Through 2011, quantitative easing was the driver of asset price recoveries globally. But QE seems to be over and that news is prompting a sell-off in markets. What matters is not the single data point of sub-par US labour statistics or the meaningless undershooting of the expected slowdown in China’s GDP by a few immeasurable decimal points of a percent; it is the expected reduction in cheap money to buy assets.
US quantitative easing is off the agenda until after the presidential election, unless the economy is weaker than I expect it to be in the next few quarters. What I read from the latest minutes of the Federal Open Market Committee is that there is a lack of support for QE among FOMC members and that Federal Reserve chairman Ben Bernanke also no longer appears to support it.
In Europe, the European Central Bank is done with its Long-Term Refinancing Operations and any interest rate cuts until further notice. There is a nasty whiff of inflation starting to emerge from German wages, with federal employees getting an increase of 6.4% over the next two years. Eurozone inflation is still running above the ECB’s target. Banks in Spain and Italy have ploughed back about 20% of the LTRO net injection of liquidity into their governments’ bonds. But that is now over.
| Yield spread of French 10-year over German bunds |
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| Source: Datastream |
QE in the UK, as in the US, no longer appears warranted by economic conditions. The economy appears to be avoiding the worst outcome. So for the first time in a long while the world is almost QE bereft, with the exception of Japan. This is a fundamental change for asset prices. Once the tide of liquidity recedes, financial assets will have to be repriced on the basis of the hard rocks of economic reality beneath. Not all the rocks represent potential shipwrecks. Global purchasing manager indices point to a resumption of growth. China’s current 8%-plus growth rate is falling but will bottom out at 6.5%. Germany is continuing to boom, with more demand coming from outside the eurozone.
But the threat and reality of a suspension of QE means that the decline in asset prices is highly correlated because nearly every asset has a liquidity premium for QE tagged on top of its economically justifiable price. While that premium is being wiped out, there are no safe havens.
The wipe-out is also bigger in assets that depended on liquidity both to sustain their prices above economic fundamentals (for example, commodities) and whose valuation depended on growth. QE contributed to economic growth through the wealth effect rather than triggering the credit multiplier to the real economy.
The removal of QE might damage growth hopes at the same time as removing the wherewithal to buy assets. That’s why equities were the most vulnerable assets. European peripherals’ debt is vulnerable to both the end of LTRO liquidity and the lack of growth that would make their sovereign debt sustainable.
So the end of QE has a different impact according to the region: the US has some growth and less liquidity; Japan has a little growth and more QE; and Europe has none of either. Thus Europe is hit worst.
Ironically, the impact of the end of QE might eventually lead to its reinstatement. Any sign of weakness in the US economy will bring the Fed riding to the rescue. And if Italian and Spanish sovereign bond yields push above 6.5%, I expect a resumption of Securities Markets Programme purchases by the ECB and possibly European Financial Stability Facility/European Stability Mechanism action too.
Failing that, we need a data surprise from the real economy that things are not so bad. That is more likely to come from the US. But some signs of stability in the peripheral economies of Europe would also do the trick. For example, the Greek election might surprise by delivering a government that sticks to the Troika agreement.
I am most worried about France and François Hollande becoming president, however. If France backtracks on the eurozone’s new fiscal compact, this might move the fissure line between the weak and the strong east of Strasbourg instead of stopping at the Alps and Pyrenees. That would question the survival of the euro in a way that has not been manifest in the latest round of turbulence.