Now that not only Mario Draghi but also Ben Bernanke have joined in the loud and growing chorus of “economic experts” debating the arrival of the monetary paradrop and suggesting that that helicopter money “may be the best available alternative“, it is just a matter of time before helicopter money is actually implemented, “maybe not today, but in the next recession” according to Deutsche Bank.
And it is the same Deutsche Bank that provides a handy primer how to trade (or frontrun as the case may be) this now inevitable and terminal monetary policy.
From DB’s George Saravelos, “Helicopters 101: your guide to monetary financing“
Market implications
The starting point of understanding asset moves should be the type of policy response as well as its effectiveness. Here we assume an aggressive form of stimulus large enough to generate an increase in inflation and growth expectations – for instance, a one-off write-down of debt owned by the central bank as well as large-scale fiscal stimulus financed by the issuance of zero-coupon perpetual bonds bought by the central bank. We assume that the market perceives the policy as “successful”, namely that both growth and inflation expectations rise. Under this scenario, we would expect the following:
Bond yields should rise and the curve should bear-steepen. Our colleagues in fixed income last year published a framework on understanding the drivers behind long-dated yields.26 We list the components of the 10-year yield below and the anticipated impact:
Taking all the factors above, the ultimate effect on yields is ambivalent, depending on the interaction between falling credit risk, rising demand-supply imbalances (downward pressure on yields) versus higher growth and inflation expectations (upward pressure). At one extreme, if the market perceives the policy as a failure, credit risk and demand/supply imbalances are likely to dominate, putting even further downward pressure on yields. At the other extreme, if the policy is perceived as a loss of monetary discipline, inflation expectations would spike, leading to an aggressive re-pricing of yields higher.
On balance, under the assumption of policy “success” without fears of hyperinflation, we would conclude that bond yields rise, driven by the long end.
- The currency should weaken, but may eventually strengthen. Real yields have proven one of the most important drivers of currency moves in the post-crisis years, so the effect of helicopter money on FX will likely depend on their direction. The large depreciations in both the euro and yen over the last few years were driven by large downward shifts in real yields (charts). The effect of helicopter money on real yields is ambivalent, as outlined above. We assume that inflation expectations would dominate over growth, at least initially, with a central bank commitment to keep nominal rates low for long also helping. Eventually higher growth and tighter policy could lead to a stronger currency, however. Other frameworks suggest that currencies should at least initially weaken as well. The monetary approach to exchange rate determination concludes that the relative supply of money between two economies ultimately determines the exchange rate. An irreversible and permanent increase in the money stock (compared to the reversibility of QE flows via maturing bonds) should all else constant lead to a weaker currency.
- Equities should rally. The most straightforward equity valuation models suggest that a stock price is the sum of the net future earnings discounted by the appropriate nominal risk free rate. Higher nominal growth expectations would, all else constant, lead to higher future earnings, but higher yields would lower the value of these earnings via a higher discount factor. Ultimately, the effect on equities will depend on the interaction between nominal growth expectations and nominal yields. A helicopter drop that allows a moderate rise in yields combined with higher nominal growth expectations should lead to higher equity prices.
We conclude that a “successful” helicopter drop, defined as generating higher growth and inflation expectations but without a permanent overshoot of the inflation target, should lead to higher and steeper yield curves, a weaker currency (at least initially) and higher equity valuations.
This notwithstanding, it is important to emphasize that there are alternative equilibria too. At one extreme, if the policy is not perceived as sufficient in size and impact, then the supply/demand imbalances in fixed income may be exacerbated (less issuance and debt outstanding) without a corresponding move higher in inflation expectations. This would lead to a market reaction similar to the one that followed the BoJ cut to negative rates earlier this year: lower yields, weaker equities and a stronger currency. At the other extreme, if the long-term commitment to the inflation target is challenged and central bank credibility is lost, long-dated yields would spike higher, capital flight would ensue and risk assets would substantially underperform.
A “successful” helicopter drop may therefore be easier said than done given the non-linearities involved: it needs to be big enough for nominal growth expectations to shift higher and small enough to prevent an irreversible dis-anchoring of inflation expectations above the central bank’s target.
Either way, the behavior of the latter is the key defining variable both for the policy’s success as well as the asset market reaction.
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Good luck Janet, and we hope it’s now clear to you why Bernanke got the hell out of Dodge when he did.
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