Quantitative Easing Will Never End

by: Nicholas Pardini

With the Fed printing $85 billion per month, monetary stimulus has resulted in a reflating of stock prices (near all-time highs), bond prices (at all-time highs), and real estate prices globally. With these recoveries, has the Fed created enough a wealth effect to put brakes on monetary easing? The answer is clearly no. The massive scale of current and previous bond purchases eliminates any credible exit strategy. Political pressure, the size, and duration of fed assets, and the fragility of an asset bubble-based "recovery" will ensure that the QE will never end.

Political pressure is the primary reason that quantitative easing will not end. Even if the economy recovers, the federal government relies on the Fed's large-scale treasury purchases to maintain affordable financing. $85 billion of mortgages and treasury purchases per month add up to 1.02 trillion dollars annually which is close to the $900 billion projected deficit for 2013. Without quantitative easing holding interest rates down to all-time lows, the federal government would face a debt crisis. Although the US situation is not as bad as Japan, interest payments still compose approximately 10% of the federal budget (19% of tax revenues). If interest rates climbed up to historical averages (5% on the 10-year Treasuries), interest payments would make more than 38% of tax revenues. This will not bankrupt the government outright, but it would be a major threat to future solvency. After assessing the Fed's actions from this point of view, it is clear that the Fed is not using QE to reduce unemployment, but to protect the bond market and federal government from a fiscal crisis.

Excluding the fiscal issues, the government relies on high spending to keep the US economy as a whole afloat and subsidize high unemployment. Federal unemployment and disability benefits indirectly support high margins across America. Transfer payments have allowed millions of Americans to continue to spend without having a job. This has kept demand and revenues stable and increased profitability as the social costs of lost customers from layoffs is minimized. A massive cut in social spending triggered by monetary tightening would be damaging to the US economy and devastating for the political class. Politicians would lose their seats from the public reaction to losses of benefits and civil unrest may result from the elimination of the safety net of the long-term unemployed. All of these political issues are the real underpinning of sustained easing.

The size of the Fed's current balance sheet is also a major constraint to any exit strategy. In terms of flow, Fed mortgage purchases are currently 70% of the daily volume and its Treasury purchases exceed new Treasury issues. With four years of quantitative easing, the Fed currently owns 14% of the total Treasury market whose duration is heavily skewed to the long term. Any attempted sale of securities will send the market a risk off signal that will create a large sell off. Since the duration of Fed assets is long-dated, letting Treasuries mature will not a significant effect for at least five years. Even if it did, letting Treasuries mature is still considered monetary tightening. On the mortgage side, selling back MBS (or even reducing purchases) would kill the housing recovery. MBS purchases are what keep mortgage rates low enough to support current real estate valuations. Since Fed purchases dominate the market, and exit would cause MBS prices to fall and yields to spike. The result of those action would end any housing "recovery" that is currently taking place.

Economic fragility is the final reason why I expect that the quantitative easing will not have a planned ending. The currency recovery is based off of cheap government financing and inflated asset prices and profits as a consequence of zero interest rates and money printing. As I previously explain with the social safety net replacing wages as the revenue source for corporations and low interest rates allow extended social programs to sustainable. If QE ends, this will make current government spending levels unsustainable and force austerity. In addition to that, market expectations for stocks and bond markets are dependent on unlimited QE. These markets will sell off just on the hint of monetary tightening and destroy the "wealth effect" that is supposedly causing the recovery. On top of that higher mortgage rates and outflows of hot money will reduce the attractiveness of buying in real estate. Europe already is in the midst of a deep recession, Japan is flirting with recession despite a falling Yen, and the rest of Asia is slowing down, so international growth will not be able to compensate for a sagging US economy. The implications from this is that US (and by extension) global economic growth is reliant on policy action from the Fed and the markets belief in their efficacy. If either of these two change, the game is over. Since the first one is the Fed's direct control, I find it highly unlikely that they will deliberately cause recession.

Due to economic fragility, fiscal politics, and the excessive current size of the Fed balance sheet, any proposed exit strategy would immediately unwind any economic progress created from four years of quantitative easing. As a result, the Fed has no exit strategy and they will continue to ease (or may even increase the size of purchases) as long as the Federal Reserve exists as a banking institution. If quantitative easing is guaranteed to last as long as the existence of the Federal Reserve System, how should investors react? The answer is not as obvious as continuing to go long on US stocks (NYSEARCA:SPY). In the upcoming second part of this two-part series, I will explain why the current recovery and low interest rate environment will end in spite of the Fed's efforts to keep permanent easy liquidity.

Disclosure: I am short SPY, IWM, DXJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.