Stocks, bonds and quantitative easing

Stock and bond investors cannot agree on where the economy is going. Their disagreement is driving both markets and only one of them is going to be right.

Congenial stock investors are seizing on any positive data point, strong earnings report and now the prospect of more quantitative easing as proof that slowly the economy is recovering, thereby justifying a rally. Meanwhile more cynical bond investors have likewise seized on any weak data, sovereign debt jitters in Europe and now quantitative easing as proof the economy still faces more bouts of painful deleveraging and possibly deflation, thereby justifying a rally.

Through until March or so, stocks seemed to have the upper hand in the argument until the European sovereign debt crisis put an end to the post-crisis rally, triggering a bond rally as investors sought refuge in the arms of the most solvent governments. Since weak economic data spooked the Federal Reserve into plotting its return to the Treasury market with a second round of quantitative easing, both stocks and bonds have decided to rally. Unfortunately, both risk and risk-free assets cannot long rally together.

Stock investors have the plausible argument on their side that shares are cheap by historic standards and can also claim that there is a dangerous bubble brewing in bonds. Meanwhile, bond investors have historically been much better forecasters of where the economy is headed. The inversion of the yield curve has an uncanny knack for signalling choppy waters ahead while stocks tend to start falling after the economy has weakened or entered into recession. But ultimately, the argument for stocks or bonds comes down to whether you believe that the downturn was cyclical or a structural shift.

If you believe that the financial and economic crisis was cyclical then there is no reason not to think that the economy can return to levels of activity it enjoyed shortly before things went pear shaped. However, if you believe that the crisis has ushered in a fundamental shift in the structure of the economy then you should definitely have big doubts about things returning to the way they were.

We side with the bond investors’ take on the world. Debt issued in unprecedented proportions has created a vast overcapacity in the economy to produce and consume. We can not afford what we are able to produce or consume unless either we take on more leverage again or unless prices come down to levels that would not require more debt. With its plans to start buying Treasuries again, the Federal Reserve clearly does not want deflation to be the mechanism of adjustment and would much rather that the economy take on more, but cheaper debt, especially to refinance existing debt at easier rates.

Unfortunately, the economy so far has shown little interest in more debt. As bonds have rallied and market interest rates have plunged, mortgage lending has not rallied as would be hoped. Rather it keeps falling.

Lower interest rates have so far not created more demand for credit. This does not bode well for a fresh wave of quantitative easing from the Fed. If lower rates are already not reviving credit demand why should even lower rates caused by the Fed’s planned Treasury purchases fuel demand? And yet, while the possible fruit quantitative easing might bear are uncertain, it carries huge risks. It could undermine faith in the dollar if suddenly the mass of dollars explodes as Fed creates bank reserves to pay for the Treasuries it buys from banks. But a perhaps more real danger is that if quantitative easing fails to revive credit demand and boost the broader economy, it could undermine faith in the Fed at a time when it is about the only institution with much credibility in Washington. That would be truly scary.

Ultimately, quantitative easing is better for bonds in the short term than stocks. Bonds can be certain to rally if the Fed buys Treasuries whereas any stock rally is likely to peter out quickly once stock investors realize how weak the economy is if it needs more liquidity pumped into it. But once stocks do stop rallying, a time will come when they will truly be a bargain and bonds will be overbought.

 

 

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