Great News! The Great Exit is coming

Monetary stimulus won’t cut it, the BIS said bluntly overnight. And it looks like central banks can’t avoid a sharp rise in bond yields as they pull back, but that means rays of sunshine for Australia.

The Bank for International Settlements has now added its weight to the idea that the Great Stimulus, which followed the Great Recession, must now be followed by the Great Exit.
And despite last week’s panicky market reaction to the announcement of the Fed’s exit timetable, it’s Great News. The world is about to get a strong US dollar and a hedge fund massacre, which are both very good things.  
A few days after Federal Reserve Board chairman Ben Bernanke was generally perceived to have announced that quantitative easing would end between “later this year” and the middle of next year (even though that was already known), the BIS has joined the QE requiem chorus in its annual report, released overnight.
“Delivering further extraordinary stimulus is becoming increasingly perilous”, says the BIS, which is regarded as the central banks’ central bank.
It argues, in effect, that the time has come for politicians to step up to the plate and “hasten labour and product market reforms”. “Monetary stimulus alone cannot provide the answer because the roots of the problem are not monetary.”
In a sense the four major central banks – America, Europe, Japan and Britain – have been papering over the failure of governments to reform their economies by distorting asset markets with ultra low interest rates and increasing the size of their balance sheets by $US10 trillion, so far.
The problem, according to the BIS, is that “despite all the monetary accommodation, economic growth remains lacklustre and job creation has yet to gain firm traction.”
“Six years have passed since the eruption of the global financial crisis, yet robust, self-sustaining, well balanced growth still eludes the global economy.”
The central banks are now in a “very uncomfortable” and “delicate” position. “When is the time right to pull back from their expansionary policies? And in pulling back how can they avoid sparking a sharp rise in bond yields?”
Going by last week’s reaction to what was really a re-statement by Ben Bernanke of the Fed’s existing exit strategy, the answer seems to be that they can’t avoid that.
So far we haven’t seen a repeat of 1994, when bond markets crashed after the Fed unexpectedly started raising interest rates in February, but all markets have become much more volatile as the exit approaches. Triple-digit moves by the Dow Jones Average have become the norm in the past week or so.
At centre-stage is the US 10-year Treasury yield, currently at 2.54 per cent, up from 1.6 per cent at the start of May and 2.1 per cent at the start of last week. The bond yield is anticipating the recovery of the US economy and is thus leading the Fed’s exit strategy rather than responding to it.
As the US interest rate structure rises, so will the US dollar. As a result the US current account deficit will rise, bringing rays of sunshine to developing economies as their currencies fall and exports grow. This includes Australia.
Also, the hedge fund carry trade enabled by negative real interest rates will be closed out. The Great Stimulus has been a golden period for hedge funds and investment banks, as they trade assets using cheap money, but soon fundamentals will take over from marginal speculation.
At least we hope so. As the BIS points out, it all depends on central banks finding a path back to their traditional role of stabilisation, and away from being the stimulators of last resort.
“…central banks are mindful of the fact that the size and scope of the exit will be unprecedented. This magnifies the uncertainties involved and the risk that it will not be smooth.”

Alan Kohler will be hosting two Ashes lunches with Gideon Haigh and Stephen Fay (former editor of Wisden and author of books about The Bank of England and the collapse of Barings) on June 25 in Sydney and June 26 in Melbourne. To book a table click here.

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