Cost of extended monetary easing

Posted By Darren Winters on Jun 29, 2019


Cost of extended monetary easing

The cost of extended monetary easing is likely to be amplified as the Fed’s great pivot to a new era of monetary easing  was recently declared in June’s FOMC meeting. 

Over-inflated asset prices in bonds, stocks, real estate, coined as the everything bubble, is perhaps the most talked about cost of extended monetary policy. 

Stocks are no longer cheap but is that still the case with the Fed’s great pivot? 

The P/E10 (price to earnings) ratio of Standard & Poor stocks is estimated to be 29.1 which is well above its historical long term average. 

The average P/E ratio since the 1870s has been about 16.8.

The cost of extended monetary easing has resulted in a P/E ratio above its long term historical average

High P/E ratios tend to proceed a stock market correction. 

In the Spring of 2009 the P/E ratio reached as high as 120 In 1999, a few months before the top of the Tech Bubble, the conventional P/E ratio hit 34. It peaked close to 47 two years after the market topped out. 

The cost of extended monetary easing has also resulted in a bubbly bond market pushing bond prices high and their corresponding yields low 

The 10year treasury yield, a yardstick which has an impact on the borrowing cost of all loans, has fallen below 2% due to weak confidence data and the Fed’s great pivot. 

Bond investors are typically the most cautious investors preferring income to risky capital appreciation. But lower bond yields also means that even the most cautious investors are being forced into the deep end and investing in higher risk bonds. 

The cost of extended monetary easing has resulted in hyper finalized markets where market forces are no longer regulating risk

Cost of extended monetary easing

The cost of extended monetary easing is that there is risk distortion. How can Italian 10 year bonds yields 2.16 which is nearly the same as US 10 year treasury?

Despite Italy’s fiscal and banking woes, the market is indicating to investors that lending to the Italian government is as risky as lending to the US. That is obviously wrong. 

The European Central Bank is clearly buying Italian bonds through its asset purchase program which is QE and inflating the price of the bond, thereby depressing the yield on Italian 10 year bond.

The cost of extended monetary easing is that investors become oblivious to risks

Put another way investors are “picking up nickels in front of a steam roller”. I would agree with the view that the next financial crisis could be another credit crisis either with peripheral sovereign bonds and or corporate bonds. 

The proliferation of zombie companies littering the business landscape could be another cost of extended monetary easing

The central bank’s cheap money provides an artificial life support machine for zombies that survive on low-interest rates.

Zombie companies do not have viable business models, they are unable to turn a profit and would not exist in a normal monetary policy environment. 

Debasement of the currency is another cost of extended monetary easing

This makes assets outside the system more attractive to investors, hence the rise of precious metals and cryptocurrencies.

So the cost of extended monetary easing is real.

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