The developed world seems to be in an inflationary boom, with neither the U.S. Federal Reserve nor the European Central Bank (ECB) apparently willing to tighten monetary policy.
“My sense is that the markets are behaving as if we’re in an inflationary boom,” said Jurrien Timmer, director of investment research at Fidelity Canada, in a recent webcast.
“We start with the notion that the bull market is intact, the market is flying, it refuses to go down, food riots, political unrest, rising yields, the market seems to be ignoring all of it and just wants to go up. What it tells me is that this market is all about liquidity.”
Quantitative easing: U.S. and beyond
The main sources of that liquidity have been the Fed’s program of quantitative easing, and a shift in investor preference, from bond and emerging market funds, to U.S. equity funds.
Since the second round of quantitative easing in the U.S. last November, the U.S. stock market has been on a tear. Timmer clearly links this performance to the amount of liquidity going into the system. “That explains why or how the market has been able to shrug off some of the negative impulse coming from a pretty sharp rise in treasury yields, skyrocketing food prices (and) Brent oil at $100 again.”
The continuation of extremely accommodative monetary policy in the face of improving fundamentals—indeed an unusual occurrence—is emerging not just in the U.S., but also in Europe and some other economies.
“In the U.S., (monetary) policy is accommodative because of housing and unemployment, and (due to) the headwinds of a private sector debt deleveraging,” he explained. “In Europe it’s the periphery: Greece, Ireland and Portugal.”
The ECB must cater to the weakest link and keep policy relatively easy, despite the effects on a stronger economy such as Germany, which, as an exporting nation, enjoys the benefits of weaker Euro and lower interest rates.
Even China, with all the talk of tightening, really isn’t nearly as tight as the talking heads on TV might have you believe. China is indeed tightening, but not nearly as much as it should, given growth in its consumer price index, asserted Timmer. What may seem like tightening is, in fact, China just easing less than it had been.
“It’s important to remember that whenever China undertakes open market operations to stem the rise of the yuan, it is basically easing,” said Timmer. “It is printing money to generate reserves to buy dollars and sell yuan, and in doing so it is essentially quantitatively easing.”
As long as the gap persists between central bank policy and the fundamentals, these economies will remain in an inflationary boom.
This divergence between global policy rates tends to affect currencies; the flagging U.S. dollar is a prime example. While Canada, Brazil, China, Australia, Indonesia, and New Zealand, are raising policy rates, the U.S. is not only staying low, but is actually going even further negative, said Timmer.
Global risks
The world economy still faces a lot of problems, and unabated structural headwinds top Timmer’s list. “This is probably one of the main reasons why the Fed keeps spiking the punch bowl with more QE2.”
Even when QE2 runs out, he predicts the Fed will hold rates in check for the next couple of years.
Deficits are the other thing that could go wrong in 2012 and beyond. “Our deficits—not just ours, but the ones in Europe—are no longer just cyclical; they’re now structural.”
Any Keynesian will tell you that deficits incurred during recessions should be balanced out by surpluses in the boom years. But as an aging society, the U.S. has very large entitlement costs, such as healthcare and social security. The same is true in much of Europe. Timmer argues that deficits caused by the need to take care of aging populations have now become structural.
“If we don’t reform our retirement programs in the U.S., a couple of decades from now we’re going to be spending a quarter of our GDP just on interest on the debt; and that’s obviously very unsustainable.”
The U.S. debt-to-GDP is already 100%. However, being the reserve currency of the world allows it to keep interest rates low, as other countries have to buy U.S. treasuries to invest their surpluses.
Keeping rates low to fund structural deficits for longer than otherwise possible is a pretty risky business, Timmer warns. “Certainly one needs to ask the question of how long can we sustain this; how long do we keep this sort of get out of jail free card, as it were, or at what point do we get into problems like what Greece and Ireland have, and we have a big spike in interest rates.”
Europe in limbo
Then there’s Europe, bending over backwards to come up with solutions to curb the spread of their debt crisis. Some of these solutions include the European Financial Stability Facility (EFSF), the European Central Bank (ECB) buying peripheral debt, and austerity plans. But nothing has really been resolved by “putting lipstick on a pig,” said Timmer.
“The issue is that we have a solvency problem in Greece, Ireland, Portugal, and all they’ve really been doing is addressing the liquidity aspect of it.”
Ultimately, there are few cures available. One is austerity, which is in effect; the other is debt restructuring. “But of course Greek debt is owned by German banks, so if the Greeks default or restructure, somebody has to take a haircut somewhere, and nobody wants to do that; so they’re still in limbo in that sense.”
A third option would be “unsterilized” quantitative easing, by which Timmer means the ECB buys a lot more of this sovereign debt without extending its balance sheet. However, given Europe’s history of inflation and the Continent’s sensitivity to it, no one seems willing to bite that bullet.
A cold war heating up
Against this backdrop of global financial interdependence, simmering antagonism between China and the U.S. threatens to boil over. The two share a very complicated relationship. The U.S. lost six million manufacturing jobs to China, the result of a labour arbitrage. China prevents its currency from appreciating and invests its export surpluses in the U.S. bond market.
“So we have this very weird relationship where we need their cheap goods or we get inflation, and they kind of need the dollar and our bond market, because they need to put those currency reserves somewhere.”
In essence, it is a symbiotic but somewhat uncomfortable relationship where “China owns $900 billion of our treasuries, and we rely on them to keep our prices down.”
Timmer does not see the U.S. ever going to war with China, but concedes it could be a cold war leading to corollary trade wars and currency hostility. “That’s not a prediction, but it’s certainly something I want to be aware of.”