QE2, bubbles & potatoes

Dr. Yuk-Ching Hon

7 January 2012

Now that I’m retired, I have more time reading newspapers especially the FT Bernard brings home from the university every day, partly to look for investment alternatives for my meagre pension since interest rates have fallen to an all time low.

QE2 has been a hot topic in the FT since the Fed’s announcement last week and I have been following some related articles for ideas in investment.

The thought behind QE is simple. Since the Fed can’t cut interest rates any further via traditional routes so instead, it buys government bonds, pushing their prices up and their yields down. Any debt priced off those yields then gets cheaper. The theory is – it then kicks up asset prices and makes everyone happier to borrow, spend and hire rather than squirrel and save. However, creating money in this kind of volume is extreme measure. QE1 makes sense because of the post – Lehman crisis. But this time round we aren’t in crisis of this magnitude.

So, on the whole, responses from economists and financial analysts are less than favourable. And the consensus, as reported by Merryn Somerset Webb, editor in chief of the FT Money Week, is – it won’t work! Just like QE1 which didn’t exactly launch a massive deleveraging of the US economy, only a huge rise in the stock market. As Webb writes, it’s already happening again – the FTSE hit two-year high on Thursday 4 Nov. Whatever the QE cash buys, it puts cash into the market. You sell a bond to the Fed and you have cash which you can use to buy another bond, perhaps from someone who then uses the money to buy a share, perhaps from someone who buys into an Asian market from someone who then buys a gold ETF (Exchange Trade Fund). The money becomes a hot potato leaping from asset to asset and leaving a little bubble dust behind it at each stop! Very dangerous!

Chris Wood of CLSA calls QE2 “a mad experiment”, one which will eventually lead to the collapse of the US dollar and one in which “the Billy boy-led Fed has crossed its Rubicon by presenting QE as part of the routine of monetary policy” rather than an unorthodox measure.

Next is a response from someone more academic.

On 3rd November 2010, writing on the FT, Martin Feldstein, professor of economics at Harvard lampooned QE2 as a risky and dangerous gamble “having only a small potential upside benefit and substantial risks of creating asset bubbles that could destabilise the global economy”. He predicts the Fed’s purchase of one trillion dollars or more long-term government bonds will add an equal amount of cash to the economy and to banks’ excess reserves. Expectation of this has already lowered long-term interest rates, depressed the dollar’s international value, bid up the price of commodities (Oil hit a six-month peak above $86 a barrel and gold rallied to $1,883.7 just shy of its all time peak. The euro hit $ 1.428, its highest since January 2010) and farm land and raised share prices. He reasons that these exaggerated increases, like all bubbles can rapidly reverse when interest rates return to normal levels. The greatest danger will then be to leveraged investors, including individuals who bought these assets with borrowed money and banks that hold long-term securities.

The problem this time extends to emerging markets which was not directly affected in the last crisis. The lower US interest rates are creating a substantial capital flow to those economies, creating volatility. The economies hurt by the increasing value of their currencies are responding with measures to protect their exports and limit their imports, measures that could lead to trade conflict. (Xia Bin, an advisor to the Chinese Central bank has already suggested using currency policy and capital control to cushion itself from external shocks.) In the short-term future, Feldstein feels that when the US economy does improve, the increased cash on banks’ balance sheets will make the Fed’s exit strategy harder. The Fed was previously “cautiously optimistic” it would be able to contain an inflation unleashed by banks with a trillion dollars of excess reserves. However, it will be harder this time if the amount of excess reserves is doubled. This could lead to much higher interest rates to restrain demand or an unwanted rise in inflation.

Feldstein concludes that although there is little more that the Fed can do to raise economic activity. The president and Congress should concentrate on measures to help homeowners with negative equity and businesses that cannot get credit, to remove the threat of higher tax rates, and reduce the out-year fiscal deficits. QE, he cautions, should be used sparingly and temporarily.

So what do you do as an investor if you want to gain something before the bubbles burst?

Webb suggests buying any old Asian or resource fund or metal ETF. If you don’t want to lose too much should it go all wrong, get gold as a hedge against inflation. For those who like a little excitement, dabble in copper – it’s one of the few metals (rare earths aside) that most agree will soon see a genuine shortage of production.