Download The Official Start of QE2 - Canada`s Excellent Future

The Official Start of QE2 Doug Noland Prudent Bear
There are a couple key facets of my thesis worthy of some extra focus today, the official start of QE2.
First, in the post-Greek crisis world – with parallels to the subprime eruption in the spring of 2007 – the
markets are increasingly keen to structural debt issues.
Second, inflationary pressures have gained significant momentum in China, Asia and the “emerging”
economies, more generally.
In the world of structural debt problems, the European debt crisis turned more acute this week. Ireland’s
10-year yields surged to almost 9% yesterday (from about 5% in early-August), before declining 76 bps
today on more conciliatory talk from European officials. Prior to today’s bond rally, Portuguese yields
were up another 50bps (to 7.0%) this week and Greece yields were another 15 bps higher (to 11.60%).
Recalling the 2007-08 experience in U.S. mortgage finance, the initial policy response to the European
peripheral debt crisis may have bought some time but has had little effect on underlying structural debt
problems.
On the inflation front, Chinese stocks (Shanghai Composite) were hit for 5.2% today on fears of more
aggressive monetary tightening by the People’s Bank of China. Chinese authorities have warned of the
heightened inflation risk related to QE2. The markets are taking this talk seriously.
Earlier this week, gold and cotton surged to new record highs. Silver, sugar and rubber jumped to near 30year highs. Copper, corn and crude traded to 2-year highs. From the beginning of September, the CRB
Commodities Index rallied about 20%. Indicative of increasingly unstable global markets, the CRB index
sank 3.7% today after trading to a 2-year high earlier in the week.
Yesterday, China reported a larger-than-expected 4.4% y-o-y jump in consumer prices. Also this week,
China reported its October money supply (up 19.3% y-o-y) and bank loan growth ($89bn) surprised on the
upside. Reports on China’s retail sales (up 18.6% y-o-y) and auto sales (up 27% y-o-y) were strong. And
to the chagrin of Chinese authorities, real estate prices remain resilient at elevated levels. These days,
China’s policymakers face an overheated Bubble Economy, a dilemma compounded by the prospects for
surging commodity costs and destabilizing “hot money” inflows. Patience is wearing thin. Prospects are
not favorable for monetary “tinkering” to be effective.
For the past couple of months, the world has been enamored with QE2 and prospects for concerted global
central bank monetization/liquidity creation. European peripheral debt problems were viewed as ensuring
ECB market intervention/support. Deflation had the Bank of Japan poised for aggressive action. In the
U.S., structural problems were sure to support multiple QE’s and a feeble dollar. A faltering greenback
equated to ongoing Asian central bank dollar purchases and the “recycling” of these balances back to the
U.S. Treasury market. Ultra-low Treasury yields would then remain a steadfast anchor on market yields for
the vast spectrum of global borrowers.
Global markets – stocks, bonds, commodities, and currencies – have been luxuriating in visions of endless
liquidity over-abundance - for all. It’s been a backdrop where fundamental factors and issues were
relegated to the backburner.
This week, it seemed like the focus may have shifted toward fundamentals. Risk is returning to the
equation. For starters, the markets’ disregard for global inflation risks has begun to wane. And despite all
the focus on global liquidity abundance, systemic risks remain quite elevated. Moreover, the world is
increasingly keen to structural debt problems. As the week wore on, the liquidity backdrop suddenly
looked a lot less certain. Perhaps the future does not guarantee ultra-loose “money” for all – but rather an
increasingly discriminating market environment of “the haves” and “have nots”.
Global yields were on the rise. German bund yields gained 9 bps to 2.51% and Japan’s JGB yields rose 7
bps to 0.99%. Notably, UK 10-year yields jumped 24 bps (3.21%), Spain 17 bps (4.53%), and Italy 18 bps
(4.15%). Our 30-year Treasury yields rose 17 bps to 4.29%, the high since mid-May. Benchmark U.S.
municipal yields jumped 24 bps to 3.70% (from Bloomberg).
If the markets are indeed beginning to reevaluate the global inflation backdrop and the prospects for
China/Asian monetary tightening, the marketplace would also be expected to become more discriminating
based on respective borrower fundamentals. After all, the potential for rising global yields and a less
accommodating liquidity backdrop would more severely impact the most heavily indebted. As such, I take
particular interest in this week’s jump in yields for the UK, Spain, Italy, U.S. Treasurys and American
municipal bonds.
If the market has in fact begun to shift from “endless liquidity for all” to a more fundamentally-driven
focus, don’t expect such a transition to go smoothly. After all, ultra-loose financial conditions tend to most
benefit the weakest borrowers. That has certainly been the case in the U.S. Credit market, with junk bonds,
leveraged loans, and municipal debt having enjoyed such stellar performance. In our stock market, many
of the most fundamentally-challenged stocks and sectors have posted tremendous gains.
An extraordinary liquidity backdrop has nurtured speculative excess – in the process creating acute
vulnerability to changing market perceptions.
On a global macro basis, few governments have benefited more from global liquidity excess than the U.S.
Treasury. It is worth noting that in the face of today’s global risk markets drubbing – Treasury yields rose
and the dollar index barely tread water.
Has quantitative easing – on this, the initial trading day of QE2 – turned counterproductive?
Have markets reached an inflection point, with concern shifting away from perceived liquidity benefits to
the heightened risks associated with additional Federal Reserve liquidity creation (i.e. inflation,
Chinese/Asian tightening, unwieldy global liquidity flows, heightened market instability, worsening
structural problems, etc.)?
Did global policymaking and the markets’ euphoric perception of endless liquidity set the stage for
disappointment and liquidity issues?
This week felt different; highly speculative global markets are overdue for a bout of “soul searching.”
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