Stock markets are wrong about QE2

Allister Heath
YESTERDAY’S stock market rebound is the proof that investors don’t always get it right – or at least, that they still love to get drunk on the prospect of cheap money. Stock markets in the US and UK jumped, taking equities back to the time when Lehman Brothers was just another big investment bank.

One may argue that higher equity prices are justified, with corporate earnings beating forecasts – but the resurgence of the past few weeks has nothing to do with fundamentals and only a bit to do with the US mid-term elections. Its overwhelming driver was the Fed’s announcement (and prior to that, the expectation) that it would buy more government bonds.

Yet America’s misguided QE2 policy will merely continue to fuel the bonds bubble, driving down yields to irrational levels and reversing the re-pricing of risk. Thursday’s 5.3 per cent decline in the Vix index, Wall Street’s fear gauge, was irrational. Several emerging market economies said the Fed’s move made any substantive deal on cutting global economic imbalances less likely at next week’s G20 meeting in Seoul. Developing countries also threatened fresh steps to curb capital inflows which are pushing up their currencies against the dollar. Brazil said it would use the G20 meeting as a forum to complain about the Fed’s decision. The Chinese were also predictably irate. In South Korea, the minister of finance and strategy said it would “aggressively” consider controls on capital flows; Turkey’s economy minister, where the central bank has been buying foreign exchange to curb appreciation of the lira against the dollar, said the Fed’s policy might backfire. Thailand raised the possibility of concerted action to combat the flood of investment dollars that are pouring into emerging markets. The Indians muttered veiled warnings. Even the Germans slammed the decision. The whole thing is turning into a disaster and whipping up protectionist sentiment. Why is nobody listening?

In truth, some are: the CRB index of commodities hit its highest level in over two years, the greenback fell and the price of gold surged. All of these are typical inflation hedging signs. In a note last night, Charles Dumas of Lombard Street Research went as far as to predict that QE2 will actually cut US GDP by pushing up food and energy prices, reducing domestic demand.

It is imperative that we start to wean ourselves from our addiction to cheap money. QE2 is creating another false market in government bonds just when we need to normalise finance and price risk properly. The Fed is the problem – not the solution.

I have a lot of time for Guy Hands but his decision to sue Citigroup over its role in his takeover of music giant EMI was a bad error of judgment. Rather than trying to shift the blame, he should have taken responsibility for his disastrous decision. He borrowed billions to buy the firm at the height of the bubble, even though the entire industry is being undermined by technological change (though EMI isn’t doing too badly at the moment).

It was always hard to know how a US jury would rule, especially in the current anti-finance climate – on the one hand, a dreaded Wall Street giant, on the other, an equally despised buy-out firm led by an Englishman. But yesterday’s decision against Hands was a breath of fresh air. He should stop grumbling and get on with trying to rescue his troubled empire.