While recent volatility in China’s stock market, currency and economic data may have acted as a catalyst to spark recent financial market instability, the wild gyrations witnessed in recent weeks has little to do with China, and a potential slowdown in its economy.
It is not something that has suddenly surfaced in last few weeks. It has been quite conspicuous for nearly half a year, particularly to anyone watching global commodity prices. And while much has been written about the wild swings in Chinese markets, particularly in stocks, the nation’s financial markets are not open enough to have triggered volatility in other more established markets.
Richard Koo, chief economist at Nomura Research Institute, argues the real cause behind the lift in market instability is not China, but the decision of the Federal Reserve to end its quantitative easing program last year, which prompted businesses and households to shift their focus from maximizing profit to minimizing debt when QE One, Two, and Three were being implemented.
In a note to clients, Koo suggests while many in the private sector were minimising debt, the funds injected by the Fed had nowhere to go but into financial assets.
Sovereign bonds yields were driven lower, sending private-sector capital scurrying into higher yielding-yet-riskier assets, but not into the real economy.
“In reality, however, neither private credit nor the money supply have demonstrated meaningful growth in spite of massive infusions of liquidity by the central banks of Japan, the US, and the UK — as should have been expected given the absence of borrowers”, says Koo.
“The lack of growth in private credit in these three countries means most of the funds supplied by the Fed, the BOE, and the BOJ never reached the real economy, which in turn explains why inflation rates remain so low”.
Koo uses this chart to show that despite the huge expansion in the US monetary base as a result of quantitative easing, there was a negligible impact on the broad money supply or loan demand from private sector borrowers.
According to Koo, while QE did have some impact on the real economy via the wealth effect – something he suggests benefitted only a handful of areas such as luxury goods demand – the rise in asset prices due to this effect was a financial phenomenon with no backing from the real economy.
He describes the subsequent market reaction during times of QE – soaring stock prices and weaker currencies – as being divorced from the realities of what was happening in the global economy. From Koo’s note:
… much of the rise in share prices and fall in currency values under QE were nothing more than liquidity-driven phenomena divorced from real economy fundamentals. Now that an end to QE is in sight, it is time for a correction.
Fed Chair Janet Yellen’s remarks several months ago about elevated stock market valuations were most likely a reference to this bubble. A correction of some kind was inevitable as the Fed moved to normalize monetary policy.
However, it still needed a trigger, and that was provided by China.
In some ways, this explains why the expected increase in interest rates by the US Federal Reserve for the first time since June 2006 – which some suspected might start this week but is likely at least by the end of this year – is such an important turning point for the global economy.
Koo believes the biggest challenge facing policymakers is to prevent a “negative feedback loop” from occurring as unconventional policies are withdrawn, something that will see weakness in financial markets spill over into the real economy, stalling an already-tepid global recovery.
“The market gyrations of the last two months represent just the beginning of the QE trap”, says Koo.
“We need to consider the possibility of an extended standoff between the Fed, which wants to normalize interest rates and drain excess reserves from the system as soon as possible, and the markets, which are likely to swing wildly in response to statements and actions by the authorities”.
Koo believes that the current market tension, expressed as higher-than-normal levels of asset market volatility, will continue in the period ahead.
“While there may be many temporary ceasefires, we are unlikely to see the kind of smooth economic recovery typical in years past until the Fed brings excess reserves down enough or take some other actions so that ending QE no longer poses a threat to markets or the real economy”.
If he’s correct, it will benefit short-term traders, but likely cause headaches for long-term investors and policymakers alike.
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