Direct from the ‘Repeat A Failed Experiment Because You Are Insane’ department the Federal Reserve appears ready to unleash ‘Quantitative Easing 2.0’ on an unsuspecting populace.
Or is it 3.0? Isn’t the Fed ‘doing’ QE right now?
Zero Hedge seems to think it’s the end of civilization as we know it:
Recently the debate over when QE2 will occur has taken a back seat over the question of what the implications of the Fed’s latest intervention in monetary policy will be, as it is now certain that Bernanke will attempt a fresh round of monetary stimulus to prevent the recent deceleration in the economy from transforming into outright deflation. Whether or not the Fed will decide to engage in QE2 on its November 3 meeting, or as others have suggested December 14, and maybe even as far out as January 25, the actual event is now a certainty. And while many have discussed this topic in big picture terms, most notably David Tepper, who on Friday stated that no matter what, stocks will benefit from QE2, few if any have actually considered what the impact of QE2 will be on the Fed’s balance sheet, and how the change in composition in Fed assets will impact all marketable asset classes. We have conducted a rough analysis on how QE2 will reshape the Fed’s balance sheet. We were stunned to realize that over the next 6 months the Fed may be the net buyer of nearly $3 trillion in Treasurys, an action which will likely set off a chain of events which could result in rates dropping all the way to zero, stocks surging, and gold (and other precious metals) going from current price levels to well in the 5 digit range.
A Question of Size
One of the main open questions on QE2, is how large the Fed’s next monetization episode will be. This year’s most prescient economist, Jan Hatzius, has predicted that the minimum floor of Bernanke’s next intervention will be around $1 trillion, which of course means that he likely expects a materially greater final outcome from a Fed that is known for “forceful” action. Others, such as Bank of America’s Priya Misra, have loftier expectations: “We expect the size of QE2 to be at least as much as QE1 in terms of duration demand.” As a reminder, QE1, when completed, resulted in the repurchase of roughly $1.7 trillion in Treasury and MBS/Agency securities. It is thus safe to assume that the Fed’s QE2 will likely amount to roughly $1.5 trillion in outright security purchases. However, as we will demonstrate, this is far from the whole story, and the actual marginal purchasing impact will be substantially greater.A Question of Composition
Probably the most important fact that economists and investors are ignoring is that QE2 will be accompanied by the prerogatives of QE Lite, namely the constant rebalancing the Fed’s balance sheet for ongoing and accelerating prepayments of the MBS/Agency portfolio. This is a critical fact, because once it becomes clear that the Fed is indeed commencing on another round of monetization, rates will collapse even more beyond recent all time records (and if we are correct, could plunge all the way to zero). What is very important to note, is that as Bank of America’s Jeffrey Rosenberg highlights, a material drop in rates, which is now practically inevitable, is certain to cause a surge in mortgage prepayments of agency securities: “Our mortgage team highlights a 100 basis point decline in rates would raise the agency universe of mortgages refinanciability from currently about half to over 90%.”
Etc.
Keep in mind that the Fed has no medicine for economic disorders other than more of what caused the disorder in the first place. It can add credit and can act to price credit more cheaply. The Fed cannot print resources or jobs nor can it add value to anything. In the real world the Fed is impotent. It can move finance markets which are basically Ponzi schemes to benefit participants who act out of ‘faith’.
The Fed’s primary role today is to swap currency for illiquid ‘securities’ for finance participants. QE is more of the same. The beneficiaries are banks which are already stuffed with cash. What is proposed is simply another form of money laundering.
The Fed sending money to individuals would have the same ultimate effect as the asset swap: money would be spent and would wind up as ‘bank reserves’. The public spends, the banks do not. They are ‘rich’ while the rest of the country rots. By aiming to generate inflation and force private consumption spending the Fed actions amplify what it intends to cure.
Quantitative Easing is a child of zero- percent interest rate policy (ZIRP). Practical interest rates cannot be lower than zero, yet lowering the cost of credit is the primary tool of central banks. When the zero- bound is reached the CB injects currency into the economy directly, usually by purchasing securities. Since the Fed cannot achieve a desired negative interest rate target, it chooses a quantity- of- money target, instead. This explains the ‘Quantitative Easing’ name.
This is of a piece of the Fed bailing out its clients in finance by trading liquid cash or Treasury securities for illiquid finance paper. This act has little effect on the greater economy as the securities are worthless and the cash is held or traded for gold which is hoarded.
The claim that QE forces longer Treasury rates lower is specious. Government borrowing by itself adds deposits to the banking system and large borrowing adds large deposits, the oversupply of deposits creates a bank- treasury carry trade that by itself drives lending rates lower. This makes both the banks and the treasury captive to each other. The Fed is simply another superfluous bank making superfluous bond purchases.
Financing long-term purchases with short-term leverage in countries that cannot hope to repay their debt at the 40-year horizon turns out to have been a dicey idea. In September 2008, when the banking system was about to fail due to the collapse of its investments in US mortgages and similar things, governments bailed out the banks. But who bailed out the governments who bailed out the banks? The banks bailed them out, by buying their paper. That is why banks that hold large amounts of weaker sovereign paper may go bankrupt all over again. The stronger governments therefore will support the weaker governments. But there is a limit to how long the charade can continue.
Interest rates are low because there is small demand for credit relative to supply. Real, top- line economic activity would increase demand for credit and cause interest rates to rise. The central bank can ‘print’ currency but it cannot print borrowers. Absent profitable business activity, there is no reason for any individual or any business to borrow, regardless of rates.
In the current deflationary environment, any loans must be repaid in funds that increase in real value, both against the amount borrowed in the first place and also against the business activity that is to be funded by the loan. For this (hardly mentioned) reason credit- worthiness erodes over the term of any loan but of the shortest duration.
The issue of new currency (or base money) has a short- term effect on rates. The issue in Japan in amounts several times that required by bank reserve requirements (beginning in 2003) drove longer term yields lower but the effort was counterproductive. The issue of more base money in the US in 2009 was without effect after a few months. It is likely that a repeat of the process would have a similar outcome; lower treasury yields for a short period followed by ‘normalization’ of yields responding to supply/demand in the markets. $3- 5 trillion in QE- bond buying is a small amount relative to the size of both the dollar and Treasury markets.
Purchasing mortgage- backed securities (from Fannie Mae or Freddie Mac) or other Agency debt creates the illusion of support for real estate businesses as this buying represents a form of final demand. This effect is also temporary as the MBS must at some point meet the real market.
While QE has little long- running effect on interest rates, the effects are felt in currency exchange. QE is of a piece with the the ongoing worldwide effort by countries to debase their own currencies relative to others so as to gain (temporary) export advantage. This is ‘competitive depreciation’. Depreciating the dollar by QE is pointless if other countries actively depreciate their own currencies at the same time by similar tactics.
What are the massive US exports, anyway? Chickens?
While the dollar and other currencies slide in value relative to each other, the dollar is still firmly pegged to the one physical commodity that all modernity relies on absolutely. The dollar price of crude oil cannot rise beyond what modernity itself – a blithe and pointless fashion – can profitably support. That level is currently $78 per barrel of Brent crude. If that price cannot hold – and there are many reasons why it cannot – the effect is to make the dollar more valuable. Priced in oil dollars are worth something, regardless of the arbitrary and capricious ‘values’ assigned to them by FX speculators.
The US accuses the Chinese of currency manipulation while engaging in blatant currency manipulation itself. Correcting the trade imbalance requires either a rise in Chinese costs or in the exchange rate of its currency relative to the dollar. Changing the exchange rate of the dollar effects the exchange rate of China’s currency relative to other currencies traded with the dollar. Manipulating the dollar for FX advantage is pointless as a consequence. There is no other planet or ‘Foreign Exchange Universe’ that the US can escape to.
I’ve been over this ground before:
Monday, October 12, 2009
Two Economies, Two Conditions.
Deflation and inflation are taking place at the same time. There are two economies, the physical economy is experiencing deflation and the financial economy is at the border of hyperinflation, particularly stock and bond markets.The central banks world- wide are obsessed with the financial economy, which produces nothing useful but does create liquidity in various forms. Since fractional lending gears with Quantity of Money effect, there is no limit to the amounts of liquidity the finance economy can create – and is creating right now. In this context, central bank interventions are minuscule, the real issues are the rolling over of swaps and other derivatives. These are also forms of liquidity; the total of these denominated in dollars is over $500 trillion and represents the largest amount of available liquidity in the finance economy. This number is from the Bank of International Settlements.One outcome is the rise in stocks against the decline of the dollar; more funds aren’t sold into the markets, but are lent into existence within the markets themselves. The monetary expansion is reflected in the ‘cost’ of dollars in less inflated currencies. What is also being measured by the declining dollar isn’t the decline of overall investment risk but the increase in derivatives risk, since dollar inflation measures the increase in overall unsecured debt. In other words, the debt is secured by the dollar itself, rather than any productive asset; this is why stock prices have diverged from underlying value; stocks measure the quantity of money- plus- velocity rather than the earnings that will probably never take place.Meanwhile, the physical economy is constrained by oil prices which at current levels absolutely prohibit inflation. Inflation could take place if the crude price was less than $20. Firms could afford very high wages at same time afford the low priced fuel which could be used to amplify labor productivity.The $20 price or its relative equivalent will never be seen again. Peak oil is real and took place in dollar terms in 1998.China’s cheap labor/cheap coal advantage is a wasting asset; increased petroleum prices are racing to catch up with the Chinese advantage and to destroy its economy as it is currently doing to the US, Japanese and European economies. Since Chinese wages are too low to allow workers to afford Chinese products, its race with increasing relative petroleum prices will be, unfortunately, a very short one. The issue is capital allocation; either fuel or other capital/operational expenses can be paid, but not both. The consequence in the US has been offshoring expensive labor and creating asset bubbles as a hedge against rising energy prices. This experiment has failed. Likewise, and the current financial bubble attempt will also fail. The reason being the inability of the physical economy to support the bubble prices.
Bernanke and the Fed are irrelevant!
Should QE shrink the yield curve further than massive fiscal borrowing allows by itself, there is nothing left for banks to earn by playing the spread. This would give the illusion of ‘recovery’ as the deleveraging rate would shrink because of a decline in bank cash flow. See my article about this: What Are They Smoking? The outcome would be more stress on the banks from the earning side even as they would retain more cash reserves. Banks are stores that ‘sell’ money. If banks do not sell they go out of business just like hat stores that do not sell enough hats.
QE is a bailout of desperate state and local governments and all that depend on them.
Stuffing cash into finance has a reactive effect on the physical economy. Adding cash to bank reserves subtracts it from employment. As I have noted here previously, businesses closest to the Fed’s funding stream choose to hire money while firing staff at the same time. Money in a deflation is more ‘productive’ than the workers; its output is relatively risk- free. Deflation amplifies itself by the exercise of this wage/cash arbitrage.
The best way to trade a finance phenomenon in the past was to invest in oneself, in the physical economy or in the tools useful therein. Getting more education was always the most certain ‘trade’ in both senses. With finance at odds (and to be at war soon enough) with our physical economy and the economy at war with the world itself, any trade is constrained.
QE is dangerous because it represents a Fed- borne failure or crisis of confidence. At bottom confidence is what the Fed and other central banks ‘sell’ along with money. Without confidence what the banks have left is confusion over values.
It is useful to keep this in mind as we examine conventional wisdom and some useful short- term trades: commodities/gold, currencies/FX and stocks. If QE is indeed a ‘done deal’ then looking at these trades makes sense.
END OF PART ONE.
PART TWO: GOLD AND COMMODITIES.
PART THREE: MONEY AND VALUE OF COMMERCE.