Will the end of Quantitative Easing trigger a second crisis?

Something strange has been happening in stock markets since 2008: they have been going up. Not just up, but absolutely flying. Through the prolonged failed recovery, unemployment, an investment crisis, the Fukushima crisis and the EU debacle, Wall street, still the market all else look to, has doubled in value.

Something strange has been happening in the stock markets since 2008: they have been going up. Not just up, but absolutely flying.

Through the prolonged failed recovery, unemployment, an investment crisis, the Fukushima crisis and the EU debacle, Wall street, still the market all else look to, has doubled in value.

Since 2008 the world’s central banks have taken a proactive stance with Quantitative Easing (QE) of which we have no historical precedent to fall back on. However, when you plot the major actions of the US Federal Reserve with the Wall Street market on a monthly basis, the correlation is clear (fig 1).

Ranjit graph

Over the last few weeks something even stranger happened: while the US economy has shown real signs of growth with house prices rising and unemployment falling, Wall Street lost 300 points and government bond interest rates spiked. Again, QE was the major factor: as unemployment closed in on the Federal Reserve’s target of 6.5 per cent, the markets got spooked that Ben Benanke, the chairman of the Federal Reserve, would start to withdraw their QE monthly fix.

The reaction was interesting as it highlighted that the market’s dependency on QE was so complete that it now overshadows any facts the ‘real’ economy can provide. Secondly, that there was such an overreaction to Ben Benanke’s remarks which were at worst benign:

“The Committee has said that it will continue its securities purchases until the outlook for the labor market has improved substantially in a context of price stability”.

There will come a day when QE will not be justifiable anymore. Perhaps the market’s reaction is enough for the Federal Reserve to kick the can down the road for another year. However there will come a time when the inflationary pressure will mean it will have to stop and investors are already getting ready for a ‘correction’ in the markets.

But, is there something else happening under the surface? Perhaps there is and to understand it we have to go back to what caused the global financial crisis five years ago.

The failure of ideas behind the 2007 crisis was the attitude of the financial sector to risk and how they gave so much credence to the models they were creating to measure it. Or, as Alan Greenspan admitted later, the crisis was caused by “the underpricing of risk worldwide”.

Any other profession would have realised that these models were broken. In the financial sector they responded, however, by making them more complex and, bizarrely, are being expanded to evaluate whether financial institutions have enough liquidity to function, something those who know the models best admit they are not designed to deal with.

These failed risk models were then applied to a completely unregulated  (Over The Counter OTC) derivative products market, which had products like Collateralised Debt Obligations (CDOs) in which sub-prime mortgages were hidden away.

Again, rather then learning the lesson from this the unregulated derivative market is still unregulated. This market has a current nominal value of $632 trillion, according to the Bank for International Settlements, an astonishing eight times the size of the whole of the world economy.

And finally, the larger back drop of the 2007 global financial crisis has been best described as a ‘Minsky Moment‘, named after the economist Hyman Minsky, who identified that as part of the economic cycle long periods of prosperity and increasing values will lead to overconfidence, and greater risk taking for greater profit, right up to the point where the assets stop rising and the whole house of subprime mortgage cards fall down.

My fear is that this period of QE has lead to a ‘mini Minsky moment’ in shares and bonds. This has led traders searching for higher returns to go back to the risky unregulated trades for larger returns; as Reuters recently reported this time these products are packed with QE fuelled shares and bonds rather then sub-prime mortgages and if they go awry they will again ‘punch yawning holes in the balance sheets’. A market correction following the removal of the QE crutch could provide just that stress point.

Pre-2007 there were those who predicted the crisis, but they were unfashionable economists who had been marginalised by the city juggernaut. This time, for almost a year we have been hearing the same mantra:

“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis, Are the derivatives regulated? No. Are you still getting growth in derivatives? Yes.”

That was not some old Keynesian economist, but Mark Mobius, executive chairman of Templeton Asset Management, a $50 billion fund, but before you feel to sorry for him he carries on to say:

“With every crisis comes great opportunity. When markets are crashing, that’s when we’re going to be able to invest and do a good job.”

Will the end of QE cause a second crisis? Perhaps, perhaps not. But, as the lessons from the first crisis have not been understood with banks larger than ever, along with the derivative market and the riskiness of the bets conveniently swept under the unregulated carpet, the exact same warning signs are here again.

And the humbling thing is if it does happen governments around the world starved by austerity will be too financially weak to do anything about it.

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