Where do we go from here? A look at the bubble propped up by the Federal Reserve.
Over the course of the past 5 months the Federal Reserve has flushed the bond markets with liquidity, through its Open Market Operation, the FOMC has bought corporate investment grade bonds worth 44BIllion USD, supported financially sound business through Main Street Lending Program with loans worth 37Billion USD, brought short term notes directly from individual states worth 16Billion USD, brought short term corporate promissory notes worth 9Billion USD and taken various measures to ensure financial institutions and the economy has enough cash to weather the current economic storm.
All these measures and the subsequent effects on the US equity markets, which has never been at a higher P/E valuation and from a layman's point of view more disconnected from the real economy, along with US dollar, lead to many believing we are in a bubble, here are 3 different short-medium perspectives for what may happen, in regards with asset prices, dollar valuation, and wider economy at large, keep in mind broad assumptions are being made in this outlook-
Scenario 1- The Extremes.
The moderate scenario, the economy chugs along- A post vaccine economic boom leads the equity markets to realign with reality, the federal reserve starts to phase out its tools and QE remains a solution to a problem which it created, a system too big to fail, doesn't.
A third perspective, one which looks at USD cash flows into emerging markets and dollar in comparison to emerging market currencies, and its effects on dollar denominated global debt.
Scenario 1: The Two Extremes
With J.Powell publicly stating that the US is not going to implement NIRP, in the event in which real GDP and other per capita metrics do not continue to grow, QE and ZIRP have failed to stimulate the real economy and would force the Fed to take either of two paths.
Expansionary policies are abandoned- One in which NIRP is not adopted, a case in which the federal reserve would have to walk away by raising interest rates which would create a correction in asset prices, this would be with precedent as seen in December 2018’s market sell off when the Fed raised interest rates. A slow down in QE would raise bond yields, pushing those previously participating in corporate bonds back to government bonds, those in high yield bond markets back to investment grade corporate bond markets, those in the stock market back to high yield bond markets, in which case the stock market with reduced liquidity would correct itself.
Expansionary policies are sustained- Yield Curve Control (YCC) is implemented which would decrease short term bond yields and further inflate bond and equity prices as those investors in the shorter term government treasury market would chase yield to longer term and so on. The bubble in this scenario would continue to inflate and asset prices would continue to rise.
NIRP in this extreme scenario would be implemented, which would bring major issues of its own, for example, if we take a look at Japan's sustained ZIRP in the 1990s which led to the “lost decade” a period of time between 1990 and 2000 where ZIRP failed to stimulate the economy, leading to stagnation and deflation as the economy would have a preference of holding cash over low yield asset classes. QE in this scenario further buys junk grade corporate bonds and ETFs, treasury yields are driven down further and banks prefer to hold cash, or even prefer to deposit money in the federal banks negative interest rate reserves. More recently in Japan's adoption of NIRP in 2016 we see the Bank of Tokyo-Mitsubishi UFJ, the country's largest private lender announcing their interest in walking away from the Japanese bond markets due to its instability. Deflation occurs as people do not spend as much due to the failure of fed's tools to stimulate the economy, do not save as much because interest rates are not attractive, do not invest as much because the consequences of the previous two points have an impact on equity market growth.
Both these are extreme scenarios, portrayed mainly to make it easier to visualise the Federal Reserve's tools and actions.
Scenario 2: The economy chugs along
In this super optimistic scenario, the economy has a post vaccine economic boom, the economy would in this case eventually meet the stock market once again, that is to the levels pre virus which were inflated as well. The federal reserve cannot however phase out QE as such a move would spook the inflation of the equity markets. The bubble exists as it did before the market stress, and how in the long term the fed eases out QE while continuing to prop up the stock market is something to think about. If we look at Japan’s QE The stock market might also continue to grow as cash flows transfer from gold and silver assets to other financial markets, however this is on the assumption that bond yields continue to sustain at current levels.
To facilitate a post vaccine economic recovery however It would be interesting to see if the federal reserve chooses to have another round of economic stimulus in the form of direct cheques to the people and PPP loans to business as done before, or perhaps choose to innovate other tools, such as the ones we see being used by the government in the United Kingdom with ‘Eat Out to Help Out’ economic stimulus.
A look at DXY and the Dollar
A viewpoint contributed over at reddit by user u/1terrortoast takes another interesting perspective. Over the past two months many have loudly proclaimed that it is the death of the dollar, looking at DXY, an index which measures the value of the USD with a basket of other world currencies.
(US. Dollar Index)
However there is a fundamental issue with proclaiming the death of the USD by only looking at the DXY and that is due to the DXY being predominantly made up of the EUR/USD currency pair, with it accounting for nearly 58% of the index. With the federal reserve maintaining currency swap lines, and the appreciation of euro in recent times, it's not surprising to see the dxy falling, however this figure does not paint the full picture.
The US Dollar is much more influential in the emerging markets of the world where dollar inflows make up a majority of international trade revenues. The Trade Weighted US. Dollar Index is a broader measure of the value of the USD as it updates yearly and consists of many more emerging economy currency pairs.
(TRADE WEIGHTED USD INDEX)
Here we see USD retaining its value even above what it was being valued at before the Fed pumped the markets with liquidity. This is because of the 12.6 trillion dollars in US dollar denominated debt across the world. With global exports still stunted due to the pandemic and its effects, USD inflows for a lot of emerging markets are stunted.
(Japan Exports growth YoY%). (South Korean Exports growth YoY%)
(Thailand Exports growth yoy%)
With exports stunted, the outlook seems to look extremely bleak. If we look at Argentina ‘technically’ defaulting on its USD debt payment for the ninth time by failing to service its debt in may of 2020 , it approached the IMF for a debt restructuring scheme, but what is the case if one more country or even 5 more countries fail to service their debts, will the IMF be of help in this grim future? Providing further context to the previous question, the IMF received emergency loan requests from 80 countries on the 23rd of march, 2020.
The potential dollar shortage has led to uncertainty within the financial systems functioning as a whole in the nearby future, we can also see this if we look at gold, many people like to think that gold rises with inflation, however if we look at the United States CPI, the Euro area CPI and gold we see a different picture.
(Eurozone CPI) (United States CPI)
(XAU:EUR : XAU:USD)
An implication of rising gold without the proportionate rise in CPI means two things, QE does not translate to the creation of actual money inside the economy and that gold prices are being driven up by the uncertainty regarding the financial world's immediate future. In effect this would also mean that Zero Interest Rate Policies are not working, as an increase in loaning facilities by the commercial banks would result in the circulation of actual wealth which would be inflationary, however, we would need further data points to arrive at a concrete finding.
In conclusion, unless the federal reserve created currency swap lines with many more central banks of emerging economies, or unless we see international trade miraculously return to pre corona levels, we might be at the start of a USD shortage. Which questions not only the stability of global economics and the stability of all currencies but also the long term future of having a US Dollar standard for the world.
By Anant Kumar Jain - BSc Management Student at Warwick University
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