In recent months the FED’s chairman Jerome Powell has explicitly announced that it is up to Congress to initiate new rounds of stimulus. Interest rates are close to zero and yields of long-term Treasuries are already very low. Negative interest rates are undesirable as they encourage banks to take on too much risky credit if interest rates are held negative for too long. In Europe years of negative rates have led to banks taking on too much sub-investment grade loans which makes them more vulnerable to downward conjunctural changes in economic prosperity. The corona crisis has been a big blow to European banks, which are suffering more than their American counterparts.
Central banks around the world have used billions of quantitative easing to soften the corona crisis burden on businesses. Governments and especially the United States have used massive amounts of fiscal stimulus to boost their economies. Part of the FED’s stimulus package consists of bond buying to lower the debt burden on the government by suppressing interest rates paid on those bonds. The chart below shows just how the current situation is significantly different than previous rounds of quantitative easing.
Figure 1 shows an effort of the FED’s quantitative tapering back in 2018, when they lowered the amount of assets on their balance sheet. And while quantitative easing can be rolled out fast and quickly, tapering has to be carried out very carefully as can be seen on Figure 1. At the end of 2018 Jerome Powell concluded that the economy was in a good enough state to continue the quantitative tapering: “Our policy is part of the reason why our economy is in such a good place right now”. At the end of 2019 the FED had dropped interest rates three times and abruptly stopped the quantitative tapering due to liquidity issues related to the FED’s tightening. This is the reason why The Golden Investor stays long on gold as central banks continue to inflate markets with large amounts of money. And as has been shown in reality, QE can not be reversed, not even if the economy is in “a good place”.²
Now, on top all this is the massive amounts of governmental expenditures funded by massive amounts of quantitative easing by the FED. Whereas quantitative easing in the previous financial crisis only boosted the balance sheets of commercial banks, this time the real economy will also be impacted due to artificially cheap loans for businesses and direct transfer payments to citizens. This is the reason why the FED recently announced it would let inflation run around the two percent rate (within a certain bandwidth) instead of a fixed two percent rate target. In other words, inflation caused by quantitative easing and governmental spending may overshoot the two percent and it would not be considered a problem. This is the reason why gold is able to rally much further from here as it can be used as a hedge against inflation of cash assets.
Europe Could Face A Debt Crisis Caused By Too Much Quantitative Easing
In Europe two months of marginal deflation of 0.2 and 0.3 percent and the PEPP-programme buying spree, which almost certainly will be extended for a prolonged period, have been dampening the initially rising 10-Year governmental bond yields. The spread between Italian and German 10Y governmental bonds has dropped to 122 bp, which is lower than the pre-corona spread. Expectations are that the ECB will continue its purchasing of governmental bonds until 2022-2023. This would lead to a situation where the ECB holds up to fifty percent of total long term government bonds, which raises questions about the real sustainability of the current amount of quantitative easing. A possible outcome of all this is that ECB has to write-off governmental debt on their balance sheet to support countries that fail to pay-off the corona debt burden. This could forever end the faith of investors in the ECB, which will have huge consequences. Moreover, if sovereignty within the EU fails to withstand the corona debt crisis, the euro will fail as a currency. Even though we are still far away from such a situation, the large market distortions and the current disconnection of financial markets to reality pose a severe warning sign for central banks around the world.
Currently the overall European bond market is looking healthy, however this could change fast. On the long run inflation could cause bond yields to rise which will disproportionately hit bad-performing countries with high debt levels. Even if the ECB’s quantitative easing is quite lower than that of the FED, as the U.S. dollar is the world currency it has higher safe-haven demand than the euro in a debt crisis. This is offset by the higher chance of inflation in the United States due the different and more extensive quantitative easing approach of the FED. This is reflected in the recent appreciation of the euro in respect to the U.S. dollar.
The United States Will Be The First To See Inflation
The United States is expected to see inflation sooner than Europe as their quantitative easing has been more extensive with indirect funding of governmental checks to citizens. A direct effort to boost the economy, but indirectly funded by massive amounts of quantitative easing. When changing Figure 1 slightly it becomes visible just how much more the real economy is affected by the current amount of quantitative easing in respect to earlier stages of QE. With more rounds of governmental checks expected after the election, overshooting inflation on the long run is inevitable. Figure 3 shows just how much the U.S. government has been funding the real economy. This can be seen as a good thing since this kind of funding, unlike previous rounds of quantitative easing, is reducing inequality. However, it is also an indication of inevitable inflation on the long run.
As many European countries show a rise in corona cases, second lockdowns are inevitable at this stage. This time around less governmental support can be expected, creating new bad debt for banks that already are in bad weather. In the most recent ECB meeting new measures were discussed and it seems to be a matter of time before new purchasing programmes will be announced, further boosting safe-haven assets.
Where this story will end is uncertain, however everything points to a new debt crisis on the long run. If we will actually see inflation only time will tell. The Golden Investor expects that unlike previous rounds of QE, this time not only financial markets will be inflated, but also “real economy” asset classes that are integrated in the CPI inflation calculations will be affected. One thing is certain, quantitative easing is not a temporary measure, but a permanent one. Gold prices are relatively high, but compared to stock market valuations at the moment and the unlimited and irreversible amount of quantitative easing, precious metals are still a bargain at these levels.
Disclaimer: The Golden Investor is not a fortune-teller, be sure to make the right decisions in accordance to your own financial situation, this is not investment advise or anything like that.