Unquantitative Nightmares

As investors brace for tomorrow’s FOMC, the market is trying to divine what lies ahead. It is clear that Fed Chairman Ben Bernanke will embark on a program of Quantitative Easing (QE), similar to what was done in the wake of the Lehman collapse. The repurchase of government securities will inject liquidity into the marketplace, with the hope that the banks will make the funds available to households and small businesses. Large corporations already have good access to credit through the capital markets. The Fed seems impervious to the fact that consumers remain highly levered and are trying to assimilate the losses created by the implosion of the credit bubble and the decline in housing prices. Instead, it is sticking to the letter of the law. The Fed’s legislated mandate is to maintain the U.S. economy as close as possible to full employment and price stability. Given that the unemployment rate continues to hover near 10% and consumer prices are well below trend, then the Fed has to act. Moreover, with the third quarter GDP data showing that the U.S. economy remains weak and today’s mid-term elections probably marking the start of a very combative legislature, the Fed has no other choice. At a minimum, it is expected to repurchase $500 billion of government securities, mostly along the mid-part and long end of the Treasury yield curve. This is expected to have the equivalent effect of 50 to 75 bps of easing. The problem is that we are in uncharted waters, and QE may create unintended consequences that could develop into nightmare scenarios.

To begin with, nine years of Quantitative Easing Policies (QEP) did not do much to turn the Japanese economy around. It remains dormant, burdened by trillions of yen in non-performing loans and declining property prices. A 2006 Bank of Japan paper written by Hiroshi Ugai stated that the only beneficiaries of QEP were the Japanese financial institutions, which saw their cost of funding decline massively—regardless of the state of their balance sheets. Clearly, this is what is happening in the U.S. However, the banks are not directing the additional funds into the U.S. economy. With consumers in the midst of deleveraging and the securitization market in tatters, thanks to the sloppiness in the documentation process, the amount of capital that will be pushed into the real economy will be nil. Therefore, most of the funds will find their way into the emerging markets. Capital is flowing unabatedly into the developing world, as investors chase yield and better growth prospects. This is the reason why emerging market currencies continue to appreciate in real and nominal terms. It is also why central banks across the globe are taking steps to introduce capital controls. However, this is producing a new asset bubble, where the returns are not commensurate with the underlying risks. The problem is that when the emerging market asset bubble burst, it will obliterate the last remaining engine of global economic growth, and the prospects for a generalized slowdown will loom large on the horizon.

The other major problem with QE is that no one ever figured out how to exit. Given that the Fed is willing to do “all it takes” to get the economy out of the slump through the use of monetary policy, odds are that they will overshoot and inflation will eventually come roaring back to life. Such a scenario will spell the death knell for the emerging markets. The Fed will be forced to act aggressively, raising interest rates rapidly and pushing Treasury yields above current emerging market levels. The result will be massive capital flight out of the emerging markets and the collapse of the asset bubble. In spite of all of the compelling arguments for investing in the emerging markets, they always need to have higher yields than developed market equivalents, due to the inherent risks and institutional limitations of the developing world. Likewise, the credit ratings of most emerging market countries and companies are lower than their developed world peers. Therefore, if there is an event that drives yields higher in the developed world, by definition, they need to move even higher in the developing world. This is why the emerging markets are setting themselves up for a major correction. The day that QE comes to an end, the Fed will be forced to reverse course and tighten monetary policy. As a result, trillions of dollars will start flowing back into the U.S. This is exactly what happened in 1982, when the Fed abruptly sent interest rates soaring. It triggered a series of sovereign defaults across most of the developing world. Ironically, the banks, yet again, found themselves in a mess, and they had to be bailed out by the Fed. But of course, zombies never learn because they are brain dead.