While most of the market participants talk about the Fed tightening cycle (short term), I am getting interested in what will happen on the long end of the curve. Over the past few months, I heard and read debates / talks of a potential round of additional QE and I am more and more confident that US policymakers could trigger it sooner than the market expects.
Last year, while we were approaching the end of QE3 (October 28th), I wrote an article called Could we survive without QE? where I gave a quick recap of the US QE history since the Great Financial Crisis and its impact on the equity market. Clearly, we saw that each time the Fed stepped out of the bond market, equities started to see red colours again, therefore giving a hard time to the Fed’s board. Whereas one would think that the long end of the curve will start to rise significantly, interest rates usually tend to decrease in periods of a steady Fed’s balance sheet (Could we survive without QE? Part II with US yields).
The chart below shows you the evolution of the SP500 index with the Fed’s balance sheet (FARBAST Index), an index that I like to watch quite a bit. The two moving average represents the 50 and 200 SMA of the SP500; it has been a month since the death cross (i.e. 50 SMA below the 200SMA) shows us a negative signal on the equity market.
I have always been curious to know if the equity market is indeed the Fed’s main index, a proxy for the so-called ‘wealth effect’. Can US policymakers afford to lose against this index? If you think about it, with rates mainly trading between the 0 and 2% range (worldwide developed economies), mutual funds and pension funds have increased their equity exposures cutting their bonds portfolio in order to ‘participate’ to this forced asset price inflation coming from the liquidity injection of the central banks. Could you imagine what it means if suddenly we were starting to see a massive correction?
The Fed’s EM concerns…
The global outlook tells me that the business cycle is going down (weak global demand), however each economy tries to create an artificial demand by injecting liquidity. This is how we have tried to ‘live’ over the past seven years. Can the Fed do it without it, especially now in the middle of this EM chaos?
Weak demand (mainly coming from China) tends to weigh on export-driven economies over the long run. The three key variables to look at are the government budget, the current account and the country’s foreign exchange reserves. Typically, if a country shows a persistent twin deficit (i.e. fiscal and current account deficits) in addition to have low foreign exchange reserves, it will definitely struggle. Take for instance South Africa, over the past five years it had a 4.5% fiscal deficit (source: trading economics), it averaged a 4-percent current account deficit and reported 41.5bn USD in FX reserves (SANOFER Index). USDZAR trades slightly below 14 now (13.91), whereas it used to trade around 7.0 in 2010 and 2011 (6.6 in the low range). That represents over 100% devaluation, and rough times haven’t even started yet. I think the big issue for the Fed is the EM crisis, with currencies now facing violent market’s attack. Look at Brazil for example, the real now trades slightly below 4, versus a low of 1.54 in July 2011. As you can see it on the chart below, the central bank has starting a tightening cycle and a series of interventions in order to counter a currency collapse.
As interventions usually mean selling FX reserves, what will happen to the US Dollar? Who will buy those treasuries that EM countries are selling?
But the most important question that I am asking myself, which economy shows healthy figures in terms of International Finance? I believe that as long as there is no obvious answer to that question, the idea of a QE4 is to be considered seriously.
EM banks and their exposure to the financial markets
Another issue for the EM economies that we have seen lately is their banking assets exposure. China banking assets have rose considerably since the Financial crisis and now stands at 31 trillion USD, and has an economy of roughly 10 trillion USD (as of 2014 according to the World Bank). It still has about 3.56trillion USD in Foreign Exchange Reserves which is considered to be an outstanding amount, but is it enough to counter an equity and housing correction? In fact, it only covers a 10-percent bank asset losses. The chart below shows three important indicators that I like to watch when I look at the Chinese economy: the equity market (white line), the FX reserves (green line, WIRACHIN Index) and the Total Non-Performing loans (purple line, CNNPTT Index). As you can see, we have entered into a bear market since June and the Shanghai Composite index is down 40%. Even if its house prices have stabilized in the past few months, the housing market took a downturn in 2014 due to weak demand and a surplus of unsold homes, and have pushed NPLs up to new highs. NPLs are up almost 170% in four years.
In addition, in order to stabilize its currency the Yuan, the PBoC has already started to ‘burn’ its FX reserves since its devaluation last month. The FX reserves are down 450bn USD over the past 15 months, and analysts estimate that we could see persistent interventions in the next few months. To conclude, the outlook isn’t great at all and this is only China. There are many other countries there that are in the same situation or even worse (Malaysia).
I think the EM crisis will be interesting to follow over the next few quarters, and especially how US policymakers will respond to it. In conclusion, a QE4 answer (combined with a 100bps increase in the Fed Funds rate) could be a conceivable 2016 scenario.