Extreme RISKS Exist in global markets:
These risks can cause highly volatile movements in all financial markets (stocks, bonds, derivatives, currencies). The impact of these risks can be sharp and extremely long lasting which would be many times more severe than the Great Recession. The impact may be seen in 2014, or it may be 2015, but whenever it happens you need to be aware of consequences and be protected.We are mentioning below the top 4 risks that can critically affect financial markets and have high probability of occurring in near future –
1. Financial asset bubbles created by QE
2. Structurally high unemployment/ underemployment
3. Severe income inequality in developed as well as developing countries
4. Sovereign default and contagion
In this issue we are discussing the first risk.
RISK #1 Financial Asset Bubbles created by QE
Why QE?
US Federal Reserve started an unconventional monetary policy of Quantitative Easing (QE or printing money out of thin air) in November 2008 to stimulate the national economy when conventional monetary policy became ineffective. It has till now printed $3.6 trillion in QE.The aim of QE was to reduce interest rate and make easy money available in the system that would lead to more consumption demand, growth in loans, increase in production, and thus creating a virtuous growth cycle.
Risks included the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio.
Has QE been effective?
If the QE was effective, it would have resulted into the following –a. Higher consumption demand and higher inflation
b. More loans by banks
c. More jobs
a. Higher Demand and Higher Inflation:
Almost zero rates should have spurred borrowing by households and consumption spending leading to rise in demand. A rise in demand should have increased the consumer inflation but so far there’s no sign of that. Annualized consumer price increases haven’t exceeded 3% since 2008, and have trended steadily downward since 2011.
Headline and Core Personal Consumption Expenditures (PCE) Inflation
b. More loans by banks:
Why the inflation did not rise? One reason could be that the recipients of all this thin-air money could just sit on it and do nothing. No loans would be made, which means no new deposits would be made, which means the economy would not simply grow.
And that's exactly what has happened.
As the chart below shows, the loans are nearly at the same level where they were in 2009.
Leading US banks have been giving lower loans compared to their deposits.
February 21, 2013: Bloomberg reported the biggest U.S. banks including JPMorgan Chase & Co. and Citigroup Inc. are lending the smallest portion of their deposits in five years.
The reports cites data compiled by Credit Suisse Group AG which shows the average loan-to-deposit ratio for the top eight commercial banks fell to 84% in the fourth quarter from 87% a year earlier and 101% in 2007. Lending as a proportion of deposits dropped at five of the banks and was unchanged at two, the data show.
According to the report, consumers and companies are reluctant to take on risk until they see more signs that business is improving, despite the fact that the Federal Reserve maintains near-record low interest rates designed to fuel growth. Additionally, the report states bankers are also holding back as regulators and investors pressure them to curtail risks that fueled the 2008 global credit crisis.
JPMorgan, the biggest U.S. bank by assets, had the lowest year-end ratio in the group at 61%, down from 66% in 2011. Citigroup’s ratio fell to 70% from 76% last year and Bank of America Corp. slid to 84% from 92% the previous year, a five-year low at both firms. SunTrust Banks Inc. decreased to 94% from 96%.
QE has failed to spur lending activity. The reasons are –
1. Demand for credit remains weak due to economic uncertainty
2. Regulatory uncertainty and tighter capital requirements are preventing banks from extending more credit
3. Exceptionally low rates make lending unprofitable
4. Banks are running unusually large excess reserve positions with the Fed that are “crowding out” lending. These reserves are effectively “loans” to the Fed paying 25bp, funded with bank deposits that pay near zero, creating riskless profits with zero regulatory capital requirement
c. More jobs:
Majority of jobs that are being created in US are temporary jobs. These jobs are created when companies are uncertain of future economic growth. The chart below shows how the temporary job growth out shadows total nonfarm jobs since 2009.
One crucial fact is missed by most of the economic reporters that while jobs are created from one month to the next, the working age population is also growing. Since 2009, as shown in the chart below, employment has grown by a cumulative total of 7.8 million while the working age population (individuals between the ages of 16-54) has grown by over 12.3 million. It results in fewer jobs for the working age population. It is best reflected by ratio of full time employees to total working age population.
While employment has indeed returned to levels seen just before the financial crisis (chart above), there is clearly an issue between the Fed's view of full employment versus the "real" economy. The next chart shows the ratio of total employment versus the working age population. It clearly shows the real employment is nowhere near the pre recession levels.
This data suggests that the "real" economy is far from achieving actual full-employment levels that absorb the excess "slack" in the labor force, increase wages and lead to organic economic growth.
QE has failed to create enough jobs for the Americans.
Risk of bubbles in Stocks, Bonds, and Real Estate and Inflation Breakout
Lending has not improved, consumer demand has not picked up, and inflation is still low – so where is the Fed money going?Since banks don’t believe in repayment ability of small American businesses and households, they are not lending to them but are more than willingly giving it to its big corporate sector and investing it on their own account into bonds, stocks, and real estate. Borrowing cost is almost zero and returns from these assets are far much higher leading to super normal profits.
Big corporates are not investing in business but are using this money for stock buy-backs, M&A, and raising dividends. The usually conservative savers and investors are also lured to high returns of risky stock markets as the ultra low interest rates generate paltry returns from their savings accounts. This massive pumping of money in financial assets has caused uninterrupted raging bull markets in stocks and bonds. Stock indices have climbed to new highs shaking off all reasons for pessimism as well as the warnings of skeptics.
The result is — asset value inflation (bubbles).
Summary:
• The Fed's money-printing actions are simply creating new unsustainable bubbles in certain assets, like stocks• QE-created huge excess reserves on banks' balance sheets will trigger explosive inflation
• The Fed is extremely unlikely to be able to unwind its QE efforts in a controlled way
• Things WILL correct, and when they do, the lack of an exit strategy will result in a massive financial dislocation
To summarize, we are living through the largest and most outlandish monetary experiment ever conducted by humans upon themselves. The mainstream media is trying its best to convince us that a rising stock market or a rebounding housing market are indications of an improving US economy, but realty is quite opposite.
The Fed is in uncharted territory, having created a monster it can no longer control. In the process, it is blowing new asset bubbles that are benefitting those with first access to the newly-printed money (banks and corporations) at the expense of savers, pensioners, and anyone exercising fiscal prudence.
When this misadventure in monetary policy ends, as history says it must, it will be messy, uncontrolled, and very painful for holders of just about every sort of financial instrument out there (stocks, bonds, derivatives, currencies etc).
One needs to stay informed and watch out for early warning signals.
