Global quantitative easing has worked with a vengeance, fueling a robust asset price reflation which is supporting the economic recovery and has dissipated fears of consumer price deflation. It has worked so well, in fact, that some fear that bubbles are already back. I disagree. I do not think asset prices have run ahead of fundamentals yet, although they will if they do not slow down soon. I also do not believe that major central banks are ready to lean against the wind yet: asset price reflation was a premeditated strategy to support economic and financial activity, and it is working. The risk of asset prices overshooting, especially when they started from extremely depressed levels, is small compared to the risk of a double-dip recession. Therefore, I still expect liquidity to remain abundant and short-term rates low in the coming months. The real action, however, is in FX markets—asset bubbles make for nice dinner party conversation, but exchange rate movements make policymakers sweat. The counterpart to rising commodity and equity prices is a falling US dollar—and a rising EUR. US policymakers are watchful, but not under immediate pressure: the Fed calls for fiscal consolidation plans and plays wargames on reverse repos to signal its readiness to tighten when needed, but is not uncomfortable with the current level of the dollar. For Eurozone policymakers it is a completely different ballgame: on a trade weighted basis the EUR is already at historically strong levels, and will start hitting the recovery at its most fragile juncture, six-nine months from now. The composed reaction of Eurozone policymakers masks a frustrating impotence, and the ECB in particular has now fallen into a more vicious version of a liquidity trap: with market rates near zero it has run out of conventional ammunition, and stepping up liquidity injections might just fuel risk appetite further, pushing the EUR higher. In the short term, I expect the EUR will move even higher, and the pain will get stronger. Further into 2010, help should once again come from Asia, where a number of countries are experiencing stronger capital inflows, stronger growth and reawakening inflation, and will probably start accepting some currency appreciation.
Earlier this year, with economic activity falling off a cliff and financial markets paralyzed, deflation fears came center-stage and triggered renewed interest in the concept of the liquidity trap. Trichet memorably encapsulated the popular understanding of the liquidity trap as “that which, once you are in it, it is extremely difficult to get out”. Other policymakers emphasized that while difficult, it was not impossible. The basic idea of a liquidity trap is straightforward: faced with deflation, a central bank will cut rates to reduce real interest rates and stimulate economic activity and prices. If rates go to zero and prices are still falling, however, the central bank is stuck: nominal rates cannot go any lower, and negative inflation keeps real interest rates positive. Fear of this scenario was at the time also expressed by ECB Governing Council member Bini Smaghi when he warned that the bank should not “run out of ammunition” by cutting rates too low. The counterargument, articulated at the time by Fed officials and by ECB GC member Orphanides, is that a central bank can always print money, a lot of money, so much money that people will no longer want to hold on to it but will rush to buy goods instead.
Quantitative easing, the now familiar technical term of this strategy, has since been deployed with gusto by a number of central banks, notably the Fed, the Bank of England, and the ECB. It has worked extremely well, along two interlinked dimensions.
First, “core” prices of goods and services have remained stable, and inflation expectations well anchored, without suffering any durable repercussions from the brutal downswing in energy prices. Fears of consumer price deflation have been substantially reduced.
Second, and more important, asset prices have recovered, at a faster than expected pace, as the massive injections of liquidity have neutralized the risk of a collapse in the global financial system with attendant asset price deflation. Equity markets have staged an impressive rally—the S&P is up 60% from the March lows—and spreads on both corporate bonds and emerging markets sovereign bonds have narrowed drastically. Commodity prices have also rebounded nicely.
Quantitative easing has worked. In fact, it has worked so well that some worry that we are already experiencing a resurgence of bubbles. This raises two questions: first, are markets indeed running ahead of fundamentals?; and second, what is the risk that central banks may soon start leaning against the wind?
I do not think markets are running ahead of fundamentals yet, but unless they slow down, they soon will. While the rally in asset prices has been impressive, we have to remember that it started from extremely depressed post-Lehman valuations, which priced an apocalyptic scenario. Ex ante those valuations were not crazy—the end of the world might well have come. Ex post, however, the fact that the worst case scenario has been avoided in itself justifies a substantial repricing. Moreover, asset price recovery has been more discriminating than in the pre-crisis bubble period. Banks’ share prices are still well below precrisis values, while emerging markets have benefited from stronger fundamentals and a quicker economic recovery—and even within EM investors are clearly differentiating between countries with stronger and weaker fundamentals and financial systems. The asset price recovery seen so far seems also consistent with the stronger than expected rebound in global economic activity. Looking forward, however, I still expect a weakening of growth momentum that should induce investors in risky assets to take a breather.
If asset prices continue to head north, will central banks react? After all, many policymakers seem to agree that one of the lessons of the crisis is that central banks should watch asset prices, not just goods prices, and lean against the wind with tighter monetary policy once there are signs of froth in financial markets. I believe neither the Fed nor the ECB are yet ready to put this philosophy into practice, however, for at least two reasons. First, both central banks still harbor doubts as to the sustainability of the recovery. Second, asset price reflation has been a premeditated strategy on their part, aimed at supporting an economic recovery. Fed’s Vice Chairman Don Kohn articulated this very explicitly in a speech last week: low interest rates help reverse the flight to quality, pushing investments into riskier assets, strengthening the balance sheets of banks which should therefore find it easier to then raise capital and extent credit. At the same time, rising stock prices and stabilizing house prices help consumer purchasing power and confidence.
There is of course always a risk that asset prices will overshoot, but, given the downside risks to growth, the absence of inflation pressures, and the fact that asset prices started from extremely depressed values, most central bankers will see this as a risk worth taking. This is why I continue to expect ample liquidity and low short term rates in the coming months, followed by a gradual rise in market rates over 2010 with policy rates on hold through most of the year.
There is always a catch, though, and in this case it is in FX markets. The global asset reflation game has turned the US dollar into the main funding currency for carry plays on risky assets, higher yielding currencies, and commodities. In the commodities space, luckily, EURUSD is now displaying a slightly stronger correlation with gold than with oil compared to last year, perhaps as oil demand is still held back by the recession and by lingering doubts about the pace of the economic recovery.
The recovery in risk appetite therefore has become the main driver of dollar weakness—and once again dollar weakness means mostly euro strength, with a number of other key currencies held more or less steady against the greenback. This is where the action really is: asset bubbles make for nice dinner party conversation, but significant exchange rate movements make policymakers sweat.
US policymakers are watchful, but not under immediate pressure. The USD depreciation has so far been extremely orderly, and is in line with the still adjusting macro fundamentals. In fact, on a trade-weighted basis the USD is still 5% away from the historical low hit in March 2008. The risk is that markets might suddenly lose confidence in the dollar, leading to a sudden sharp depreciation, lower demand for USTs and rising market yields. The risk is limited, because large holders of USD assets have too much at stake, and because demand for USTs is supported by the size and liquidity of the market. But the consequences would be disastrous, which is why US policymakers are carefully sending the right signals, with Fed Chairman Bernanke stressing the importance of a fiscal consolidation plan, and several Fed officials indicating that the bank is ready and willing to withdraw liquidity when needed—the recent “wargames“ on reverse repos are an example.
Eurozone policymakers are instead quickly coming under serious pressure. On a tradeweighted basis, the EUR is at historically strong levels, reflecting a sharp depreciation of the pound sterling as well as the USD—the UK is a key trading partner. French policymakers have been particularly vocal on the issue, calling the strong euro a “disaster”. Other EU policymakers have been more restrained in their language, mostly pointing to the US’s declared preference for a strong dollar, but still clearly indicating that FX developments eature prominently in their discussions.
There is a frustrating impotence behind the composed reaction of Eurozone policymakers: they know there is nothing they can do by themselves, and that China and the US are unlikely to come fully on board unless FX movements really become disorderly.
The ECB in particular has paradoxically run into a new liquidity trap: with market rates already near-zero, it has no ammunition left to try and reduce the attractiveness of EURdenominated assets; and stepping up liquidity injections might end up fueling risk appetite further, pushing EURUSD up further—this really does feel like a trap. In the short term, I expect the EUR will move even higher, and the pain will get stronger. Further into 2010, help should once again come from Asia, where a number of countries are experiencing stronger capital inflows, stronger growth and re-awakening inflation, and will probably start accepting some currency appreciation.
