The Fed was able to end its massive $3.7 trillion series of Quantitative
Easing campaigns without the stock market and economy falling apart. The end
of QE 3, in October of 2014, did cause temporary turmoil in the major
averages; but all in all, it did not lead to a protracted market decline, nor
did it immediately send the economy into a recession.
The consensus view then became that the Fed's strategy of unprecedented
interest rate and monetary manipulations was a huge success, and it would be
able to slowly raise the Fed Funds rate with impunity.
Perhaps it was this assurance that gave Ben Bernanke's successor, Janet
Yellen, the temerity to begin liftoff in December of 2015. However, when the
Fed commenced its first rate hike, it led to the worst beginning of a year in
stock market history, as the Dow Jones industrial average lost more than 10%
of its value between January 1st and Feb. 11th. Therefore, while the markets
seem to have become somewhat comfortable with the end of QE (at least for
now), they have also reached the consensus that a protracted tightening cycle
is a completely untenable position for the Fed to hold.
The U.S. Central Bank's "success" with QE, coupled with the
pervasive condition of economic weakness throughout the world, persuaded the
Bank of Japan (BOJ) and the European Central Bank (ECB) to not only follow in
the Fed's QE footsteps, but also to force sovereign debt yields into negative
territory. In fact, thanks to the BOJ's ¥80 trillion ($660 billion) and the
ECB's €960 billion ($1.06 trillion) per annum bond-buying schemes, there is
now nearly $12 trillion worth of government debt that trades in sub-zero
territory. What's more, is the ECB's total QE program now exceeds the entire
GDP of Spain and Italy; while the BOJ's intervention has brought its
ownership to over half of all ETFs and over 33% of all its sovereign bonds.
But as arduous as the path to interest rate normalization will be to the
Fed, it will be far more chaotic for the BOJ and ECB to even hint at rate
hikes. Indeed, it will be virtually impossible for these two central
banks to terminate their counterfeiting sprees without causing complete chaos
in global markets and economies.
This is because the Fed stopped its QE programs well before inflation hit
2%, and when the Ten-year Note yield was well above zero percent. Year over
Year CPI in the U.S. was 1.6% in October 2014 and was headed down towards
negative territory by the start of 2015. Also, the 10-year Treasury was 2.3%.
Hence, inflation was below the Fed's target and going lower, while Treasury
yields were far from being negative. These two conditions allowed the Fed to
stop buying bonds without causing the market to completely revolt.
In sharp contrast, Messer's Draghi and Kuroda have vowed they would not
end QE until the inflation target of 2% is achieved in a sustainable manner.
But these gentlemen have been trying, unsuccessfully, to bring inflation to
that level for years; what gives them the confidence they can stick the
landing on a 2% inflation target? They cannot. Inflation will eventually rise
to 2% and keep on moving higher.
Also, 10-year yields in Germany and Japan are negative 20bps and 28bps
respectively. This amounts to a tremendous difference in economic conditions
that were evident in the U.S. during the end of QE 3 and what we find in
Europe and Japan today. By ending QE when disinflation was still prevalent
and yields were in positive territory, the Fed was able to cease its
intervention in markets without causing its bond bubble to burst.
However, by waiting until inflation is well entrenched in the mindset of
investors and after pushing sovereign bond yields well into negative
territory; the ECB and BOJ have unwittingly backed their sovereign debt
markets into death traps. Therefore, even suggesting that it is time to
gradually pull back from bond purchases will cause a colossal stampede out of
Japanese Government Bonds and European Sovereign Debt.
Traders that have habitually been front-running the central banks' bids
will try to dump their holdings of negative yielding debt as bond prices
plunge in response to a 2% -- and rising -- inflation rate. Throw in debt to
GDP ratios that have absolutely soared since the Great Recession of 2008 and
the result will be complete chaos in bond markets.
Even worse, whatever anemic growth rates that have been achieved in
Euroland and Japan have come off the back of asset bubbles and persistently
falling borrowing costs and debt service payments. Therefore, as bonds begin
to reverse decades of falling yields, look for the denominators in the debt
to GDP ratios of these countries to plummet. Thus, exacerbating the move
higher in rates, which will only expedite the plunge in asset prices and in
turn further depress GDP growth.
This is the inevitable result of such massive and unprecedented
distortions in market prices. Sadly, the price discovery mechanism has been
trampled on for so long that a safe return to free markets has now become
absolutely impossible.
