Quantitative Easing, Supply, Demand, and Distortions
“Investors should be more bullish when the S&P 500 is at 1830 (today) than at 2130 (May 2015). Obviously, most aren’t.”
Those are the wise words of Wall Street Daily Chief Income Analyst Alan Gula, 117 taut characters built for Twitter on January 20.
That day, the Dow Jones Industrial Average was down as much as 565 points, but closed with a loss of 247. The S&P 500 Index, meanwhile, recovered from a 3.7% plunge to post a 1.2% decline.
Yet even within those compressed, social media limits, Alan’s tweet is broad enough to capture the essential human fallibility that precedes failure in financial markets.
It’s easy to say, “’Be fearful when others are greedy and greedy when others are fearful,” or, “The time to buy is when there’s blood in the streets.”
But it’s hard to be a contrarian. Perhaps it is purely a matter of “nature.”
Perhaps not. I like to think it’s a discipline we can “nurture,” if set on a proper approach.
Around Wall Street Daily, we place high value on the concept of constant learning. We like to develop our minds… and thus continue to improve the quality of our output.
Sometimes that requires we challenge our own long- and deep-held ideas. Sometimes “nuance” is merely a matter not of complexity but of simply digesting a facts- and data-driven argument.
That’s what we have in store for you in today’s Saturday Spotlight.
The Qualities of Quantitative Easing
“What is QE?” asks Alan at the top of his presentation, setting the stage for an in-depth explanation for what quantitative easing is and what its major effects are.
He also answers the question, “Why should you care?”
To wit: In the post-crisis era the stock market has not risen without QE.
As far as a pure definition, “quantitative easing” is a monetary policy tool whereby central banks buy securities.
Such securities are usually long-dated, backed by government agencies and mortgages, although the Bank of Japan is now actually buying equities, through purchases of exchange-traded funds (ETFs).
Central banks, including the BoJ and the U.S. Federal Reserves, use QE when target interest rates are at zero in order to provide additional economic “stimulus”
The Fed is buying effectively from institutional and retail investors. Interest rates stay low because supply is shrinking but demand remains the same.
Treasury prices rise, and interest rates fall.
Is QE “money printing”?
According to Alan, it is “…sort of, but not really. It certainly hasn’t led to runaway inflation.”
Rates and Other Impacts
Over three programs (December 2008 through March 2010, November 2010 through June 2011, and September 2012 through October 2014), the Fed increased its portfolio of bonds to $4.2 trillion.
Interest rates have stayed low because of the Fed’s QE programs.
At the same time, they would have been historically low without such efforts because inflation and economic growth have been so subdued in the aftermath of the Global Financial Crisis/Great Recession.
The primary effect of QE – a pernicious one – is to reduce the supply of relatively safe income-producing securities and thus leave the market “starved for yield.”
Investors have been moving into investment-grade corporate bonds – demand for these securities rises, prices increase, and yields fall.
Investors – including insurance companies and pension funds – then move on to high-yield (pejoratively known as “junk”) bonds, adding even more risk to their portfolios.
Because of this “reach for yield,” investors are no longer being properly compensated for the risk they’re taking on.
A Valuable Picture
The impact of the various QE programs and other extraordinary monetary policies such as “Operation Twist” are evident on a chart of high-yield credit spreads.
As Alan notes, “It’s not a coincidence that these miniscule spreads occurred in mid-2014, during QE3. Even highly leveraged energy companies were able to issue debt at 5 or 6%.”
QE has therefore contributed to the shale oil boom in the U.S. that’s helped create a supply glut. And it’s “at least partially responsible for the spectacular bust” in the global crude market.
High-yield spreads spiked upward almost immediately after the Fed wound up QE3 in October 2014.
Credit stress is now spreading to other sectors beyond energy. Spreads for single-A credits, including high-quality issuers such as Visa, Intel, Home Depot, Starbucks, and Disney, are widening.
Incentives, Good and Bad
Alan makes another critical point about QE and narrow credit spreads. When corporate bond yields are low, companies are incentivized to pursue mergers and acquisitions and to issue debt to buy back stock.
These activities are also good for the stock market.
In addition, QE has a psychological effect: Investors’ confidence grows, and they become bullish on risk assets in general.
Meanwhile, there’s little evidence the impact of QE is felt throughout the broader economy.
A critical secondary impact of QE is deflation. For example, lower yields encouraged energy companies to borrow to fund expansion projects. The resulting supply glut led to a continuing collapse in oil prices.
“That’s deflationary in nature,” notes Alan. “a negative, unintended consequence of QE.”
And debt continues to pile up.
Alan wraps up with three takeaways.
- QE is stimulus for the financial markets (higher financial asset prices)
- QE’s most important impact is narrower corporate bond credit spreads/lower yields
- QE stimulates the real economy to the extent that it fosters more debt issuance through lower bond yields (more cowbell?!?)
And he concludes with a question: “QE4, anyone?”
In addition to serving as Wall Street Daily’s Chief Income Analyst, Alan is the top strategist for The Shockproof Investor.
Alan’s research, analysis, and recommendations are meant to provide exactly what the name of the service implies: protection for your portfolio against major market shocks such as occurred during the 2007 to 2009 period.
It represents what I consider to be an essential foundation piece in Wall Street Daily’s suite of premium services.
There’s not a lot of flash to it.
It is, however, the type of tool you’ll wish you’d had before a calamity.
Chief Income Analyst Alan Gula, the star of today’s Saturday Spotlight, harkens back to a 1990s sitcom classic in further explication of the idea that we can do better than our “nature” via “nurture.”
“If every instinct you have is wrong, then the opposite would have to be right,” Jerry Seinfeld once mused to his friend, George Costanza.
As Alan notes, “The financial markets are ultimately driven by human behavior, and that will never change.”
The money quote: “Planning is what separates the buyers from the sellers during emotional and chaotic times.”
Global Markets Analyst Martin Hutchinson weighs in with a thoughtful piece on “the glut of money in the economy… one of the primary causes of this deflation, both in the United States and worldwide.”
Thankfully, Martin provides some actionable solutions to this problem: “a modest investment in top-quality corporate bonds seems appropriate, even if their yields are unexciting.”
Martin also takes a fresh look at the political climate in the U.S. as the race for the White House heats up.
With primary voting in Iowa just around the corner, “…voters not only have contempt for the Washington establishment, but they also have a clear set of policies they’d rather see enacted.”
In short, Bernie Sanders (on the left) and Donald Trump (on the right) are enjoying the benefits of a populist revival.
Though the platform served as a convenient jump-off point for our talk today, Chief Technology Analyst Louis Basenese took Twitter Inc. (TWTR) to task last Thursday.
Amid “a mass exodus of executive talent,” slumping user growth, and declining prospects, it’s time for the tarnished social media darling to sell itself.
Finally, as is becoming a recurring theme in these parts, Senior Analyst Jonathan Rodriguez provides the positive outlook.
Based on his analysis of support and resistance, Jonathan concludes that “the DJIA’s long-term uptrend is still intact, which is very good news for the bulls.”