QE2 and the undead homicidal zombie market

By Felix Salmon
November 16, 2010
Baruch has a fantastic new post up, which nails what I'm really worried about when it comes to quantitative easing.


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I know this blog has been way too heavy on the QE of late; apologies for that. But Baruch has a fantastic new post up, which nails what I’m really worried about when it comes to quantitative easing.

Essentially, says Baruch, the stock market rally is like the cat in Pet Sematary: it looks real, but it isn’t. And in fact it’s likely to turn out very harmful indeed.

Part of the problem is that QE has become, in part, a game of “kill all the shorts”—a game which a glance at IOC or OPEN or even UTA will tell you is being played very well indeed. Correlations are high, which is always a bad sign, and that weakens the raison d’être of the entire market, which is to allocate capital efficiently. Instead, the stock market becomes a place where people park their money in the hope that it will go up and in the expectation that if it goes down, the Fed will step in and rescue them.

But Baruch isn’t reassured:

Will we crash? Will we carry on straight up? Will we pause and rally? Who can say? We’re in a period where anything is possible, as I’ve said before, a world of unintended consequences coming down the pipe. Some may be good, and some may be bad…

I’m not saying we’re in an undead homicidal zombie market, though we may be. But here’s an example of what the Pet Sematary market is capable of in terms of unintended consequences: QE inflates all asset prices, including commodities. This pressures the Chinese consumer, who we are relying on to pull us all out of this mess, who can suddenly not afford his new LCD TV because his Moo Shu pork Big Mac and fries is costing 20% more than it used to. Changes in commodity prices have a much greater impact on his consumption than Joe Schmoe in Idaho. The BoC has to raise rates to offset the inflation this is causing, hurting Chinese growth even more, and global GDP growth drops 50bp. Bravo the Bernank. With your Quantitative Easing you just killed off the only good thing in this market which was working naturally without outside interference.

Baruch doesn’t think this is going to happen, necessarily — but the point is that neither he nor anybody at the Fed is remotely able to judge its probability, or, for that matter, the probability that QE will actually work.

Kevin Drum makes the very good point that we’re not actually arguing about something hugely important here:

Despite the scary sounding $600 billion number, the actual impact of QE2 is almost certain to be fairly small. With interest rates already so low, there’s simply not enough money involved to move markets substantially.

But the key word here is “almost”: QE might well end up making very little difference either way, but there’s no doubt that it’s made the tails fatter. Global markets have ramped up a lot since QE2 was effectively announced, and a sudden unwind of that move would devastate confidence. There’s lots of things that can go wrong, and the chances that the stock market has its valuations right have never been smaller. If you’re buying stocks right now, I hope you’re able to withstand a very bumpy ride. Because there’s a substantial chance that you’re going to get exactly that.

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