Why European QE is bearish for U.S. stocks

2015-01-22

Investors and traders have been trained in a Pavlovian fashion to respond to quantitative easing as stock-market bullish. As central banks act to stimulate through non-traditional means, equities rise, volatility VIX, -5.23%  is crushed, and worldwide markets benefit. That certainly has been the takeaway in terms of QE coming out of the United States, and somewhat so in the case of Japan.

Now, all focus is on Europe VGK, +0.82%  and the universal belief that not only will quantitative easing reverse deflation, but so, too, will it push worldwide markets to new highs. After all, "money printing" (which is not what QE really is) leaks outside borders and helps push risk assets to new heights.

There are a few problems with thinking that type of reaction will persist however, particularly when it comes to Europe. As I stated recently on CNBC, any kind of bond-buying program done by Draghi and company seems to be treated as something that would be euro FXE, +0.32%  bearish, much in the same was as Japan's own stimulus has had the effect of depreciating the yen FXY, +0.79% Draghi has in the past alluded to a strong Euro as something to be concerned of given significant deflationary pressures, and the reflationary force a cheaper currency can have on a domestic economy.

A depreciating euro, however, could more have a more dramatic impact on U.S. equities than people realize. If, indeed, QE in Europe pushes the euro down to parity (or below 1 for 1 on the U.S. dollar), European exports would be cheap for U.S. buyers, but in turn, negatively impact our exports which are already feeling the sting of a surging dollar UUP, -0.28%

More so than that, as a cheaper euro exports deflation to the United States, we have our own problem of failed reflation. I believe volatility, which our alternative inflation-rotation and equity-beta-rotation mutual funds and separate accounts tend to benefit from, has returned precisely because the market is starting to wake up to this.

Take a look below at the weekly chart of the S&P 500 SPDRs ETF SPY, +0.51%  and below it, the correlation of the S&P 500 to the CurrencyShares Euro Trust ETF. Note that the S&P 500 has been inversely correlated since June of last year to a collapsing euro, meaning that as the euro has fallen, U.S. stocks have risen. Note also that the rolling correlation may be turning, implying a positive correlation between euro movement and U.S. stocks may soon come.

Certainly as can be seen in the chart, a strong euro can be positively correlated to rising U.S. equities, but keep in mind that this occurred when the euro itself was at a higher level, the dollar was lower and less disinflationary, and U.S. quantitative easing was in full force. This time around, should this correlation turn positive, it would likely be fundamentally damaging, as a falling euro — which QE in Europe likely achieves — actually breaks U.S. stocks.

That is one outcome. The other outcome? The Last Great Bubble — faith in central banks — becomes tested, and pops this year as the harsh reality of deflation kicks in. Remember, folks, we have yet to see an example where deflationary forces are successfully countered by central-bank action. Once stock markets realize this, risk management, which has been punished for far too long, will return with a vengeance.

Refresh the fear.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.