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And you thought yesterday was fun--what happens when the Fed stops buying Treasuries in June?
04/19/2011 8:30 am EST
What happens in June when the U.S. Federal Reserve stops buying $100 billion in U.S. Treasury notes every month as part of the program of quantitative easing know as QE2?
You’ve heard the wails of worry. Which buyers, if any, will pick up the slack when the Fed exits this market? At the least U.S. interest rates will have to rise to attract those additional buyers. At the worst, a lack of buyers will tip over the entire tower of cards that is U.S. government finances.
And I’m starting to hear another still-building cacophony of worry. The Fed’s most recent program of bond buying will have put $600 billion into the U.S. money supply by the time it’s over in June. A significant portion of that hasn’t stayed in the United States. Instead some of that money has gone overseas seeking better returns in Brazil and China and Turkey and Indonesia than it can get in any domestic U.S. market.
What will happen, the emerging worry goes, when this hot money starts to flow out of the financial markets in Brazil and China and Turkey and Indonesia? Won’t the flight of this hot money create another global financial crisis akin to the Asian currency crisis of 1997 that brought the world to the brink of a financial meltdown?
The key thing that both these scenarios have in common is that they envision a big blow up. Things will go wrong quickly and big time.
Actually, I think, the most likely scenarios have less in common with the Hindenburg disaster than with the slow leak from an inflatable plastic model of the globe. In other words, the end of QE2 will bring not a bang disaster but a whimper of pain—but investors still near to pay attention.
Let me look at each of the two big worries to see how much sleep you should be losing.
First, the Who will buy our Treasuries? worry.
Unless you’ve got some secret alternative global currency that investors, institutions, and central banks can buy instead of the dollar, I don’t think this is as dire as it seems.
The foundation of this worry is a belief that overseas investors have so many dollars already in their portfolio that they certainly won’t buy any more. At the moment at least that doesn’t seem to be the case. Foreign investors as a whole—and this includes the world’s central banks—owned $4.45 trillion in Treasuries as of January 2011. That’s up from $3.7 trillion in January 2010.
You may find this hard to fathom—I know I’ve got trouble wrapping my mind around it. Given the size of the U.S. budget deficit why would any sane investor buy U.S. government paper? The U.S. budget deficit for the fiscal year that ends in September is 10.5% of GDP. Greece, where 10-year bonds yield more than 13%, shocked investors when the 2010 budget deficit was revised upward to 10.5%.
The yield on the 10-year Treasury is, in contrast, 3.41%.
But the United States isn’t Greece in some critical ways. First, Greece is saddled with a euro run by a distant central bank. The United States in contrast controls its own currency. Greece can’t depreciate the euro to restore the competitiveness of the Greek economy. Restoring the profitability of the deeply uncompetitive Greek economy so that Greece can pay off its debt will require very painful long-term reductions in the pay that Greeks take home for their work. Frankly I doubt that Greece can get there for here using this method. The country will have to restructure its debt.
The United States, on the other hand, can depreciate the dollar. I know this possibility is often greeted with horror. The United States has no intention of paying back its debts, the criticism goes. It will just depreciate its way out by letting the dollar sink so that it pays back what it owes in cheaper dollars.
That is a problem, especially in the long run, if U.S. creditors decide that the country has no intention or ability to pay its debts. Then the U.S. could see the same kind of buyers strike that Greece, Portugal, and Ireland have gone through—but without the backup of buying from a central bank. There simply isn’t a central bank in the world big enough to provide that support.
But a depreciating dollar that’s combined with some kind of reasonably credible budget deficit reduction plan is something else entirely. That’s just business as usual: The world’s bond holders recognize that the United States will have to let the dollar depreciate in order to reduce the U.S. balance of payments deficit with the rest of the world. An orderly reduction of that deficit because of a slipping dollar would, in fact, be a good thing in a world that can’t keep running huge surpluses in some economies and a huge deficit in the United States. (Whether the world can engineer that kind of orderly rebalancing is an open question. Right now the odds aren’t good.)
But the biggest thing the U.S. Treasury market has going for it is the disarray in financial markets that might now provide reasonable alternatives in the volume that global investors need. The euro is still in crisis and the euro block of nations looks further away from a solution to the core/periphery problem than it did six months ago. Japan’s budget is even further out of balance than that in the United States—the yen may be a great currency to borrow in if you want to invest somewhere else but Japanese government bonds are even less attractive than U.S. Treasuries in the long run. The Chinese renminbi may be an alternative to the U.S. dollar someday but not until the Chinese government decides that its currency is fully and freely convertible.
All this may explain why, despite saber-rattling about diversifying out of the dollar, foreign central banks bought 60% of the $66 billion in 10-year Treasury notes sold this year.
I think the end of QE2 is likely to come and then go without a big bank explosion in global financial markets. U.S. interest rates may move up slowly as the U.S. dollar falls—if the euro crisis moderates so that the European Central Bank can continue to raise its benchmark interest rate.
But as long as U.S. inflation remains subdued—and the data released on April 15 show U.S. core inflation (the number the Federal Reserve cares about) running at an annual 1.2% rate as of March with headline inflation at an annual 2.7%--I think the Treasury market will be able to absorb the end of the Federal Reserve’s buying program.
The biggest chance of a big bang disaster will come not when the Fed stops buying but when, in order to fight inflation, the Fed needs to start selling the some of the assets that it piled on its balance sheet in QE1 ($1.3 trillion) and QE2 ($600 billion.) Then investors will get to see how big the world’s appetite truly is for Treasuries. I think that challenge is a question for 2012 and not this year. And if you think what I’m saying is that the Federal Reserve will be able to kick its balance sheet problem down the road for another year—assuming that our politicians don’t send the country into default in July in the battle over raising the debt ceiling—then you’re exactly right.
A big bang disaster in the Treasury market is a worry for 2012 and not 2011.
That doesn’t mean the end of QE2 can’t have some wicked effects in 2011 that fall short of disaster in their scale. Even a small increase in U.S. interest rates from the end of QE2 could significantly slow growth in the U.S. economy when it’s added to the effect of higher oil prices and to the cuts that have been made so far in U.S. federal and state government spending. Each of these measures is a small drag on growth in the economy. Together they’re enough to produce a slowdown in U.S. growth that’s noticeable even if well short of a return to recession. Looking at the combined effect of all these factors on U.S. economic growth is one reason why I think the U.S. stock won’t do as well in the second half of 2011 as it will do in the first half.
That’s my take on worry No. 1. Now what about worry No. 2?
A good deal of the money that the Federal Reserve pumped into the U.S. financial markets through QE2 didn’t stay in those markets. Instead it went looking for better returns elsewhere in the world. Since the start of QE2 back in November through February 2011 about $58 billion of that money went into emerging financial markets, according to EPFR Global, a company that researches fund flows. Of that $58 billion about $12 billion went into emerging market bonds and $46 billion into emerging market stocks. That flow of cash is one reason why emerging market stocks were up about 6% in 2011 as of March 31 and emerging market bonds were up 1%.
What happens when those cash flows reverse and this hot money starts to flow out of these emerging markets? The worst imaginings result in something like a replay of the 1997 Asia financial crisis when outflows of hot money took down stock markets in countries that included Thailand and Indonesia, requiring major rescue efforts by the Federal Reserve and the International Monetary Fund to prevent a global financial market meltdown. Less catastrophic scenarios merely call for an extended correction in emerging market stocks. Emerging market stocks recently traded at a 10% premium to developed market equities, Alain Bokobza of Societe Generale calculated in the Financial Times on April 14. With the end of QE2 that could turn into a 15% to 20% discount by the end of 2011, he said. To buttress his argument, he notes that stocks in India trade at three times book value despite inflation well above 8% and with the prospect of more interest rate increases from the Reserve Bank of India.
I think investors can rule out the worst case scenario. The Asian financial crisis was such a close thing in 1997 because the countries involved were had built up debt loads that left them dependent on hot money. They didn’t have the kind of foreign exchange reserves that emerging market countries do now. China’s $3 trillion in foreign reserves is by far the largest fund but Brazil, India, and Korea each come in near $300 billion. Even Thailand, one of the countries at the locus of the crisis, has reserves near $200 billion now. When overseas hot money fled as asset bubbles in these countries burst, some emerging market countries, Thailand, for example, found themselves essentially bankrupt. I don’t think recent asset bubbles are big enough to sink these much bigger and much better reserved economies. (Which doesn’t mean, of course, that individual banks in these economies couldn’t find themselves over-exposed to bubbles in real estate and consumer loans.)
The second worse scenario—a 15% to 20% correction in emerging market stocks is certainly possible. (And while I certainly wouldn’t enjoy that please remember my rule of two that says emerging markets are about twice as volatile as developed markets so a 20% drop in emerging market stocks isn’t a bear market—as it would be in the U.S., for example—but instead roughly equivalent to a 10% correction.)
I think this scenario is unlikely because it ignore the positive effects of the end of QE2 on emerging economies. An end of heavy hot money flows would reduce the upward pressure on the currencies of these countries. That would give relief to exporters in economies such as Brazil who now say they are being priced out of global markets (and thus add to economic growth in these economies.) And it would also give central banks in these countries more room to fight inflation, thus bringing interest rate cycles to a quicker end. (Central banks in some countries have been reluctant to raise interest rates to fight inflation because higher rates would attract more overseas hot money, pushing up the domestic currency even more and hurting national exporters.)
Reversing the flow of hot money out of emerging economies into the U.S. economy would also, quite possibly, strengthen the U.S. dollar. That would itself lower global commodity inflation since global commodities priced in dollars go up in price when the dollar falls.
But it’s not clear to me how quickly these flows would reverse. About $15 billion or one-third of the money that flowed into emerging market equities from the start of QE2 in November 2010 through February 2011 has flowed back out of these markets since then, according to EPFR Global. That’s either as lot—if you look at how fast it happened—or not very much—considering the outperformance of the U.S. stock market in 2011.
And there is, of course, just the little question of how fast this money will flow out of these emerging markets if investors are looking at slowing economies in Europe and the United States.
But whichever way you look at it that outflow hasn’t tanked emerging market stocks.
I think the course of worry No. 2 depends on the timing of the inflation battle in emerging economies. The longer the fight drags on—and more growth that central banks need to take out of these economies—the more hot money will flow out of emerging stock markets.
But I think that question will be answered on a market by market basis as investors see that the inflation/interest-rate/economic-growth story is very different for a Chile, a Brazil, a China, or an India.
That’s the reason that I’ve urged investors to be very selective when they allocated money to emerging markets now. To repeat, you want to put money into economies that are closer to the end of their cycle of interest rate increases and to hold off on investing in countries where the length of the battle is still open.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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