"There's no such thing as a free lunch" is an oft-quoted maxim in economics, and it seems like a maxim that could easily be applied to the Federal Reserve's bond-buying program known as quantitative easing.
In a new note titled "The real cost of QE," Bank of America's FX strategist Athanasios Vamvakidis takes a critical look at the U.S. central bank's particular brand of unconventional monetary policy, and its changing relationship with financial markets. He contends that "excessive reliance on unconventional monetary policy" is not without side effects, many of which are only now being felt in markets.
At some point during Fed QE, the markets started reacting positively to bad news. In our view, this is when things started going wrong. Bad news became good news for asset prices, as markets expected more QE by the Fed. Asset prices were increasingly deviating from fundamentals, as the markets were trading the Fed instead of the economic reality. This was clearly not sustainable.
Vamvakidis argues that the market's violent reaction to the Fed's announcement in the spring of 2013 that it planned to "taper" its bond purchases was one sign that QE had already gone wrong.
We should have known something is wrong. The Fed “taper tantrum” could have been the first signal that QE had gone too far. The second warning may have been the across-the-board emerging markets sell-off that started in mid-2014, as QE tapering was coming to an end and the market started pricing Fed tightening, a sell-off that intensified substantially this year.
All of this doesn't mean Vamvakidis believes QE should have never happened, of course.
He does recognize that the Fed policy helped the U.S. avert another Great Depression in the aftermath of the financial crisis, but he doesn't believe that bond-buying should be the first choice for action whenever something goes south in the economy. He calls the first round of QE "a necessity," but is more skeptical of the Fed's subsequent programs known as QE2 and QE3.
Moreover, he notes that despite the continued expansion of balance sheets at a number of central banks around the world, monetary policy conditions have tightened and liquidity has fallen, as shown in the below BofAML charts:
So what happens next? Vamvakidis contends that markets are embarking on a big readjustment:
The story of the year so far may be that of a negative feedback loop leading to a bad equilibrium. First, risk assets sold off expecting the Fed to tighten. Then, the sell-off went too far and started affecting the real economy, including in the US. Now, the Fed is not tightening as a result. However, postponing Fed tightening does not necessarily increase the demand for risk assets. This is a new regime, in which bad news is bad news. This is how it is supposed to be, but the adjustment back to normal has not been and is not going to be smooth, in our view.