It must have been the end of June or July, as it was very hot. However, the room was very fresh and a shiver of excitement went through it when David Zervos, Jefferies strategist with a long experience in the Fed's research office, began to go into the details of helicopter money. Quantitative easing had paved the way, but now financial engineering was ready to try its hand at a quantum leap with unimaginable potential.
It was like being in a Star Trek prequel in which the spaceship designed by Cochrane succeeds for the first time, thanks to an energy field that exploits the interaction between matter and antimatter, to bend spacetime and reach warp speed, exceeding the speed of light by many orders of magnitude. Cochrane, in 2151, had paved the way for the exploration of the galaxy we would see two centuries later by Kirk's and Spock's Enterprise. And while Zervos spoke of the infinite possibilities that the controlled use of that sort of dilithium reactor which is the outright purchase of irredeemable zero-interest public debt by central banks, we began to daydream. Spending more and getting not an increase but a reduction in the public debt, these engineers are really very good.
Unless we wake up today to the warmth of the October sun and hear that central banks, far from taking us to another quadrant of the galaxy through magical black holes and very daring space ships, are even thinking of raising rates and scrapping Quantitative easing without apparently replace it with nothing. Which is like scrapping the Shuttle or the Concorde and going back to our traditional airplanes. Noise of shattered crystals, end of the dream.
So let's see if by chance, from June to today, something has changed in the global economy and in the markets, something that justifies the rise in yields on the long end of the curve, the silence on helicopter money after the summer uproar and this cold and detached attitude from central banks, still recently so loving.
Has growth exploded? Is inflation rising? Here the answer has to be nuanced. In America, after three quarters of disappointing growth, we finally see some acceleration. Nothing exciting, however, since the Atlanta Fed's instantaneous velocity indicator, which was nearly 4 percent a month ago, has already fallen back to 2. Inflation, meanwhile, is higher than to a year ago, but seems to have stabilized.
As for Europe, growth is stable, the Brexit effect has not yet been seen (but it will come) and inflation is on a very slow, almost imperceptible, rise. Of course, the stability that the world is showing (including, very importantly, that of China) is in itself a positive factor which, marginally, can induce central banks to become less accommodating. However, it is insufficient to explain such a radical change of rhetoric.
We then put forward two hypotheses. The first is that, silently, central banks are preparing the ground for precisely that helicopter money that is no longer talked about. Debt monetization isn't exactly Qe squared, it's a different thing. Qe leads to a compression of nominal and real yields while monetization can lead on the one hand to a further compression of real yields but, on the other, brings with it an increase in nominal yields. Central bank-financed spending increases, in other words, create inflation. This inflation leads to an increase in nominal rates which may even be less than that of inflation, but which is still an increase. Hence the normalization of the long part of the curves in America, Europe and Japan.
Yes, one may ask, but what certainty do central banks have that public spending will increase? There are elections in America and there will soon be elections in France and Germany. All right, expansionary fiscal packages will be ready in late spring. What's the hurry to bring up returns on the long end? It is true that both Clinton and Trump will be fiscally expansionary and that Japan, according to Ben Bernanke, is already under helicopter money, but isn't it still a bit soon?
And this is where the second hypothesis comes into play. Yields below zero, especially on long maturities, are starting to have more negative than positive effects. We already have companies that invest little, but now we seriously risk that even individual investors, seeing the flow of coupons on their bonds disappear, start saving more by depressing growth. Furthermore, negative rates are particularly toxic for banks and reduce their already low propensity to grant credit. Without credit, growth remains weak and thus negative rates, designed as a stimulus, actually become counterproductive.
That said, it is highly unlikely that the ECB will actually go as far as starting the phase-down of QE as early as February. On the other hand, a six-month extension followed, eventually, by tapering seems more logical. In any case, European QE will not be eternal, especially in this dimension. Only the Japanese one will probably be permanent.
The current purchases of securities by the ECB and the Bank of Japan are today equal in quantity but affect the market in very different ways. In Japan, the BoJ does nothing but finance the public deficit that gradually arises. In Europe, the ECB goes much further and in addition to financing the deficit, it buys pre-existing debt. Japan is therefore in a stable state situation, while Europe, if it extends QE indefinitely to this extent, even risks the complete extinction of its debt.
Negative rates and Qe will become ordinary first aid tools in the future in the event of a recession. In normal times, however, greater recourse will have to be had to fiscal policies coordinated with monetary ones. The era of monetary policy alone as the alpha and omega of economic policy is drawing to a close. From an operational point of view, we reiterate what was written in recent weeks, stable markets until November 8th. There is still a month to accumulate cash.
