Whether or not and when the Fed should start reducing its monetary stimulus known as QE has been one of the most hotly discussed topics since the Fed released its May FOMC meeting minutes on May 22, which showed some FOMC members were calling for QE "tapering" as early as June. I will argue that, based on two key factors, not only will the Fed not taper, but it will be ultimately forced to up the ante on QE or risk a serious accident in the banking system and in the economy.
The first factor to support my view is Wednesday's (June 11) Treasury budget report for the month of May. The budget deficit for May was reported to be $138.7 billion vs. an expected $110 billion (per Bloomberg). The government spent $335 billion in May, the largest May outlay and the fourth largest one-month outlay in history.
The cumulative deficit for the first 8 months of Fiscal Year (FY) 2013 is $629 billion. Incredibly, the CBO reported on May 9, that is was projecting a full FY 2013 of $642 billion. I find it beyond fascinating that nearly three quarters of the way through FY 2013, the CBO missed so badly on its deficit projection.
Fed QE purchases of Treasury bonds are currently de facto funding 75% of all new Treasury issuance. On the assumption that the government's spending deficit will continue to widen more than is currently anticipated, the Fed will have no choice but to maintain - at a bare minimum - its current level Treasury purchases or risk sending interest rates significantly higher in order to induce enough outside investor money to replace the Treasury financing being funded by the Fed.
The May budget report shows that the government is spending more and taking in less revenue than was expected by the market just a month ago. In order to "stress test" the current expectations for the full Fiscal Year deficit projections, I pulled up the actual May report from the Treasury - Monthly Treasury Statement [pdf] - and did my own projections based on the trailing eight-month actual numbers for 2013 and 2012.
Simplistically, if the receipts and outlays for the final four months of 2013 and 2012 are identical, the total deficit for 2013 would be $871 billion, or nearly 36% higher than projected by CBO and expected by the market just a month ago. That would also mean that the Treasury would have to issue $229 billion more in new Treasuries than is expected.
It is likely, however that the deficit will be even larger than $871 billion. The government is currently spending at a rate of $303 billion per month this year vs. revenues of $225 billion per month. Assuming those metrics remain constant for the last four months of FY 2013, the final spending deficit would be $936 billion, requiring nearly $300 billion in additional Treasury debt. To be sure, Treasury Secretary Jack Lew has already stated that he can delay making payments into the Federal pension fund plus a few other "tweaks," in order to avoid hitting the mandated Treasury debt ceiling by the end of FY 2013 at the end of September. But his accounting maneuvers would push those spending requirements into FY 2014 and not address the actual spending deficit.
My point here is that the discussion inside and outside of the Fed about tapering is predicated on the faulty assumption that the Federal spending deficit will continue to narrow vs. 2012. As I've shown, this is just not realistic based on projecting the deficit over the final four months using the actual deficit incurred over the first eight months. In addition, the monthly revenue calculation includes a one-time $59.4 billion payment from Fannie Mae and the one-time tax windfall that occurred in December from investors selling assets ahead of the tax increases that hit January 1. In other words, the monthly revenue rate into the government is likely higher for the first eight months than it will be for the final four months, which implies that the final deficit for FY 2013 could easily hit $1 trillion.
The second key factor that will prevent the Fed from tapering is banking system solvency. Amazingly, no one seems to be digging down and analyzing why QE is not helping the real economy, except for an artificial boost to the housing market. The reason is because 75% of all of the Fed's printed money has gone back into the Fed's bank Excess Reserve account.
Since the Fed started buying assets from bank balance sheets in September 2008, the Monetary Base - defined as cash held by the public plus bank excess reserves held at the Fed - has jumped from about $800 billion to $3.2 billion. You can see that data and chart here: Adjusted Monetary Base. In this same period of time, the Excess Reserves held by banks at the Fed have jumped from zero to $1.8 trillion. Excess Reserves are funds held by banks in excess of statutory capital reserve requirements. You can see the chart and data here: Bank Excess Reserves.
In other words, 75% of all of the cash liquidity created by QE has cycled right back into a Federal Reserve holding account, where it sits earning interest paid to the banks by the Fed and subsidized by the taxpayers. The other 25% is being used to fund Treasury auctions. It is not finding its way into the real economy.
My point here is that the Fed's QE is largely being implemented in order to keep the banks liquefied and the government deficit spending funded. If the Fed were truly serious about tapering, then why has the Monetary Base literally spiked in parabolic fashion during May?
That chart is entirely inconsistent with comments about tapering coming from FOMC and regional Fed bank Presidents.
I believe the Fed needs to keep pumping liquidity like this onto bank balance sheets because real cash flow at the big banks - as opposed to the paper income created by GAAP accounting maneuvers - is being squeezed by lower net interest margin income, non-performing mortgages attached to homes, which have not been foreclosed, expenses related to the large number of foreclosed homes being retained by banks - foreclosed homes held off the market - and the likelihood that banks are suffering problems in the OTC derivatives holdings related to the de facto sovereign defaults in Greece and Cyprus. By injecting cash like this - and paying the banks interest on it -the Fed is enabling the banks to remain operationally solvent. If the Fed were to taper, it would risk another financial systemic disruption like the one in the autumn of 2008, only worse.
As I've thus tried to lay out, I believe that not only will the Fed not engage in a program to reduce monthly QE stimulus because it is primarily being used to finance a bigger than anticipated Government spending deficit and to maintain operational liquidity at the too big to fail banks, but that ultimately the Fed will have to once again increase the level of liquidity it is putting into the system as outlined above. The recent big decline in the U.S. dollar index, which is now below its 200-day moving average, further supports my thesis in that the sell-off in the dollar reflects the market now anticipating at the very least that there will be no tapering.
Aside from parking your money in short-term dollar-denominated liquidity instruments, I think the most obvious way to take advantage of this is to move your fiat U.S. dollars into gold and silver. Recall that gold and silver suffered a similar price correction in the spring and summer of 2008, prior to making an extended to new bull market highs and ahead of the eventual banking system disruption and initiation of the Fed's massive QE policy. I believe the current correction in the metals is similarly precluding another big wave of Federal Reserve and government stimulus, only this time around Bernanke will be seeking to avoid the mistake of implementing QE after the triggering event. Recall that avoiding the mistakes of the past by the Fed has been Bernanke's mantra ever since his name was circulated as Greenspan's successor.
The best way to play gold and silver is to start accumulating the physical metal and storing it yourself. If you want to engage in shorter-term trading plays, you can use GLD and AGQ. If you want to piggyback George Soros' latest move in this sector, you can start accumulating GDX and GDXJ, the mining stock and junior mining stock ETFs.
Additional disclosure: The fund I manage is long physical gold and silver and mining stocks