Economics and Strategy
How can we follow the QE if there is no QE to follow?
— David Zervos, Chief Market Strategist
Before I write more on the implications of a U.S./Japan U.S. Treasury purchase for yen weakness accord – and to be sure this development, if it comes to pass, would create some serious longer-term troubles in EM, commodities and China – I want to tackle one other very important issue - the significant changes that are likely in store for U.S. monetary policy.
Looking back over my seven years of writing for our clients at Jefferies, one basic message permeates all of the trading recommendations – follow the QE! And to be sure, this message consistently frustrated many in the investment community who felt that our fragile post-crisis global financial markets needed more than just lower risk-free real rates to sustain gains.
The pushback to this thesis certainly waned over the years as global stock markets rose and economies stabilized. But beneath the surface there was always a healthy skepticism associated with the power of monetary policy. Even earlier this year when the markets swooned, the “See, I told you it doesn’t work” crowd came out in force to proclaim yet another victory on their long-standing call for financial Armageddon. But as usual, the Fed executed a dovish monetary pivot – and the doomsayers were once again trounced while the risk parity crowd sailed on to another post-crisis victory.
Our baseline strategy of following the QE kept us in the U.S. reflation trade from 2010-2014, the Japanese reflation trade from 2013-2015 and the European reflation trade in 2015. However, when the commitment to QE in Japan and Europe became questionable at the end of 2015, we abandoned both. We have only recommended following the QE if there was a clear commitment to expand its breadth in the event that the economic outlook started to darken. The ECB and Bank of Japan failed on that front. And it was only the Fed which ultimately stayed completely committed to QE-style policies until a reflationary recovery was fully in place.
In retrospect, our long-time trading strategy could be characterized more as a combination of QE following and QE commitment – BOTH were necessary for success. And our pivot back to a “spoos and blues” strategy at the start of 2016 was really just a slightly different bet on the “conditional” commitment component. Not of course a commitment to restart QE, but rather a commitment to pivot towards more monetary accommodation in the event that the U.S. outlook deteriorated. It was just a bet on the Fed reaction function.
But in looking ahead to U.S. monetary policy under a Trump administration, we will clearly lose this commitment structure. Trump will immediately have two FOMC governors to appoint, as well as a vicechair for financial stability. Then, in early 2018, he will appoint a new chair and vice-chair for the FOMC.
To be sure, these newcomers will NOT be in favor of using QE-style monetary policies except under the most extreme of circumstances. And they will not be easily pivoted into a dovish stance upon every minor deterioration in the economic outlook. In fact, most of the names floated for these positions signed a petition in the WSJ back in 2010 against QE2 – and by the time we got to QE3, most were penning, in major financial publications, vitriolic tirades on Fed policy gone wild. There is a seismic shift in the Fed policy reaction function looming, and it is highly unlikely we can return to a strategy of following the QE in the U.S., since there will be no QE to follow.
Thus, the question becomes, what do we follow? Well, as highlighted in my first post-Trump commentary, the new policy levers to consider in the U.S. are fiscal, regulatory, trade, and immigration.
And for now, the market seems set on following just the fiscal and regulatory shifts. Lower taxes, higher spending, and less regulation have ratcheted expected real rates of return on capital higher. The dollar, spoos, and bond yields are therefore rising. But of course monetary policy will likely move real rates even higher via the Trumpian institutional shift discussed above. This implies the dollar and bond yields have even further to run (which in turn is not great news for spoos). For the moment, the only macro trades which stand out are a stronger dollar and higher rates – In particular, shorter term rates. But even then, the risks associated with lower expected real rates of return on capital from protectionist trade and immigration policies lurk in the background. There are sadly many moving parts on this new policy front. And in the end only one thing is quite clear: This new world is much more complicated than the old one with an effective and committed QE-driven Fed.
Of course we could pivot to Japan and Europe, where QE is still in place; but as mentioned above, those commitments still look dubious. Nonetheless, as I’ve previously written, the Japan story does look quite intriguing only because the U.S. fiscal expansion will endogenously accelerate a Japanese monetary expansion. So in a sense there is a yield curve control (YCC) plus U.S. fiscal policy driven commitment to Japanese QE which could certainly reaccelerate the long NKY (Nikkei 225) / short yen reflation trade. But honestly, I’m just not overly excited about any global risk assets given the prospect of higher real rates in the U.S. – especially when these higher rates are likely to generate some systemic risks in commodities, EM and China (which I promise I will elaborate on in the next note). For now, and as I mentioned in my last two notes, the stronger dollar, especially against the yen, is really the only standout macro trade which comes out from all this analysis.
But going forward I suspect there will be many new opportunities for those focused on a traditional bottoms-up approach to trading. The QE-dominated world of the past seven years masked individual corporate and sector weakness as ubiquitous credit was delivered to even the weakest and most leveraged non-financial companies. One of the most common complaints I heard from the equity long/short community over this time was “QE is killing my shorts.” With tax, spending, and regulatory policies likely to have very different effects across both sectors and companies, those who dig deeper into corporate-level balance sheet leverage, taxation structure, and regulatory impediments will likely be handsomely rewarded. And without a QE backstop, weaker business models will have a higher probability of failing while stronger business models will have a higher probability of succeeding.
Naturally, I will leave these deep dives at the corporate level to my sector specific equity research colleagues at Jefferies. But it suffices to say that their work will take on even more importance as we move forward into a brave new U.S. market without any QE to fall back upon.