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QEII is a formula for lower and not higher equity prices

Posted on 26 October 2010 with 3 comments from readers

The US has just sold the first treasury bonds with a negative yield. These are inflation protected bonds, and that explains why they sell despite actually charging bond holders interest. For the buyers think inflation is going to be so high that these bonds will pay a positive return in the future after the yield is corrected for inflation.

That is strangely a vote of confidence in the Fed and its capacity to deliver inflation through printing money. Inflation protected bonds are in fashion for a reason. But will inflation really be good for equity prices, or bonds for that matter?

Carry trade

Markets certainly seem to think so at the moment, and a carry trade has developed pumping low-cost dollars into a rising stock market, and making a turn. But this sort of financial circus is a high-wire act with no safety net. Eventually the players take a fatal fall.

Spotting when to step off the wire is not easy. It could come as soon as next week when the Fed actually announces its hugely anticipated QEII money printing exercise. You often buy on the rumor and sell on the news in markets, and this being a bigger than average example, the correction on the other side risks being violent.

Do the markets not look a bit hesitant and wobbly this week? Nobody wants to be the last man or woman to step onto the wire. A few more cowardly souls are quietly creeping away around the back, and buying those index-linked treasury bonds. Bond purchases by banks were up on recent depressed levels.

Even the euphoria of presenters on Bloomberg is less pronounced. The 10 per cent rise in US house sales yesterday was greeted with skepticism as it came off a low bottom, although nobody pointed to the obvious that this probably represented an increase in repossessions.

Focus out to the global macro risk. Say the US succeeds in pushing up global inflation. This will be manifest in commodity prices and hit China hardest. It already is and Singapore export figures show it. Chinese export prices are rising strongly and demand for them from an already depressed developed world is falling.

China bubble

So the Chinese economic bubble implodes. That puts millions out of work in China. It also brings a sharp correction in commodity prices. There is a bust across emerging markets dependent on oil revenues and commodities.

But then inflation will reduce US debt in real terms and devalue the US dollar boosting US exports. Thus the global economy is rebalanced back to where the Fed would like it with China poor and the US rich. But will it be that simple?

For as China implodes it will pull money back out of the US and crash US asset markets too. The bond market is the most vulnerable and interest rates will have to soar to replace Chinese money with US sourced investors.

That will naturally leave those buying US treasuries at negative interest rates with thumping losses. But then any investor buying something on a negative yield ought to know better.

But will equity markets really deliver good returns after adjustment for inflation in this sort of crisis? That does take some imagination indeed, and perhaps that is why insider sales of stocks outnumber buyers by 1,400 to one.

Posted on 26 October 2010 Categories: Banking & Finance, Global Economics, US Dollar, US Stocks

3 Comments posted by readers:

Comment by jeff roth - 26 October 2010

i thought all that new money sloshing around was supposed to cause more money to flow into the market and more carry trade. Why are you saying the reverse is the case?

Ed Note: markets rise on the anticipation of more stimulus and will fall on the reality of less than expected. This is a money bubble and all bubbles burst!

Comment by jeff roth - 26 October 2010

will bond yields fall or rise then?

Ed note: when stocks sell off bond prices will rise and yields fall, then bond prices will fall dramatically and yields rise sharply, and presumably share prices will recover to some extent. Dangerous days, be prudent!

Comment by Jag - 28 October 2010

Dear Ed,

Your analysis is logical, plausible, insightful but unlikely!!!

The Fed will do it’s damndest to keep the inflation rise ‘orderly’.

So while they will inflate their way out of this ‘mother of all deficits’ it will be an orderly rise, preagreed with the Chinese, who wouldn’t want riots in the streets of Beijing either!

So in the end all will turn out well. The wall street fat cats will get fatter, the unemployed will stay unemployed and the pensioners will get scre..d!!!!

So dear Ed, please don’t spread panic, but have faith in the supreme wisdom of the Fed and the Chinese :-)

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