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12 February 2014

QE, the Precursor to a Black Swan?



In an earlier article, “Is QE Sharpening its Teeth?”, we discussed the underlying reasons why QE was used and the intended consequences that Central Banks had in mind. Based on the premise that they achieved what they set out to do, one might say that QE has been a success. The structure and integrity of the banking system has been maintained, (fraud aside) asset prices have been held steady and, in the case of stock markets and bonds, have excelled. What, though, are the unintended consequences of QE, particularly now we are into the “taper” or the reduction of monetary stimulus measures?

The Black Swan

The phrase ‘Black Swan’ was coined by the Roman poet Juvenal who lived in the 2nd century AD, and was a metaphor characterising the rarity of something, as a black swan was presumed not to exist. This metaphor was taken and used to describe unexpected events of significant magnitude by writer and academic Nicholas Nassim Taleb in his book “The Black Swan.” The question now being asked is what is the possibility of a significant financial event brought about by QE manipulation of the global financial markets initiating another Lehman moment?  Are the actions of Central Banks and colluding governments likely to trigger an event that they fail to recognise in their economic models which will topple the first domino? Let us consider what may be outside the control of the new normal QE command economy.

Stimulus

Trillions of Dollars, Yen, Yuan, Roubles, British Pounds and so on have been printed electronically since the outbreak of debt deflation or bankruptcy in 2008 in order to imply solvency and trigger so called “escape velocity”, where debt based spending stimulates the economy to such a degree that increased productivity is achieved. This helps to help reduce deficits to the point that eventually overall debt loads can start to be reduced. Bah, humbug, tosh! You can’t borrow your way out of a debt crisis I’m told, so this must be an exercise in kicking the can down the road.

QE however has had implications, particularly for the US dollar. The dollar is the biggest problem currency at the moment, not because the Federal Reserve is printing even more currency than before, but because they are starting to cut the amount of stimulus. The “taper” is now firmly on the table. The dollar as the reserve currency has an obligation to maintain its purchasing power as most international trade is settled in US dollars and thus most countries have dollar reserves which they rely on to be a good store of value. However, since the 2008 debacle, the Fed has made it clear to the international community that the dollar is the American currency to do with as they (the US) will, and thus it becomes every other country’s problem. They have printed and printed until now, when at last stimulus taper is occurring and the Fed is doing the right thing by the international community. However, as stimulus is being withdrawn some unintended consequences are rearing their heads and could potentially trigger another 2008 moment.

Emerging Market Currency Crisis

Even before the taper started for real, when it was “just talk of a taper,” emerging economies that initially benefited from increased capital flows chasing yield suddenly saw that money being sucked back to the safe haven US treasury bond market, which put pressure on some of their currencies. These currencies generally run hot in inflation terms as their Central Banks have tended to keep interest rates low in order to remain competitive in their export sectors. Also, they want to run a trade surplus as a buffer against foreign capital being withdrawn as happened in the 1997 crisis. High inflation stimulated further by a collapsing currency puts significant pressure on a low-paid working class, potentially stoking political instability in the emerging markets. We have seen many examples of unrest and ultimately deposed governments in countries due to external economic pressure (think Tunisia and Egypt) and currently there are issues in countries like Turkey, Ukraine, Thailand, Argentina and Venezuela. Black Swan material?

Taper Effects in the US

The US economy has its own problems with taper. Think of the perceived “safe haven dollar.” As currency flows back to the US it strengthens the dollar putting the supposed export led recovery in jeopardy. Structural changes that are needed for the US economy require a weaker dollar. The repatriation of manufacturing to the US or re-shoring can only be achieved with a weaker currency.

The taper also has a significant effect on the paper markets. Due to its perceived deflationary effect, the fixed income treasury bond market improves (although that is probably more about its liquidity than anything else, especially as it is the Fed that now holds most of the treasury paper); however, the stock markets start to take a hit. In January we saw a 1000 point pullback in the Dow Jones index. This is certainly not something that the Fed really wants as it is generally felt that a strong stock market has the effect of bolstering consumer spending (so called growth). The reality is however that consumer spending is being maintained by consumer credit, more borrowing which is being driven by low interest rates which the Fed have to maintain at all costs. If interest rates were allowed to rise, monetary contraction (deflation) would start apace forcing the Fed to act by restarting its QE policy once again. The unintended consequence of QE here is that the Fed must always walk a tightrope of holding off deflation by printing enough currency to maintain monetary stability while not printing too much and thus having surplus trading nations losing faith in the dollar and dumping it en masse leading to potential hyperinflation. This leads us nicely into:

Reserve Currency Status

As we saw above, it is the responsibility of the US to maintain the stability and thus the purchasing power of the dollar. This has been brought into question by the policy of QE. China, the global hub of manufacturing and world trade, is sitting on the best part of $4 trillion in reserves. We must consider whether they truly believe that their productive economic hard work is being undermined by US monetary policy. This may be answered in part by what we are witnessing in the physical gold market. Thousands of tonnes of gold have been exported from West to East. It would appear that to protect themselves against continued dollar devaluation the Chinese are hedging themselves with the oldest of global currencies. If this is the case then we could be moving towards a global currency reset with gold being brought back in as a stabilising entity as it is becoming pretty clear that the dollar is losing its appeal as a “store of value.” Could a Black Swan be rearing up from a potential dollar crisis or some kind of physical gold default? Whispers of Comex or LBMA default are coming thick and fast. Where has Germany’s gold gone and why has so much gold left GLD (the gold ETF) in the last year? Time will tell.

Conclusion

Put simply, a Black Swan event may come at any time from any number of events but it will probably be the one we least expect. QE aside, we still have an ongoing Euro crisis, military tensions between China and Japan, Israel and Iran, North Korea and the world, and the US pretending to be everyone’s friend providing they can make on the deal. Putting QE into perspective, it isn’t helping. The QE tightrope we are walking is stretching; let us hope it doesn’t snap.  


This article is written by Richard Horswill. All opinions expressed are strictly his own.   


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