While this week's announcement of a massive new QE program by the European Central Bank (ECB) was the worst kept secret in the world, it may not produce the results that everyone expects.
For one thing, while the immediate reaction was to push European interest rates lower, recent experience in the US shows that QE results in higher rates.
And while everyone is talking about deflation – and Europe is definitely experiencing deflation – the US is still experiencing inflation that could lead the Fed to start raising rates by summertime.
So before getting too carried away with celebrating another major central bank opening up the printing presses, investors should take a serious look at the facts and then decide how to play the markets.
How the ECB Got Started With QE
The ECB opened the newest front in the global currency wars with a €1.14 trillion ($1.27 trillion) QE program slated to run through September 2016.
Market pundits sung ECB President Mario Draghi's praises for a bigger than expected plan to reverse the $1 trillion shrinkage in the ECB's balance sheet that has occurred over the past couple of years.
Already miniscule government bond yields in Europe shrunk to microscopic levels on the news as investors piled into bonds yielding next-to-nothing. Ten-year German yields closed the week at 0.36%, French at 0.54%, Spanish at 1.37% and Italian at 1.52%. Giving new meaning to the adage, "In the world of the blind, the one-eyed man is king," 10-year US Treasuries yielding 1.79% looked like a feast!
The magnitude of the collapse in European bond yields can be seen in one figure: 10-year German yields have dropped from 1.66% to 0.36% over the last year. This is important for investors in US Treasuries because there is a 96% correlation between US Treasury yields and German bond yields. And over the same period, the yield on 10-year US Treasuries has dropped from 2.72% to 1.80%.
The real question, of course, is what lower yields can really do for the European economy. Are German companies and consumers really going to start spending because rates have dropped another 20 basis points when they were already too low to matter? Interest rates aren't holding back the European economy anymore. Instead, economies remain paralyzed by archaic labor and tax laws.
To his credit, Mr. Draghi has repeatedly warned that there is only so much that his institution can do to promote growth if these other changes aren't made. Until they are, markets may continue to rally but they are only further diverging from weak economic fundamentals.
Investors should beware putting too much emphasis on the market's short-term reaction to the ECB's move. In the US, the Federal Reserve's QE moves actually didn't lower Treasury yields; they raised them. Only after each of the three times QE ended did Treasury yields drop. Since the last round of QE ended in October, the 10-year Treasury yield has dropped by about 60 basis points. Stocks dropped sharply after the first two times the Fed ended QE. They haven't followed that script after the third time but they have flirted three times with corrections since October only to be bailed out by massive new QE programs from foreign central banks. First there was the Bank of Japan on Halloween and now the ECB.
The Contagion is Spreading
So while European bond yields dropped sharply last week, it would not be surprising if they started to rise again very quickly in the weeks and months ahead. After all, other than the European central banks who will be buying them under the new program? Only brave souls who already expect ridiculously low yields to move even lower are likely to chase them. And that's only if they can find bonds to buy, since the central banks could crowd them out of the market.
The risk/reward on buying long-term bonds yielding close to zero is something most investors should avoid.
The most likely beneficiary of this week's ECB action may be US stock and bonds since lower European interest rates will push investors to the US for higher-yielding bonds and higher economic growth expectations. Even with the latest push from QE, the European economy has a long way to go before it starts showing any meaningful growth.
Much more important than what happens to bond prices and stock prices in Europe, however, is the collapse of the euro, which closed the week at a 12-year low of $1.12 to the dollar. This can only be partially attributed to the ECB, however.
It takes two to tango. The Fed's decision to end QE and hints that it will start raising rates in 2015 are equally responsible for the rise in the value of the dollar against the European currency. As sharp as the move has been, investors should expect further declines as the Euro moves toward parity with the dollar (i.e. to $1.00) by late this year or sometime in 2016.
Stock markets celebrated the news of another major central bank priming the money printing pumps. European stocks jumped to 7-year highs. The MSCI world stock index popped by 2%. In the US, the Dow Jones Industrial Average jumped by 161 points or 1% to close at 17,672.60. The S&P 500 rose by 1.6%, or 32 points, to end the week at 2,051.82. The Nasdaq Composite Index tacked on 124.70 points, or 2.7%, to 4747.88. Stocks are sending a diametrically different signal about the economy than both bonds and commodities. Oil prices as well as the prices of other industrial commodities showed no signs of recovery this week. The death of the Saudi King is unlikely to lead to any change in Saudi or OPEC policy. In the meantime, US oil companies are cutting production and jobs in a mad scramble to keep up with the new oil era.
The ECB wasn't the only central bank engaging in currency warfare this week. The Bank of Canada surprised markets by dropping its benchmark interest rate to offset weakness in its heavily energy-dependent economy and Denmark lowered interest rates further below zero to deter appreciation in the Danish krone. But while central banks are fighting deflation, there is only one problem – away from energy prices, there isn't any deflation in the US. Instead, there is mild inflation (which, by the way, is healthy).
Excluding energy, the U.S. inflation rate has actually increased in the past year to 1.9% from 1.6%. Moreover, median 5 to 10 year consumer inflation expectations in the University of Michigan's survey – which the Fed watches very closely – have been steady at 2.8%. Headline inflation numbers have suggested that there is a deflation threat looming in the United States. But you have to look behind the headlines. And behind the headlines, the data shows that there are only a few sectors where prices are weak, such as energy and currency-sensitive goods while most other sectors, including services and shelter, are still rising at more than 2%. The Fed is closely monitoring these numbers and is not yet seeing anything on the inflation front to deter it from raisings rates sometime in 2015.
Why This Will Hit the Stock Market
What the Fed does will prove decisive for stock prices since the market has demonstrated zero tolerance for higher rates. This is unfortunate because there are good reasons why the Fed should stick to its plan to raise rates sooner rather than later. With rates at zero, it doesn't have any room to maneuver if the economy starts to weaken. The Treasury yield curve has been flattening since the beginning of 2014. That means that long term rates are dropping faster than short term rates and usually signals that the economy is slowing down.
According to economist David Rosenberg at Canadian investment firm Gluskin Sheff, while real GDP was 5% in the third quarter of 2014, it looks like fourth quarter 2014 real GDP will come in at a much lower 2.5% and first quarter 2015 at an even lower 2.0%. This may surprise all of the pundits who have been touting the positive impact of lower oil prices on the economy. Despite arguments to the contrary, lower oil prices are likely to prove negative overall for economic growth even if they are good for consumers. But high interest rates aren't the reason growth is sluggish.
The problem is too much debt, too much government regulation, and a lack of pro-growth government policies. If the economy were to slow further, the Fed would have limited tools at its disposal to stimulate it. Higher rates would send an important signal that the economy is capable of standing on its own two feet while giving the Fed some breathing room if it needed to lower them later in response to a recession or a crisis.
The ECB's move may actually make it easier for the Fed to raise rates without causing Treasury yields to rise too quickly or too high. The ECB program is going to create additional demand for all sovereign debt, including Treasuries, which will keep yields down. The gravitational pull of low rates globally may provide the Fed with additional breathing room were it to raise rates as early as this June.
For the moment, however, yields appear to be heading lower globally. While stock investors seem to be interpreting that as a good thing, it is actually a very bad thing.
Low yields should be seen as a sign that all is not well in the U.S. economy despite a rising stock market. US yields are being dragged down by even lower yields around the world, another sign that the US economy cannot decouple from problems in Europe, Japan and China, all of the many economies are struggling. Sooner or later, US stocks will wake up to this fact, and when they do the long overdue correction will come.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.