Just finished reading a cracking little note from the always-excellent James Ferguson over at Macro Strategy from early May. James makes what I think is a very strong argument for not having your cake an eating it. By this I mean that if QE clearly contributed towards monetary easing and thus the inflation of asset prices, then its reverse – all things being equal – namely quantitative tightening (QT) must produce the reverse effect. That is monetary contraction and declining asset prices. Or as James puts it “QE was inflationary and so efficacious in preventing money supply contraction, thereby pushing up risk assets and long bond yields…it would be irrational not to expect QE do the exact opposite”.
James also makes a number of crucial observations.
The first crucial one is that QE evidently worked in helping boost asset prices. Ferguson contends that each $100 bn of QE asset purchases “on the face of it boosted equity valuations by +5.7%. We are looking at as much as $320 bn of anti QE through the remainder of this year”. On that basis, a correction of 15% is in order i.e a massive taper tantrum spasm.
The next key observation is that the current increase in Treasury yields (back above 3%) can’t be “ due to inflation fears”. The main driver must be expectations of the GDP growth rate. Or as James puts it “ the bond market is betting the ranch on continued GDP growth combined with dollar weakness to keep upward pressure on CPI”. But what happens if this view is wrong? What happens if actually another set of measures – money supply numbers – point to a possible slowdown on the horizon.
Ferguson argues that investors should monitor money supply and bank credit creation. In the absence of QE, bank deposits shrink, loan creation ebbs away and we end up with deflation, defined as a nominal contraction in broad money supply. That makes Treasuries the only sensible investment. By contrast, with QE investors dump safety, chase yield and buy risky assets. So, what’s happening with current money supply numbers? Ferguson reports that US M2 money supply is now only growing at 4% per annum, while the broader M2 measure is slightly higher at 4.4% and bank loan creation at 4.2%. These are all well down from recent levels of between 5 to 8% for each measure.
Ferguson concludes that “a large proportion of US QT will feed through directly into a drain on bank deposit liabilities (aka money). Since QT began, broad M3 money supply growth has shrunk from a quarterly annualised rate of +7.1% to a sobering +1.7%”. As proof of this link, Ferguson points to recent examples of balance sheet tightening by the Fed which have resulted directly in declining share prices in the last 6 to 12 months.
Stepping back from the inevitable blizzard of charts and macro numbers, an important point emerges. In its dreams, the US Fed may want to sharply increase interest rates but the US economy is now having to fight the headwind of QT. The numbers are huge and despite tax cuts and clearly strong GDP growth, the US financial system can’t reach proper escape velocity if the banking and monetary system is in contraction mode because of quantitative tightening.
Sooner or later the US Fed will have to realise that its QT and proposed steady drip feed of interest rate rises is causing real damage to the monetary base of the US economy. President Trump will also be hectoring them about strangling growth and pushing them to be more accommodative. My own view is that we’ll see QT stopped in early 2019 and interest rate rises will grind to a halt once they move above 2.25%.
In investment portfolio terms, until this particular penny/cent drops and investors realize that QT will be short-lived, Ferguson contends we should prepare for increased volatility. He reckons US Treasuries are a buy compared to gilts and bunds, with EM stocks also likely to be vulnerable moving forward.