Chris Hart
How Ben Bernake spooked the world's markets
LAST week’s meeting of the Federal Reserve’s open market committee was a pivotal moment.
This was the market’s moment of truth, when the dependence of equities and bonds on the massive amounts of quantitative easing was exposed. No major decision was communicated, merely a suggestion of a potential shift in monetary policy in the future.
But the Fed’s statement was an immediate shock, because it indicated that the US central bank was considering tapering off its quantitative easing programme, which runs at $85-billion a month.
The shock was global. Immediately, there was a sell-off in bonds and equities — including in South Africa.
The normal trade pattern when people think there is an increase in market risk is a shift from equities to bonds; when the perception of market risk drops, there is usually a shift from bonds to equities.
Last week, the reaction even extended to US treasuries and German bunds — a major concern. Although another global crisis is not necessarily immediately on the cards, signs point to underlying distress.
One reason the authorities were able to stabilise the European crisis last year was a dependence on the stable “core countries” to shoulder the bailout burden. But there is no backstop if bonds are sold off, because there will be no jurisdictions where ultra-cheap financing is accessible other than short-term funding through the central bank.
What the past two weeks have shown is that the recovery following 2008’s crisis may well just be a function of extraordinary — but completely artificial and unsustainable — monetary easing by central banks. Interest rates have been suppressed to virtually zero in most of the developed world and central banks have extended their easy monetary policy by pumping in unprecedented amounts of money. This liquidity has propped up bonds and equities. The equity bull run has been separated from underlying fundamentals and bonds are often described as being in a bubble because their valuations are so expensive.
The market reaction to the hint of the Fed tapering quantitative easing was a glimpse of what could happen in a world in which it is absent. The US would not cope if funding costs went back to 5%, where yields were last in 2007. Back then, US government debt was $0.9-trillion — as opposed to $1.7-trillion now.
The market reaction implies that central banks are trapped. Markets have become overdependent on quantitative easing and zero interest rates, and the hint of withdrawal has led to volatility and weakness. Bonds give the greatest cause for concern.
The US economic recovery has depended on a housing recovery mechanism, and higher bond yields will reverse the nascent recovery. Rising bond yields also threaten banking stability as bank balance sheets get eroded by mark-to-market losses on their core assets: bonds.
The rise in bond yields is assured without quantitative easing because there is little fundamental value in bonds. Yields have come down as far as possible. The question is whether this is the turning point, or whether another dose of quantitative easing will drive yields lower yet again. The only good investment outcome for bonds is if central banks persist with, or escalate, their policies.
It is a grim scenario. Debt levels have risen to a point where higher funding costs will strain the system, drain liquidity and compromise credit quality. The nature of the debt is problematic because much of the new debt creation is for consumption rather than investment. The implication is that the global debt pyramid appears increasingly Ponzi in nature.
If financial markets further extend their weakness, tapering will be merely an idea floated at a particular Federal open market committee meeting. To bring stability back to the bond market, the Fed may have to consider escalating quantitative easing — not a tapering. However, confidence in central banks is being eroded as the mar- kets examine the effects of current monetary policy.
The implications for investment strategies are important. Market distress is owing to excessive debt in the developed world and the welfare spending that is fuelling the rise in deficit spending. Assets that depend on confidence should be cut back (these include bonds and cash), whereas assets with intrinsic value — property, precious metals and equities of companies that produce goods of recognisable value — should be accumulated.
Quantitative easing has helped to provide financial market stability, but it is not sustainable. Its scale means it is no longer merely a policy strategy — it has become systemically embedded.
This is the equivalent of a policy mistake and the developed world’s central banks will find themselves in a precarious position in extricating the world from their policy trap. Markets will have to painfully adjust back to reality.