Conclusion: While some strategists consider QE2 (or Quantitative Guessing as we’ve termed it) a bullish factor, we believe it won’t end well. We outline below the market risk that Bernanke has been brewing which may potentially come to the forefront in the very near term.
Position: Short U.S. equities (SPY)
We don’t quite yet have a quantified way of measuring this, but we feel reasonably comfortable saying that, lately, Deflationistas have been awfully quiet of late. Perhaps watching nearly every commodity (outside of natural gas) make either a YTD or all-time high takes the wind out of their sails (on the margin, of course).
Fear not, supporters of Krugman’s Kryptonite; soon you may have plenty of deflation to fear monger about – particularly in equities and commodities. Both the S&P 500 and the CRB Commodity Index have inverse correlations to the U.S. Dollar Index north of 0.90 on a two-month basis (coincidentally, Bernanke got everyone excited about QE2 in Jackson Hole roughly two months ago). The chart below tells the story much better than my prose:
If you don’t know, now you know. Equities weren’t going up globally on the strength of great earnings – and if they were, shame on those Year-End Bonus Peddlers for cheering on more stimulus and talking up bullish fundamentals at the same time.
The largest risk in today’s market (as it was the entire way up) is the interconnectedness of global risk, as evidenced by some of the lofty inverse correlations many equity markets globally have versus the U.S. Dollar over the last two months:
- Hong Kong: 0.96
- South Africa: 0.95
- Brazil, Mexico: 0.94
- S. Korea, Singapore, Poland: 0.93
- U.K., India: 0.87
South Africa?? Poland?? Well, you get the point…
As Keith has been calling out on our Morning Macro Call seemingly every day for the past 3 months, at a point, dollar down becomes a very bad thing. Particularly, if the dollar catches a bid from a round of short covering, a lot of assets globally will come under pressure. Interestingly enough, we’ve had a measurable shift on the margin towards more hawkish monetary policy globally. In the last ten days alone, we’ve had:
- CHINA raised interest rates and called out inflationary U.S. monetary policy for accelerating price gains within their country
- SWEDEN raised interest rates
- AUSTRALIA’s Central Bank set the tone for a near-term rate hike
- GERMANY’s Axel Weber (Bundesbank President) called for the ECB to phase out its bond purchase program
- BRAZIL’s Finance Minister raised taxes again on foreign capital inflows; calls out against inflationary U.S. monetary policy for fueling “bubbles in emerging economies”
- SOUTH KOREA is preparing measures to curb inflationary inflows of capital
- GERMAN and CANADIAN Finance Ministers spoke out against U.S. dollar debasement
- U.S.: Kansas City Federal Reserve President Tom Hoenig delivered a speech warning against the ill-effects of “pumping excessive liquidity into the banking system”
- U.S.: Philly Fed Charles Plosser and former OMB Director Peter Orszag said flat out QE2 won’t help and it fails to address America’s real issues; risks Federal Reserve credibility
- U.S.: PIMCO’s Bill Gross called out QE for what it is – inflationary and bad for both bonds and equities
Not that we need Bill Gross or Peter Orszag to validate our conclusions, we do, however, appreciate the recent Plague of Sobriety that is spreading thorough the market. This week’s (-0.55%) TIPS auction yield explains just how worried investors are becoming of inflation – and rightfully so. If we’ve learned anything from the 1970’s it’s that nothing works from an investment perspective in periods of stagflation. The chart below gives you a prelude of what might become if QE2 is as heavy as some would like:
Now, we’re mired in a slowing growth environment (email us if you’d like to see our presentations on why) and Heli-Ben seems heli-bent on creating inflation to the tune of a sustained +2% YoY in Core CPI. In our models, QE2 = Quantitative Guessing = Inflation; AND Inflation + Slowing Growth = Jobless Stagflation.
From a more immediate term perspective, the confluence of hawkish global monetary policy, hawkish fiscal rhetoric (see: Republican’s new plan to cut discretionary spending by ~$100bn as early as January), and the likelihood that the QE2 announcement will disappoint lofty expectations of $500 billion-$1 trillion is providing a bid for the dollar. We measure the spread of 30-year Treasury yields and 10-year Treasury yields as one gauge of the bond market’s expectations of QE2. That spread has started to come in recently, as 10-year yields have backed up meaningfully over the past 2 weeks. Today, however, on the news that the New York Fed is surveying its banker cronies to gauge market expectations for the size of the program and its impact on yields, the spread has inflected meaningfully. Today’s move might be a sign that the next week’s announcement is more likely meet consensus’ lofty expectations.
As we’ve said before, Ben Bernanke, Charles Evans, and Bill Dudley have officially primed the pump for QE2, and in doing so, have fueled the two-month dollar-debasement rally we’ve seen across asset classes globally. If the size of the asset purchase program in next Wednesday’s announcement doesn’t meet market expectations, look out below. If the market crashes, which we think is in the realm of noteworthy probability, there will be no one to blame but these three amigos. If their announcement satisfies expectations, then the “look out below” simply gets extended in duration, as Jobless Stagflation begins to show up in the reported numbers in 2011 (unless, of course, they change the CPI calculation again).
Should the QE2 announcement miss expectations there’s no meaningful downside support to 1,113 on the S&P 500.
Should QE2 fail to have the desired impact of stimulating growth, what will the next bullish catalyst be? QE3? We have to look no further than Japan to see how this game of failed monetary policy will end. I believe they are on QE86 after 20 years of economic malaise.