction and cost (hence reference to British Leyland and policies of the 1960s). It could involve a variety of policy tools, with wholesome titles (i.e. “Giving the economy a competitive edge”, “Helping hard working American families” or indeed recent ideas from the British Labour party of “People’s QE”). Who can possibly object to helping hard working families or improving productivity?
However as the title of our previous note suggested (“Back to the Future”), most of these policies have already been tried before (such as Britain in the 1960-70s or China over the last 15 years) and they ultimately led to lower ROE and ROIC as well as either stagflationary or deflationary outcomes. Whilst the proponents of new attempts of steering capital could argue
that we have learned from the lessons of the past and economists would start debating “multiplier effects” and “private-public partnerships”, the essence of these policies remain the same (i.e. forcing re-allocation of capital, outside normal capital market norms), and could include various policies, such as:
- Central banks directly funding expansion of fiscal spending;
- Central banks and public instrumentalities funding direct investment in soft (R&D, education) and hard (i.e. infrastructure) projects; and
- Outright nationalization of various capital activities (such as mortgages, student loans, SME financing, picking industry winners etc).
Whilst, these policies would ultimately further misallocate resources, they could initially result in a significant boost to nominal GDP and given that capital markets are now populated by highly leveraged financial instruments, the impact on various financial asset classes would be immediate and considerable. In other words, neither China nor Eurozone need to spend one dime for copper prices to potentially surge 30%+.
Are we close to such a dramatic shift in government and CB policies?
We maintain our view that for CBs to accept this new form of QE, we need to have two key prerequisites:
- Undisputed evidence that it is needed. The combination of a major accident in several asset classes and/or sharp global slowdown would be sufficient; and
- There has to be academic evidence (hopefully supported by sophisticated algebra and calculus) that there are alternatives to traditional QEs.
At the current juncture, none of these conditions are satisfied. However, we maintain that as investors progress through 2016-17, there is a very high probability that both conditions would fall into place.
What about short-term (say next three-to-six months)?
Whilst we believe that it is indisputable that the Fed needs to ease rather than tighten, the hurdle rate for Fed to embark on QE4 in an election year is far greater than doing nothing. At the same time, both ECB and BoJ are likely to maintain their current policies, perhaps somewhat expanding the scope but they are unlikely to embark on anything more dramatic. In terms of PBoC, it is currently attempting to fine tune its policies and avoid what it perceives to be excessive policy shifts (as it tries to reconcile short-term liquidity and a long-term structural agenda). Ultimately, we maintain that China is at the very early stages of massive stimulus (both monetary and fiscal). However, it probably lies beyond the next three-to-six months.
If the above policy choices are made, then we believe that global liquidity would continue to contract, creating ever greater deflationary pressures and potentially causing both “accidents” as well as slower growth.
However, this assumes perpetuation of perceived policy errors, which is always a dangerous assumption to make. We maintain that it is likely that prior to trying extremely unorthodox measures, Central Banks are likely to have another try of more traditional monetary stimulus measures. However, as outlined above, in order to make a difference, the incremental increase in the size has to be significant. Small and incremental changes are unlikely to make much difference.
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Thank you Macquarie for stating what most "fringe" blogs have been saying for years.
To summarize what Australia's biggest investment bank just said, in a nutshell, "small and incremental is out", and will be replaced by big and "paradroppy", a step which as Macquarie succinctly puts it, will "ban capitalism and by-pass banking and capital markets altogether."
Crazy? Not at all: since the status quo will be fighting for its life, this step is all too likely if it means perpetuating a broken system, and an economic orders based on textbook after textbook of lies. In fact, we would go further and say war (of the global variety) is also inevitable, as the global "1%" loses control. It won't go quietly.
Finally, we most certainly agree that the catalyst to unleash the "endgame" cycle will be some "combination of a major accident in several asset classes and/or sharp global slowdown." But long before that even, keep an eye on gold: having provided a tremendous buying opportunity for the past 4 years because for some idiotic reason "conventional wisdom" decided that central banks are in control, have credibility and can fix a problem they created and make worse with each passing day, soon the global monetary debasement genie will be out of the bottle, and not even the entire BIS trading floor will be able to suppress the price of paper (as physical gold has not only decoupled from paper prices but long since departed on a one-way trip to China) for much longer.