The ills of easy money

The US and Europe have been trying to revive their economies through Quantitative Easing(QE) policies. However, we are now witnessing the repercussions of their actions. See interview with billionaire activist Carl Icahn.

In the past 7 years, the money created has flooded financial markets in the guise of higher stock prices, but have hardly permeated the real economy, or got to the Man on the Street. Property and stocks have been inflated by excess money chasing after limited assets, and borrowing against inflated assets will only make this bubble even bigger.

Note that the job of the Fed is to manage inflation, but not assets. However, this misguided effort has led mainly to the inflation of assets, but not demand or prices. John Burbank of Passport Capital hit the nail on the head with this remark:

"QE had caused a misallocation of capital across the world, while the end of QE last year triggered a dollar rally with consequences that were only now beginning to be realised. The wrong people got the capital — emerging markets countries and corporates and a lot of cyclical companies like mining and energy, particularly shale companies — and this is now a major problem for the credit markets,” he said.

QE has in fact, gone against its purpose, leading to declining prices from an imbalance between an excess of supply from Asia and a drop in demand from the West - Overleveraging has led to overcapacity that is driving down prices (read: China).

So, where will real growth come from? And what can we put our bets on? I will highlight some of these promising sectors in my next post...

When the rates goes up...

It is only a matter of time before the US Federal Reserve hikes rates. Everyone is watching Janet Yellen like a hawk (although she has yet to become one) because the impacts of the move distills down to everyone of us. In order not to tip the scales, the rate rise is likely to be gradual. However, here are some of the more pertinent implications for us to be prepared for:

Rise in borrowing costs (mortgage, car loans, credit cards) & savings rates - 

Savers can start smiling again as deposit rates will finally go up. However, the higher cost of funds will have to be compensated by higher borrowing rates for mortgages, car loans, and credit cards.

In Singapore, we have already seen that happening with the 3 month *SOR and SIBOR climbing to 1.405% and 1.075% respectively in August, the most since end 2008.

In light of the rising SOR, banks are already dangling offers to refinance home loans:

Rise in USD + fall in Emerging market currencies and EUR:

This presents a good window to accumulate the USD, which is set to appreciate as rates increase; and sell Emerging market currencies (e.g IDR, THB, MYR, VND), before they drop further when the Fed starts the ball rolling.

The Singapore dollar is already set for its biggest annual loss since 1997, hitting 1.42 to the USD just before the Fed decision. Declining currencies also implies lower asset values for foreign investors, but an opportunity to accumulate assets in emerging markets.

Companies at risk:

Interest payments for low grade debt could rise more quickly. This would increase the burden on ASEAN companies, which have already seen their currencies depreciate, and face higher USD repayments. The extended period (7 years!) of low interest rates have also sustained zombie companies, which might be unable to survive a rate hike. Look out before investing in these companies at risk.

*The Swap offer rate (SOR) is typically used to price corporate loans. A softer Singapore dollar can put upward pressure on local interest rates such as SOR, as investors seek higher yields as compensation for holding the weakening currency; the Singapore Interbank Offer Rate (SIBOR) is the rate at which banks lend to each other, and is used to price mortgages. It usually follows the SOR with a lag.

Something we don't know - Post Fed reaction

Oddly, the markets did not respond well to the Fed decision to hold rates at zero on Friday. The Dow was down almost 300 points at one point (1.74%), while the S&P 500 was down 32 points (1.62%). Convention would dictate that the markets rally if the Fed kept rates low, which translates into lower financing costs for the economy. Here are some reasons I can think of for this anomaly:

The Fed knows something we don't:

The US economy might not be on the recovery we all think it is. Inflation at 0.4% was far away from the target of 2%; the only number on track was unemployment dropping to 5.1% ... but could it be because people gave up looking for jobs altogether? More people not looking for jobs would also exclude them from the workforce, thereby leading to a lower unemployment rate... there is more to the numbers than meets the eye.

OR

There are external risks (i.e China, Emerging markets,Commodities or ??? ) too great to ignore that it had to be taken into account. See previous post.

OR both.

Does she know something we don't?

Either way, investors are selling off because of the lack of clarity and certainty. They have interpreted the decision that the table of wise men do not think well of the economy. What happened on Friday should be a knee jerk reaction, unless things get worse. Till then, as Chuck Prince remarked infamously before the crisis," As long as the music is playing, you've got to get up to dance".

If not now, when?

Not now! Market watchers, including myself, will be dissecting Yellen's statements word for word after the Fed made the decision not to hike rates. Here are some excerpts and my interpretation of them:

The Fed could still hike rates next month in its October meeting. The decision to hike will not hinge on any data release, but a broad range of economic and financial indicators. Her main concerns were inflation running under 2%, a depressed housing market (all time low 30 year mortgage rates and slowing housing starts), as well as volatile markets caused by China and commodity prices. The Fed has discarded negative interest rates as a possibility, adding that its goal is to put people back into jobs, not increase income inequality.

At least this gives us a clearer picture of the Fed's considerations. So...if not now, when?

US Fed - To raise or not to raise?

Come September 18, the most hotly debated decision will be known: whether the US Fed will raise its interest rates. Here is my cow sense on what will happen and why:

The Fed is likely to raise rates, if not this time, at least by 2016. Rates have been held close to zero since December 2008. Amidst a lamentable recovery, the Fed's dual mandate of employment and price stability have been about met: Unemployment has halved to 5.1% since its peak in 2009, and inflation, at 0.2% (for the last 12 months till Aug 2015) is slowly approaching its target of 2% (Inflation for a large part of 2014 was nearer 2%).

In addition, assets are reaching "bubble" territory. In her July 15 semi-annual testimony to the Senate Committee, Janet Yellen has alluded to this herself by warning that she sees signs of asset price bubbles forming in some markets such as those for leverage loans and lower rated corporate debt, while indicating that stocks aren't overvalued. Car sales are rising at the quickest pace in a decade (also fueled by low pump prices), while commercial real estate prices are going through the roof.

Detractors (i.e. the World Bank, Lawrence Summers, Lloyd Blankfein) claim that raising rates would hurt a fragile recovery and impact emerging markets; the higher interest rates would cause outflows from emerging markets into the US. However, as pervasive as the impact of this decision may be, the US has to tend to its own backyard in order not to sow the seeds for runaway inflation and asset bubbles, as during the Greenspan era.

Whatever the case, it is most certain that a rate raise will happen; if not in September, at least within 6 months. Should it happen on September 18, it will be largely priced in as the Fed has done a good job of preparing the markets for it. If it doesn't, the markets will likely continue with its upward trajectory.