The Bank of Japan started the era of quantitative easing with their first long-term purchase of government debt securities in the late 1990s.
QE is basically a temporary monetization of debt as central banks create money to buy existing securities from the marketplace and hold them as assets on their balance sheet.
In Japan, they are even buying equity-based exchange-traded funds in addition to bonds. In fact, the BOJ is the largest holder of ETFs in Japan.
I'm mortified by the extent central banks have gone to in an attempt to stimulate the economy. Negative interest rates and asset purchases are the worst culprits.
While global economies have seemingly rebounded, the reason they bounced back is now beginning to be removed in what will be known as quantitative tightening (QT). The biggest beneficiary of the liquidity were equity markets not bond markets.
The U.S. Fed first launch QE on Dec 8, 2010, and the total U.S. equity market has had an annualized return of 13.2 per cent. The entire U.S. bond market had an annual return of 3.25 per cent. So ask yourself: which market is more at risk from and unwinding of QE?
The Fed told us this week they will begin to unwind asset purchases and the pace is relatively slow at $10-billion per month, which should not have a material impact on markets just yet. For perspective, they were buying as much as $80-billion per month when QE was in full swing.
The Fed's goal over the next few years is to reduce the excess reserves in the banking system. The Fed created money to give banks liquidity to lead, and, for the most part, the money has been sitting at the Fed as excess reserves, which it (read tax payers) pays them interest on.
In addition, the Fed is likely to raise rates again in December and expects to raise rates three more times in 2018, according to their dot plots. Of note, they lowered their long-term neutral rate to 2.75 per cent from 3 per cent. The long-term target was at 4 per cent a few years back and have been downgrading the long-term expectations for several years.
Keep in mind, that the Fed first forecast they would be raising rates in 2010 as QE1 ended, and did not actually until late 2015.
Market consensus, based on overnight swap rates, the standard for assessing Fed rate hikes, are still less than certain that we will see even two rate hikes over the next year. Nevertheless, we are in a new era and other central banks, including our own Bank of Canada, are now focused on removing stimulus.
Eventually, this will have a negative impact on the global economy. We should now be looking for the signs of a tightening cycle slowing the economy. Make no mistake, this cycle is very different than others due to the unprecedented low rates and unusual stimulus. Do not expect interest rates to rise much, though they will rise a bit until the economy starts to slow.
We also heard from the BoC this week too, and they suggested that the stronger Canadian dollar is a problem.
The combination of the Fed being a bit more hawkish and the BOC concerned about the rising loonie is leading to a bit of currency weakness. For the snowbirds, you just missed the best buying U.S. dollar opportunity, when the exchange rate hit 83 cents a few weeks back, though I would not look for it to weaken too much below 80 cents through the winter months.
When I look out for the next few years, the forward curve for U.S. crude WTI oil is anchored to the $50 (U.S.) price plus or minus 10 per cent. I see the Canadian dollar sitting around the 79- to 84-cent level for the next year or so. One reason it should not get too much stronger is that the Canadian economy is not as hot as the recent data suggests, and Prime Minister Justin Trudeau's tax "fairness" policies are likely to hurt economic growth if implemented.
So when we look at the narrative of the Street, they are mostly saying be bearish on bonds and that stocks are the place to be. And while I've been suggesting caution on your portfolios for more than a year now, I still see a much bigger risk in equity valuations. there is no doubt that bonds are expensive, but if the unwinding of QE hurts equity market liquidity, as I expect it will, then longer-term bonds will become a safe haven, and the yield curve will invert portending a recession. This won't play out overnight, but I suspect we may see that play out by 2019.
With confidence in central banks, fiscal mismanagement and a polarized political landscape, enter the speculation swirling around Bitcoin and other electronic currencies that are creating the next bubble.
Make no mistake, when we move to electronic currencies (I suspect within the next decade) to reduce the grey economy and improve tax collection (much better than increasing tax on the backbone of small business in Canada), the governments will control the blockchain technology that drives it. If you are inclined to speculate in Bitcoin, the downside of the bubble will likely be quite nasty along with the downside in equities once liquidity dries up.
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Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor.