Against the tide: Why the Fed’s QE2 won’t float

The big fall in US treasury yields after the announcement by the Federal Reserve of its latest quantitative easing measures (QE2) shows that sovereign bond markets of some of the most fiscally horrible countries in the world continue to deny history and fundamentals. Japan, the UK and the US are the cases in point. Why are yields so low? The deflationists believe the world is stumbling into a nuclear winter of deflationary double-dip recession and debt deflation; inflation will be nonexistent or negative.

But ‘double dip’ is hardly ‘debt deflation’ and I see nothing in either the dispersion or the degree of US price changes that heralds deflation. It is more likely that the world economy is entering a glide path of low growth in a post-credit-crisis economy that will last for five years or more. Over-leveraged private and public sectors both deleveraging simultaneously will cap demand growth; the supply side of the economy will suffer weak potential growth, as well as the permanent loss of output incurred during the credit crisis.

This loss of potential growth is because of the unresolved overhang of bubble assets; the misallocation of resources that sprang from misconceived policies to combat the credit crisis (for example, an explosion of sovereign debt financing crowding out productive investment); and a continued impairment of credit and savings intermediation.

The Fed has now stepped in to buy yet more US Treasuries along the yield curve. Bond markets have reacted accordingly. Equity markets are calm, which they would have no business being if deflation was truly at hand. Equity investors are simply waiting for a new wave of liquidity from QE2 to find its way into more risky assets. This more than offsets the motive to sell because the economy is slowing. In a nutshell, bond markets and equity markets are reacting rationally in anticipation of QE2, but not in anticipation of deflation.

The Bank of Japan is likely to follow the Fed soon with its own QE2, using both purchases of foreign currencies and Japanese government bonds. There is a need to weaken the yen. And the opposition Your Party is demanding inflation targeting by the BoJ in return for supporting the weakened government coalition. So the BoJ is likely to produce the same response as the Fed, although it will do so with great reluctance compared with the Fed’s enthusiasm.

We are going to wake up one morning with both the Fed and the BoJ expanding their balance sheets by another 50%. This can only drive sovereign yields lower – at least in the US and Japan, and possibly in the EU by contagion. Equity markets and commodities will also rejoice at QE2 because of the liquidity injections that will flow into all compartments of financial markets and not just treasuries or JGBs.

In currency markets, the likely effect of QE2 will be to punish the implementers. It could mark the turning point for the yen. And it could be the last nail in the coffin of the dollar too.

But investors beware! QE2 is yet another policy perversion that will result in great pain down the road. Resources will continue to be misallocated in both fiscal and monetary terms. Deleveraging will be delayed because debt will cost nothing. Government debt will be monetized, allowing governments to bloat their activities even further. Inflation and low growth would be etched even deeper into the long-term future of the major economies.

The rejoicing at the Fed’s move could come to an end pretty quickly if the dollar collapses as foreign investors lose faith completely in US policies. For those who want to play the QE2 anticipation theme, remain very nimble of foot, be prepared for the markets to turn negative on the policies much more rapidly than previously and watch the dollar’s value as the signal to leave by the fire exit. A rout of the dollar or the yen would mark the moment when the sovereign debt crisis spreads to places that really matter.