The Federal Reserve ended QE3 last week as was widely expected and markets seemed to take it calmly enough. Stocks and bonds fluctuated, as they tend to do, but the end result was a non-event. It seemed that investors were willing to give the economy and the markets the benefit of the doubt as we wait to see how things function without the morphine drip of QE. I have thought for some time that the economic effects of QE are not nearly as large as the Fed claims (at least in the US) and that any improvement in the economy, minor as it has been, is merely coincidence and not a result of the Fed’s ministrations. And if QE had little effect on the US economy then its end shouldn’t either.

The effect on asset prices though is a much trickier question. There is no doubt that stocks have moved relentlessly higher during QE periods although correlation as they say, isn’t necessarily causation. It is also true that stocks have performed poorly after the end of the Fed’s bond buying periods and anyone long stocks – or more accurately, too long stocks – surely felt a little angst as the Fed announcement hit the wires last week. For two days, we were on the verge of finding out how stocks perform when QE is gone and the economy has to stand on its own. Then the Bank of Japan came to the rescue and ramped up their latest version of QE by about a quarter. The BOJ will be buying more JGBs, more stocks, more REITs and seemingly anything else that isn’t nailed down in Tokyo. Stock speculators around the world rejoiced, short sellers ran for the hills and the S&P 500, a mere couple of weeks removed from the fear of an actual correction, hit new all time highs. Oh, and Japanese stocks surged too despite the fact that this is about the ninth version of QE they’ve tried over the last couple of decades. Hope springs eternal.

As I said earlier, I don’t think QE had much of an effect on the US economy. It did probably lower yields on corporate and high yield bonds as investors were forced to reach for yield and that probably funded some businesses that would have otherwise gone unfunded. Whether that is a good thing or not is something we’ll only know in the future when we find out if those companies are actually able to pay back the loans that have been so easy to get (and with easy terms to boot!). On the other hand, the loss of interest income to bond investors certainly had an impact as well so maybe the whole thing comes out to a wash. Actually, I think that is probably a best case scenario. I could be wrong but I don’t think the default rate in the junk sector is likely to stay at the current low levels.

Outside the US however the effect of QE was felt far and wide. Fear that the Fed’s policies would reduce the value of the dollar drove capital into countries perceived to have better growth prospects and more friendly monetary policies. Those countries were largely in the emerging world and many of them boomed while the capital continued to flow in. That all started to reverse last year as the Fed started to plan their exit from QE. The result has been a global economic slowdown, centered in Europe and China, but with global outposts in all the countries that benefitted from Fed induced emerging market growth. Now the capital flows have reversed, the US economy, as lousy as it is, is seen as the best in the world and the dollar is rising against whatever proxy you choose for value (Yen, Euro, Gold, Oil).

The lesson for central bankers, one that the BOJ doesn’t seem to have learned, is that we live in an interconnected world and the effects of monetary policy are not confined to domestic accounts. The immediate effect of the BOJ’s decision was a rapid fall in the Yen to about 112 to the dollar. It may not have dawned on the BOJ yet but it is hard to invest in the Japanese economy while also desperately trying to avoid anything denominated in Yen. Yes, Japanese stocks were up big but that is, at least partially, nothing more than money illusion. Japanese stocks are worth more in Yen but the rise in dollars is a lot less impressive. In addition, the surge last week in Japanese stocks was a function of the coming change in asset allocation at their largest pension fund which is reducing their bond allocation so they can roughly double their equity exposure. Which goes a long way toward explaining the BOJ’s decision to buy more long term bonds. Somebody has to buy the bonds being sold by the pension fund.

As many of you know, I’ve been a bull on Japanese stocks and a bear on the Yen for most of the last two years. The majority of our investments in Japanese stocks are via an ETF that also hedges the Yen exposure. We also hold some individual Japanese stocks, most of which are value situations where we are less concerned about the effect of the Yen. My bullish stance on Japanese stocks and bearish stance on the Yen were and are based on two things. First is that Japan had reached the point of no return with government debt and had no choice but to devalue the Yen (in other words to try and inflate away the debt). Second is that the cheaper Yen would have a positive effect on Yen earnings for Japanese corporations, especially those that are export oriented. QE in Japan, no matter what the BOJ or Shinzo Abe say, is about weakening the Yen to regain export competitiveness and to reduce their nominal debts.

The effect of Japan’s weak Yen policy on the domestic Japanese economy, as our own Jeff Snider has pointed out repeatedly, has not been positive. The BOJ has indeed been able, aided by a rise in the consumption tax, to raise inflation rates and while that is considered the path of success for central bankers, it is not positive for the Japanese people who must contend with a currency that doesn’t buy what it once did. Japan’s problems, in my opinion, are not monetary but structural. I have thought the last two years that if Abe actually follows through with real structural reform that the Japanese economy and stock market would benefit greatly and for a long time. Like most people waiting on those reforms, I’ve been disappointed with the pace of change. Like their US counterparts, Japanese politicians are wasting the window of opportunity QE offered them for reform. The cheaper Yen has raised corporate Yen earnings but that doesn’t mean their factories are making more stuff.

With this latest increase in QE, the Japanese are raising the stakes in the global currency war. It seems unlikely to me that the rest of Asia will just stand by and allow the Japanese to devalue their way to more market share. Korea, China, Taiwan and any other country competing with Japan must surely be thinking about enacting their own version of QE or something like it in an attempt to match the Japanese devaluation. In other words, just as the effects of the Fed’s QE were mostly felt outside the US, so will the BOJ’s. And the effect is essentially that Japan is exporting its deflation problem to the rest of the world. The rising US dollar is already pushing down inflation in the US and will have a similar effect in Europe (where they are already on the verge of deflation). It may be that the decline in US inflation expectations is as much about BOJ policy as Fed policy.

The problem with that is not the deflation itself – lower prices for goods and services is as good as it sounds – but rather the capital flows the currency volatility induces. If Asia is seen as an area where currency devaluation is not only tolerated but encouraged, global investors are not likely to continue sending their capital there. And local investors, the Mrs. Watannabes of the world, will also look to protect their capital by either exporting it or investing it in things that will hold their value (commodities, real estate, etc.). And the most likely beneficiary of that capital? The US dollar is a pretty good guess.

That might sound like a good problem to have but there are risks. While the US dollar was seen as weak and likely to remain that way, Asia and most of the rest of the emerging world splurged on US dollar debt. If the dollar continues to rise those debts will become more onerous and less likely to be paid. It should be noted that the Asian crisis of the late 90s was essentially the same scenario and in fact every emerging market debt crisis has come during a period of dollar strength (and Yen weakness). The Fed is certainly aware of this – and in fact warned Europe just last week that there was a limit to our patience with the falling Euro – but I’m not sure there is a lot they can do about it short of matching the BOJ – and maybe soon the ECB – QE for QE.

And that may be what eventually happens. The Fed is officially in the wait and see period between easing and tightening, but with Japan’s QE push, it seems unlikely that inflation will rise to levels worrisome enough to warrant rate hikes. As for economic growth, it seems unlikely that the Fed would hike rates based on better growth if inflation is still below their target. In any case, I’ve still not seen any evidence the US economy is actually accelerating. The GDP report last week showed year over year growth of 2.3%, right in line with what we’ve been doing for years. And a big part of the quarter to quarter growth was from a ramp in defense spending ahead of the election.

One last worry is the dependence of the US economy on the energy industry over the last few years. I’ve written about this before so I won’t get into the details but a large component of our growth of the last few years has been based on the rise in oil and natural gas production and well drilling. Current prices are probably not enough to cause a problem but if the dollar keeps rising and oil prices keep falling, the shale boom will come to an end and with it a large piece of US growth will go down the well with it. The US and the Saudis are attempting a delicate balancing act. Reduce oil prices enough to hurt our enemies – Russia, Iran and ISIS – but not so much that it kills the US shale industry and the growth it supports. At least not until something emerges to take its place, which may not happen until you put a stake through the heart of the shale industry and free up the capital it is currently consuming.

The ramp in stock prices last week based on the end of QE here and the upping of the ante from the BOJ was nice but it doesn’t come without some significant risks. Global monetary imbalance and the currency volatility it creates is not a stable equilibrium and the longer it lasts the greater the danger of a mistake. The BOJ has filled the gap left by the Fed but it may turn out to be a bridge too far in the global currency war.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.