Short Opportunity: QE2 Won’t Remove Risk

Central banks cannot manipulate stock prices upward for very long. The harder they press, the more they risk ultimate disaster. Unless the Fed want to risk confidence in the U.S. dollar spiraling out of control, its future policy will fall short of its most aggressive rhetoric.

With the QE2 decision and his Op-ed in the Washington Post, Ben Bernanke took an aggressive stance because he knows that next year’s Board of Governors will consist of more QE critics. He’s certainly getting an earful of criticism from foreign creditors this week. I’ve spent a lot of time researching the international reaction to QE2, because this factor will probably dominate the direction of individual stocks and sectors in the coming months. Some sectors of the stock market will likely benefit from QE2, but most will suffer.

The market should soon start discounting other factors aside from the Federal Reserve’s behavior. That’s what we’re seeing today. Two of the biggest risk factors include:

1.    Continued stress in Euro-area sovereign credit (specifically Ireland)

2.    Slowing economic activity in China

Ireland will likely need a bailout from the EU in the coming months. I’m referring to an actual financing commitment, not just jawboning G-20 bureaucrats.

Spreads on Ireland’s sovereign debt have widened so far that the interest rates on future refinancing would be so high that they’d be self-defeating. The Irish government claims to have enough liquidity to last through mid-2011 without tapping the bond market — but this is a solvency issue, not a liquidity issue. This government has effectively hit the debt wall. So Ireland is another case study in how Keynesian economic policies ultimately lead to bankruptcy.

Ireland will eventually need to restructure its debts (including haircuts for bondholders) to avoid paying a politically unacceptable share of its GDP to bondholders. In “Ireland’s Fate Tied to Doomed Banks,” The Wall Street Journal highlights how rapidly the government’s financial health deteriorated in the wake of its bank bailouts. During its housing bubble, Ireland pulled too much future economic activity into the present. Now, not only is its suffering under the loss of that “pulled forward” economic activity, it’s also having to pay interest on the debt it incurred to finance the housing bubble.

Greece and Portugal will likely restructure as well. In my view, over the next 6-12 months, the Euro is at risk of another crash against the U.S. dollar as Germany’s export prowess is simply not enough to both support its own economy and continue to bailout its neighbors. Germany’s taxpayers don’t want to bail out lenders’ follies; they saw our experience with TARP, and don’t want to repeat the same mistake.

A haircut for PIIGS bondholders is coming, sooner or later. That, in turn, means trouble for the big European banks that hold those bonds. Germany and France will eventually realize that it makes more sense to save dry powder to recapitalize their banks, rather than squander it on delaying inevitable PIIGS defaults for just a couple of years. The longer bureaucrats and bank lobbyists delay this process, the more cash flow will be sucked out of the economy for the alleged benefits of propping up bondholders.

As sovereign budget stress remains in place, the Euro should start looking less like the old German mark and more like the Italian lira. The Euro/U.S. dollar exchange rate is highly correlated with the “risk on” trade, so as the Euro falls, U.S. stocks should correct — perhaps violently. The consensus clearly believes that “stocks can only go up during QE2,” so that makes a correction even more likely.

In Europe, the political will to sustain austerity programs in Greece and Ireland will wane, but probably not before we see disappointing GDP figures and more public protests. The U.K.’s austerity programs may not have a long shelf life either.

Meanwhile, on the other side of the globe, China’s massive credit bubble is starting to pressure prices. Even the heavily doctored Chinese economic stats can’t hide the obvious pricing pressure at the consumer level. Its stock market is selling off on fears that the central bank will raise rates. If that doesn’t help, perhaps China will accelerate the appreciation of the Yuan against the U.S. dollar — a move that in the short run would slow its GDP, but in the long run would make commodity imports cheaper for China (and more expensive for the U.S.).

There are numerous ways to profit from these risks on the short side. I promise to keep you updated as the affect of the QE2 continues to unfold.

Sincerely,
Dan Amoss
Penny Sleuth

November 15, 2010

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