Quantitative Easing and the Disappearance of Income 21 comments
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The following are some thoughts on the Fed's announced policy of Quantitative Easing (QE).
How should we interpret the desire of those who will be selling their current holdings of Treasuries and other asset backed securities to the Fed as a replacement for their entitlement to receive a future reliable income stream?
The substitution of immediate liquidity for longer term income is just one of the many troubling aspects of QE. Why would a pension fund or an insurance company want to receive large dollops of cash now rather than a recurring coupon income downstream? Aren't these companies maturity transformation vehicles that need to manage their liabilities with the duration of their holdings of income generating assets?
If so then one has to become genuinely intrigued as to why these companies should (or would want to) benefit from the replacement of a long term payment stream by a one-off large payment or credit to their account with the Federal Reserve. Could the reasoning behind the QE move be that some major pension funds and insurance companies have hit the wall in terms of their immediate liquidity requirements?
The economic environment can increasingly be characterized as one of income disappearance. There is an ongoing decline in the number of corporations paying any, or maintaining, their dividends. Continuing rises in the level of global unemployment is leading to a chronic reduction in the returns to labor; and now exacerbated by the QE policy there is even further reduction in the returns to savings and fixed income instruments. All of this is surely pointing to a structural asset deflationary spiral that, in the context of a monetary policy environment of zero based interest rates (actually negative if even modest consumer price inflation is factored in), is now de facto beyond the influence of central bankers. So perhaps it is just a growing sense of desperation which explains the timing of the policy move.
There may even be a further element of desperation to the timing which is not yet manifest. It is possible to hypothesize, without appearing to be too conspiratorially minded, that there may be some event or realization that has been made by the Fed which is requiring them to be out in front of some new potentially devastating development in the ongoing financial meltdown. The timing of the policy announcement, coming so soon after the Chinese government announced its concerns about the creditworthiness of the US Treasury, is even more than a little puzzling. Could it be that the Fed has realized that the demand from traditional sources (e.g. China, Japan and the Middle East) for the enormous supply of sovereign credit that needs to be funded this year and in coming years can no longer be relied upon?
The positive spin that has been put on the fact that recent Treasury auctions have gone well does not reassure. The main buyers at these auctions (e.g. PIMCO) know that there is enormous short term liquidity in Treasury instruments, especially so in a risk averse market place, and even before yesterday's declared policy it was widely recognized that the Fed would step in at the first hint of any shortage of buyers at a US Treasury auction.
Very similar reasoning can be applied to the decision made by the Bank of England to engage in its own version of QE which was adopted earlier in March. The UK government faces even larger refunding needs as a percentage of GDP and does not have the benefit of a reserve currency.
Perhaps the rationale for the Fed's timing is to keep up with the leaders in the competitive devaluation scenario. It could be argued that QE is nothing more than a currency debasement strategy thinly disguised. Maybe the FOMC's decision shows that the US is not overly concerned at present about importing inflation from a weaker dollar and does not want to get left behind in the race to the bottom as other currencies are being managed downwards. But this does not seem likely to provide a tangible benefit in the near term as world trade is diminishing, the sale of visible goods is declining and the value of the invisible balance of payments account is something that the US cannot be too cavalier about.
Rather I would suggest that the best way to consider the timing of the QE policy is that it is tied pragmatically to the US real estate market and that the Fed is being encouraged by, and hoping to germinate, anecdotal evidence that the bottom may be in sight and that this is a good time to be providing maximum support to the mortgage origination and re-financing market.
Not just in the US but in many parts of the world, central bankers are now becoming desperate to try to ignite some spark under their property markets. Much more so than even supporting equity markets, central banks know that the most damaging form of wealth destruction and the evaporation of consumer confidence is evidenced by the perception that property values remain in free fall. Will the QE inspired reduction in mortgage rates spark some life into the US property market?
It is highly unlikely on its own to do so because the Fed and other central banks appear to be overlooking the fact that only macro increases in income levels will be able to drive a sustainable recovery path. Residential and commercial property prices/rents are still not genuinely affordable, and will not become so while final demand and levels of employment are declining and, notwithstanding even both of those changing direction, it can be further argued not until the median value of a family home has reverted to a more historically sustainable alignment with median family income.
It is axiomatic (or should be) that spending capital (even phantom capital that the Fed just prints) is not the path to renewed economic growth and the desire to stimulate a new property based asset reflation, based on injecting new capital in place of future income into financial intermediaries is just a variation on the theme that has been tried now for several months and which is clearly not yet showing any evidence that it is working. Unless capital infusions are harnessed in an economically productive manner and the requisite amount of time is provided to enable that capital to generate real increases in long lived income, in one or all of its many forms, the QE initiative is going to lead us towards yet another dead end.
As income sources are rapidly disappearing on a global basis and there is no engine to drive authentic (as opposed to Ponzi based) asset inflation the Fed's chosen path appears to be one of borrowing more from future generations to re-finance the current debt at nominally lower rates. The knock on effect that they are engineering will be extraordinarily low mortgage rates and the Fed's hope is that this may trigger some new arithmetic showing much greater affordability in the housing market.
Apart from the amorality of continuing to pile up ever more inter-generational debt this reliance on trying to engineer abnormally low long term rates to jump start the property market is dangerous, desperate and self-defeating. If buyers are tempted back into the property market by the rigged mortgage rates on offer we will only be back into a new default cycle as these buyers will once again have been seduced into buying homes that, in the fullness of time, they really could not afford.
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To take the "conspiracy" theory a bit further, if income is depleted by debt service does this make governments, i.e., politicians and brueaucrats, more powerful? We, in the U.S., have already seen this being done the past year by Congress and intensified by the Obama Administration. After the first $350 billion TARP money, which freed up commerical credit and money market funds, does anyone believe we needed any more debt financing, "the date that brung us here"?
Could the Free Market System, Free Enterprise and freedom, with responisbility in general, screwed things up as badly as governments have? It is ironical that those in Congress, with the help of the Goldman Sachs water carriers (they got their AIG dough first), complain that those working at firms that got in trouble are still working at those firms. The last I noted was that Barney Frank and Chris Dodd still have their jobs and are becoming more undemocratic by the day.
Something we forget is that the moral hazard is real and has a practical side to it. Every family that tried to do the right thing and saved gets wiped out while the others who overextended themselves get to keep the assets they couldn't afford and pay them off with cheap (really cheap) dollars. It creates a perverse inversion where wealth transfers from strong hands to weak (or foolish at any rate). Also pools of investment capital, if held in nominal assets, get shrunk to nothing and the government de facto takes a larger role in the future evolution of our country---because the printing presses can stay ahead of the curve and the more they print, the smaller your piece of the overall pie gets and the larger the government's gets.
I discussed this with a friend who said we were in crisis and this isn't a morality play. I guess I disagree. All of life is a morality play to some degree.
Obama has given a lot of lip service to the American Dream. If this process continues, wiping out life savings with printing presses and mega spending bills that no one can find time to read will drive a stake through the heart of what is left of that dream.
On Mar 20 08:36 AM prudentinvestor wrote:
> "......Not just in the US but in many parts of the world, central
> bankers are now becoming desperate to try to ignite some spark under
> their property markets....."
>
> True. The amazing fact is that they lit bonfires under the property
> markets for over a decade, propelling them into the bubblesphere.
> These supposedly intelligent central bankers created the bubble,
> totally oblivious of its inexorable consequences that we are now
> experiencing. Now we expect the same school of economic geniuses
> to find a painless solution (?)
Maybe they're a comedy team. They certainly lack honesty. We know that. They're supposed to be the best and the brightest. They're the best-paid, anyway. Give'em the hook.
"Devaluing the dollar wipes out savings and lets the debtors off the hook-in the old parable. the grasshopper gets to stomp on the ants. "
Even if mortgage rates go to zero and a house costs ... $200000 and I make $2000/mo before taxes (say I have $1800 left after Fica, SS, Fed/St takes - I'm probably being a little generous here), how do I make a $555 payment on a 30 year loan and still eat, commute to work, maintain/buy an old car, insure the car, cover even minimal medical expenses, save for my progeny's education, handle the occasional unexpected home repair, save for my retirement, etc.?
When I was growing up, the portion for housing was traditionally 25% (IIRC), not the current 31% being targeted in mortgage relief programs.
A more direct flow of cash to my pocket would be more stimulative to the housing market. One proposal I heard would take the money and divide it up by the number of families in the nation. What's stupid about that idea (other than the fact that we are taking money from the families, reducing it through government friction and then giving it back to those families with some substantial redistribution of the wealth) is that the cash goes directly to those who need it instead of into the pockets of the well connected and financed.
Tax reduction is not possible because that directly reduces the power of the government.
Better paying jobs are not possible because we shipped those jobs overseas (and they can be retrieved only by reducing the wages here to levels competitive with those overseas, or waiting a couple generations while those overseas wages eventually rise, ala the Japanese automakers over the last 30 years or so). Regardless, a reduced living standard results as the middle class slides inexorably towards extinction.
HardToLove
You ask a very important question about why pension funds and annuities with pay-out stream commitments would sell "secure" income stream treasuries for cash:
<<<If so then one has to become genuinely intrigued as to why these companies should (or would want to) benefit from the replacement of a long term payment stream by a one-off large payment or credit to their account with the Federal Reserve. Could the reasoning behind the QE move be that some major pension funds and insurance companies have hit the wall in terms of their immediate liquidity requirements?>>>
One possible (and I think likely) reason is that the income stream from these treasuries range from 1-3% and the assumptions of the plans are based on income streams of 3-5%. Therefore, take the cash and look for short-term holdings that fall short of the maturity matching windows, while waiting for the treasury bubble to break. It might not break in 2009 or even 2010, but it must break. The cash obtained in 2009 will make investments in targeted maturity vehicles with returns at much higher levels in the future.
Just a thought to add to your very complete discussion.
the cost of living is going up in every walk of life, so paying less in
interest to a bank is not the problem. If it spurs buying, good, as long as the buyer has traditional income ratios, 20+% equity, and a fixed rate with 15-30 year loans.
Problem, was in qualifying, appraisals, HELOC scams, and lack of
enough equity. If banks held the line at 20% equity with no 2nd mortgages allowed, then we would not have this massive problem.
The game in Florida flippers was a 90% first mortgage and 15-20% 2nd mortgage, aka 110% mortgages. Not very sound business and we can see where that lead to, a collapse of our markets.
On Mar 20 01:30 PM Vincent Ci wrote:
> Someone please explain why in unison the entire system of credit
> derivatives and holders of default swaps etc.. can not simply be
> written down and be done with. Technically credit is not real or
> backed by anything but simply created out of thin air, what am I
> missing?
You make a very valid point as to how a fund manager might be able to juggle the maturity transformation process with the market timing assumptions suggested.
It is perhaps a validation of the overall thesis that current fixed income streams are insufficient - part of the deflation scenario that was being outlined in the article - and that fund managers are having to resort to speculative re-financings which will (hopefully) benefit from the (un) intendended consequences of the QE strategy.
This I believe is the point that you are making?