Europeans Declare War On The Fed
Pushing the market higher this week was the policy announcement by the European Central Bank and the relatively less-important domestic jobs number that was surprisingly good.
U.S. payrolls went past their pre-recession peak and the unemployment rate is now near a six-year low. At the same time, the U.S. expansion seems to be generating some meager job growth. The market's recent strength is signaling some degree of GDP growth in the second quarter of 2014, but I remain concerned given last quarter's growth numbers.
Effectively, the U.S. stock market is hitting new highs, not on growth prospects but, rather, on the belief that worldwide interest rates are not going much higher. The reason is the Europeans.
Europeans - due to World War II - have a pre-occupation with preventing inflation almost built into their DNA. This concern about inflation is so great that one of the unstated goals in forming the European Union was to take monetary policy away from the European periphery countries. As a result of this obsession regarding inflation, the Europeans were reluctant following the 2008 crisis to loosen monetary policy for concerns of causing inflation.
If you remember, in the USA, we increased spending and engaged in monetary stimulus in response to the 2008 crisis. The Europeans, for the most part, preached austerity (cutting fiscal spending and raising taxes) and were slow to engage in monetary stimulus. Fast forward a few years and the USA is beginning to pull back its monetary stimulus so as not to stoke the flames of inflation. But, European policy makers are now completely focused on deflation, and show no signs of pulling back the monetary stimulus any time soon.
Welcome to the new war of the central banks.
What happens when the U.S. Federal Reserve pulls back its bond buying and, at the same time, the European Central Bank actually increases its monetary stimulus?
The answer is that neither policy has its intended effect, for although there are two separate central banks, there is only one world economy.
There is good news for stock investors though. The fact that European policy decisions are the opposite of those in the USA causes interest rates to not go as high as when it looked like Europe was taking its cues from the U.S.A.
This is good for the stock market in the short-run as it means interest rates will remain lower for longer-than-previously anticipated. This explains why the market is hitting new highs while corporate earnings remain lackluster.
The Europeans are likely to be pretty upset with the USA. They saw the financial crisis as being caused by U.S multi-national financial institutions. Then they witnessed the U.S. economy recovering better from the crisis. In a piece of economic irony, the U.S.A. created the last financial crisis and yet, because of our policy response to that crisis, we rebounded sooner than the European economies.
While jobs are increasing slowly in the United States, Europe is stuck in a slow-growth malaise and is now concerned with potential deflation as opposed to inflation.
Deflation, or falling prices, is far more dangerous than mild inflation.
In a deflationary environment, falling prices cause consumers to put off purchases. If a car is going to be coming down in price, who in their right mind would buy a car today? Instead, people would delay buying a car in anticipation of lower prices in the future.
The conventional wisdom is that monetary policy is the best way to fight deflation. If prices are in danger of falling, the answer is you print more money. As more money circulates in the economy, prices rise and people start buying cars again. This is the view espoused by Stanley Fisher who, at M.I.T., taught both Ben Bernanke and Mario Draghi, the head of the European central bank.
The central bank basically pumps money into the system by cutting the discount rate and by buying bonds. Cutting the discount rate lowers interest rates on the short-end of the yield curve, and buying bonds causes longer term interest rates to fall. The lower interest rates cause more people and firms to borrow money, and this borrowed money is used to jump-start the economy, causing inflation and job growth.
However, when the central bank causes interest rates to fall, even though their primary goal is to increase lending, a secondary effect materializes. The stock market goes up.
Financial securities rise in value when interest rates fall. The reason is that all financial instruments are valued based on the current value of their future cash flows. Lower interest rates result in the current value of these future payments to move higher. The net result is that the stock market rises in value when the Federal Reserve cuts interest rates.
This does not bother the Federal Reserve because the people are made wealthier as the stock market rises. When people have more assets, they tend to buy more things. In other words, this wealth effect helps contribute to economic growth. Driving the stock market upward in value causes people to begin to buy more stuff.
The problem, of course, is that rates are about as low as they can go. Or, so we thought. What happened in Europe last week is that the European Central Bank actually lowered what is called the deposit rate to below zero for the first time ever.
This means that the European Central Bank will actually charge member banks for keeping their deposits at the central bank.
If you are an individual with cash, you simply bring the money to a U.S. bank and the FDIC insurance lets you sleep at night. But what do you do if you are a European bank with billions of dollars in cash? The answer is that, if you want to keep it safe, you give it to the central bank or, if you want to make a return, you might buy securities or lend it to another commercial bank.
The action by the European central bank is designed to stop member banks from holding cash. By charging them on their deposits, the hope is that the member banks will lend the money out, and this lending will help stimulate the economy and cause inflation to pick up.
Essentially, the Europeans are taking a page from Bernanke and doing anything under the sun in order to spur growth and prevent a recession. This monetary policy is effectively establishing some sort of perceived put option on the world equity market.
The biggest risk is holding equities.
We could be entering a period in which a recession occurs and, at the same time, interest rates rise. At times like these, the stock market generates the majority of its losses. My concern is that the constant monetary easing by multiple central banks around the world is creating a situation where this bad scenario is becoming more and more likely to materialize.
Additionally, by having the European central bank do the opposite of the U.S. Federal Reserve, the net result is that neither bank will accomplish their goals. I am concerned that the lack of global coordination with regard to central bank policy is depleting global monetary resources. The problem I see is that the central banks are quickly running out of ammunition, and that they are wasting it fighting each other.
If another macro-economic shock were to hit the USA, the Federal Reserve would not really be able to lower interest rates any further. Additionally, with the Fed's swollen balance sheet, it cannot really engage in the magnitude of bond buying that followed the 2008 crisis. The same is true for Europe, and ditto for Japan. The defensive salvos of the central bank - primarily in the form of lower interest rates and extensive quantitative easing - have already been fired across the world, and Europe is now wasting what it has left trying to offset the activity of the Federal Reserve.
Do not get me wrong. The central bank activity in the USA has been instrumental in spurring the economy to recover from the last recession. The problem is that when a central bank effectively buys bonds they are borrowing from the future. It is a means of essentially pulling economic growth from the future into the current period. The net result is that the future growth must be muted. This is exactly what we are seeing in the USA, and it is also what we are seeing worldwide.
As I have said many times in the past, the stock market prefers a low GDP growth, and a low interest rate environment, but this is not the natural state of the economy. Its natural state is to have some degree of inflation.
My concern is this:
The bond buying that central banks are engineering across the world to prop up financial markets and spur economic growth through a wealth effect will eventually have a bill come due. That bill, in my mind, very clearly comes due when the next recession hits the central banks, and they will not be able to provide monetary stimulus to the same extent as before. Additionally, if inflation starts to materialize at the same time that a recession hits, watch out below.
Right now, as an equity investor, you have the benefit of every major central bank across the world engaging in some form of monetary easing. As the saying goes, you do not fight the Fed, and the best bet is to continue to look for market appreciation. However, the longer a correction is put off, the more severe the correction will be when it materializes. This bull market, in the short-term, will likely continue to climb the wall-of-worry, but when the correction materializes it will be far more violent.
We must always remember that the potential for a sell-off exists every single day in the stock market. So, while the market may be going higher in the short run, eventually interest rates must rise. When they do, the market is going to come under pressure.
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