The Trouble with Addiction
The problem with addictive substances is that while they may be pleasant, they are also addictive. Global monetary policy setters are finding that out; well, actually, we all are, as the QE juggernaut rolls on. In the beginning, as the ruins of Lehmann Brothers were swept from Wall Street, central banks, particularly in the developed world, struggled to prevent a complete meltdown of the economic system caused by the weight of public and private debt built up in the boom years of the preceding decade or so. QE – effectively creating new money to pump into the economy to try and stimulate demand – was one of the preferred choices of action. Over the last cycle, the Fed has been feeding $85 billion per month into the US economy through a programme of bond purchases.
Now, every good thing must come to an end, as my mother used to tell me. So speculation has been growing that the Fed would begin to taper that amount, reducing it by perhaps $5 billion a month; that’s not really a big reduction, and in fact, given that we are talking about an overall increase in money, reduction is probably the wrong word. It’s a slowing of the rate of increase. Nevertheless, just that partial expectation of something that may happen caused a 1% rise in 10-year US bond rates.
That increase has an effect not only domestically in the US but also around the world. In the US, a rise in bond rates is a precursor to higher mortgage rates and across the globe the effect it will have is to cause investors to withdraw funds from perceived higher-risk assets. In other words, a rising (nominally) risk-free US bond rate lifts the hurdle rate of return investors will require to invest in riskier assets. Amongst those riskier assets, obviously, are international stock markets (particularly those of developing nations) and commodities. Clearly, industrial metals are also part of this asset class. So there is a lot riding on the Fed’s decision, domestically and internationally, because the money created under QE does not stop in the US; it flows throughout the global economy.
Lack of Confidence
The fact that they have decided not to begin the tapering now tells us a couple of things about their sentiment as to where the economy stands. It suggests that the people at the top of the US monetary policy making are not that confident in the strength of the recovery there, and that they would rather face the potential of a dose of inflation than risk exploding the property market (again) by seeing mortgage rates increase. I think it also signals to us outside the US that the US is prepared to set the price of money to suit its domestic situation; that may sound obvious – what government wouldn’t do that, after all? – but it sits uncomfortably with the US dollar’s role as the world’s reserve currency, because one day the tap will have to be turned off. What the policy makers are betting on is that they can ride the wave for the moment and hope that they can stay afloat in the maelstrom when it breaks. But up to now, we still have to ask the question of whether QE is any more than a band-aid stuck over the wound, hoping that it will heal. Looks OK on the surface, but can we really see what is happening underneath?
So far, since the decision was announced on Wednesday (18th Sept) we have seen the predictable rally in stock markets across the globe, commodities have picked up (poor old aluminium still looks unhappy, though) and I am sure the putative rise in US mortgage rates has been put on hold for the moment. Also, the US dollar has weakened against its major trading counterparts. That, of course, points to the danger; the countries in the world with growing surpluses – mostly in the Far East – hold a lot of their surplus wealth in US dollar-denominated assets. That creates a potential problem, as well, because ultimately they are going to question the reason to keep reserves in a currency being devalued by its own government to protect the domestic economy. That doesn’t chime with the role of global reserve currency.
Addiction, or not?
So that’s the problem with addiction; if you keep on, everything looks rosy, but the long-term effects just keep on getting worse. Stop, and the pain is immediate. Up to now, the policy-makers have gone with the former; at some point, they will have to choose the other course.
Next week’s article – by a guest writer – paints a far more apocalyptic view; one I don’t necessarily share, but good for the gold bugs. It will appear next Thursday or Friday.