The Ending of QE2 Should Lead to a Down Summer but Eventual Return to Growth
May 16, 2011
In a WSJ article by Mark Gongloff on May 13, 2011 UBS commodities and mining analyst Julien Gallan was quoted as having written:
But I do take seriously that these experts in commodity trading see the end of QE2 causing the unwinding of the commodity carry trade, when QE2 in fact comes to a stop. Their statements imply that they expect the ending of QE2 to lead to a rise in the dollar and a increase in yields. This will in turn lead to a further unwinding of the carry trade, which will in turn should result in a decrease in the price of commodities through the summer.
In the international area, the full impact of QE2 can now be seen in the emerging market stock exchanges. They are all showing signs of serious weakness. And most have already taken definite losses. This was probably caused by their having to raise their interest rates so as to combat the inflation which was in turn caused by the commodity carry trade exploding and commodity prices rising to meet world demand. Even those countries with large natural resource exports were faced with rising cost for their imports, even as they benefited from the increase in prices of their exports. So they like the rest of the world they have had to increase their interest rates as well. These increasing interest rates have caused the downward pressures on their stock markets. This constriction is now being felt in diminished world demand for goods and commodities.
But what impact will the end of QE2 have on them? For one thing the unwinding of the commodity carry trade will reduce the outside pressure on their price levels. This should stop or at least slow the inflation so they will be able to stop raising their interest rates and even consider providing some stimulus for their faltering economies.
Meanwhile back in the U.S., the dollar should rise and with it yields on bonds. The rise in the dollar should come about by the natural tendency to return to long term averages when the artificial downward pressure being applied by QE2 is removed. The rising dollar should mean the carry trade will continue to unwind. This should push down inflation and reducing producer resource costs. Both good things, and this pressure should continue throughout the summer. But even though good for the economy, it will not be good for the stock market over this time period.
At some unknown time after this summer the world economy should start growing again. And this should again push up demand for commodities. The carry trade may start up again, though likely with some other country serving as host.
To summarize, the ending of QE2 should cause the prices of commodities to continue to have downward pressure throughout the summer, while the stock market will continue to be concerned about the apparent weakness in world demand. This may well lead to a down market during the summer months. But at some point after that when these forces have played out, the stage should be set for a worldwide return to growth.
Of course, as the Fed. learned when QE2 began, outside events can produce effects which swamp the pressures it is exerting. For now the European Sovereign Debt problem and our Congress seem to be the greatest threats to the world-wide recovery due next year. In addition to these other things could happen which negate the logic provided here. For example, if emerging markets recovered for some reason, whatever carry trade which disappeared would come back for these markets. Then commodity demand would pick back up and commodity price pressure return. Or if QE3 is not the non-starter I think it is, but instead concern for the housing market outweighs every other concern, then the logic based in the rising dollar is false. So take your pick as to the true outcome. But I believe the chain of reasoning just spelled out is true in terms of the direction of the pressures which the ending of QE2 will create.
This has lead me to think about what this says about the impact of QE2 ending. I find the logic of saying that the end of QE2 is causing the commodity carry trade unwinding questionable. After all, QE2 is still going strong for another month and a half. Much more likely in my view is that the current downward pressure on commodities being caused by the dollar will be pushed up by debt concerns in Europe and the increase in margin rates.
The key question we face here is whether our concerns are "priced in" or whether last week's market action a prelude to a deeper commodities correction in the weeks and months ahead. We call for a deeper correction.
In the mining team we see the end of QE2, a reversal of capital flows back to the U.S., and an unwinding of the severely crowded short dollar/long commodities carry trade as the central roadmap for the coming weeks and months. Only once this has played out do we see a potential for a return to reflation and commodity bullmarkets later in the year
But I do take seriously that these experts in commodity trading see the end of QE2 causing the unwinding of the commodity carry trade, when QE2 in fact comes to a stop. Their statements imply that they expect the ending of QE2 to lead to a rise in the dollar and a increase in yields. This will in turn lead to a further unwinding of the carry trade, which will in turn should result in a decrease in the price of commodities through the summer.
In the international area, the full impact of QE2 can now be seen in the emerging market stock exchanges. They are all showing signs of serious weakness. And most have already taken definite losses. This was probably caused by their having to raise their interest rates so as to combat the inflation which was in turn caused by the commodity carry trade exploding and commodity prices rising to meet world demand. Even those countries with large natural resource exports were faced with rising cost for their imports, even as they benefited from the increase in prices of their exports. So they like the rest of the world they have had to increase their interest rates as well. These increasing interest rates have caused the downward pressures on their stock markets. This constriction is now being felt in diminished world demand for goods and commodities.
But what impact will the end of QE2 have on them? For one thing the unwinding of the commodity carry trade will reduce the outside pressure on their price levels. This should stop or at least slow the inflation so they will be able to stop raising their interest rates and even consider providing some stimulus for their faltering economies.
Meanwhile back in the U.S., the dollar should rise and with it yields on bonds. The rise in the dollar should come about by the natural tendency to return to long term averages when the artificial downward pressure being applied by QE2 is removed. The rising dollar should mean the carry trade will continue to unwind. This should push down inflation and reducing producer resource costs. Both good things, and this pressure should continue throughout the summer. But even though good for the economy, it will not be good for the stock market over this time period.
At some unknown time after this summer the world economy should start growing again. And this should again push up demand for commodities. The carry trade may start up again, though likely with some other country serving as host.
To summarize, the ending of QE2 should cause the prices of commodities to continue to have downward pressure throughout the summer, while the stock market will continue to be concerned about the apparent weakness in world demand. This may well lead to a down market during the summer months. But at some point after that when these forces have played out, the stage should be set for a worldwide return to growth.
Of course, as the Fed. learned when QE2 began, outside events can produce effects which swamp the pressures it is exerting. For now the European Sovereign Debt problem and our Congress seem to be the greatest threats to the world-wide recovery due next year. In addition to these other things could happen which negate the logic provided here. For example, if emerging markets recovered for some reason, whatever carry trade which disappeared would come back for these markets. Then commodity demand would pick back up and commodity price pressure return. Or if QE3 is not the non-starter I think it is, but instead concern for the housing market outweighs every other concern, then the logic based in the rising dollar is false. So take your pick as to the true outcome. But I believe the chain of reasoning just spelled out is true in terms of the direction of the pressures which the ending of QE2 will create.
