From all the tirades in the past few years, one may be excused in thinking Bernanke was born with a printing press on his shoulder, as if the guy experienced tremendous psychic value from debasing currencies. But that's not really true. Bernanke did deliberate on a Plan B in case of a deflationary scenario early on (which has since become world-famous). But when Bernanke began chairing the Fed in 2006, he raised rates 3 times. At the time, the overarching concern of the Fed was inflation. It was only when there appeared to be no end in sight to the financial turmoil in late 2008 when Bernanke actually put his musings to test with QE1.
Both the rise and fall of QE have economic fundamentals underpinning them and this article will attempt to explore these fundamentals from a cost-benefit angle.
The Roots of QE
We could go on and on about mortgage delinquency rates, pension funding gaps, corporate bond spreads and issuance etc.
But essentially it boils down to overly high leverage by households and some companies on the basis of asset price appreciation expectations. Once those expectations reversed, the whole system became insolvent.
A "natural" wind-down could work in theory, but "the end of history" might have come before markets reached any clearing point. We're talking about decades of leverage->bubbles->bailouts->more leverage->more bubbles. The practicality of undoing that would be questionable.
So at that point, the only viable option under the current framework was to stabilize asset prices and asset price expectations. Yes, it rewarded plenty of gamblers that were caught on the wrong end in the last cycle, it did steer monetary policy further into uncharted waters, and the economy is still languishing. But it was the most practical option and so it became policy in a pretty desperate period.
Why QE will end
Fast forward 4 and a half years and Bernanke's reputation as an "enabler" has cemented (or in Fedspeak, anchored). Now we're faced with QExit, something market participants may not be taking seriously enough.
But now QE will come to an end, simply because the calculus has changed. Since the financial sector has been the strongest advocate of QE when it began and is pushing strongly for QExit, we'll take a look at their angle. While other segments of society may be unhappy with QE too, they are either too confused over the policy, too disorganized to lobby effectively, or don't care enough. But the financial sector knows where its interests lie and can lobby effectively.
The Cost-Benefit Analysis
Let's take a look at the major credit assets the financial sector hold and how this necessitates QExit. By financial sector, I am mainly referring to major lenders and major owners of debt securities. So this mostly includes banks and institutions that own a lot of debt (either in the form of loans or securities).
If a mortgage is delinquent and underwater, it puts the bank in a bad position because if the bank forecloses and tries to sell, it'll take a loss.
Higher real estate prices would help an underwater mortgage get back above water.
But after a certain point, the mortgage is mostly secure and the increase to the value of the mortgage from an increase in the price of the collateral decreases, down to the point where it is no longer very important.
In Q1 2013, negative equity in mortgages is only $580 billion and 33% of that is concentrated in 4 states(source). Recovering that negative equity may be an "out-of-the-money" option on QE and the low hanging fruit, i.e. preventing a debt-deflation spiral in asset prices, has likely been picked.
2) Business and consumer loans
These will mostly perform based on economic conditions (corporate buyout loans will be more influenced by financial conditions). If markets are pricing in a depression and the Fed successfully dissuades the market from that notion, then business loans gain in value.
From an aggregate demand point of view, expenditures can be divided into consumer spending, investment, government spending, and net exports and the Fed can influence these through the credit channel. In a balance sheet recession though, consumers are no longer willing to borrow so end demand remains weak and this dampens business investment spending. Residential investment has been stronger lately but it doesn't seem advisable to build an economic recovery on real estate... again. As fiscal policy is no longer incrementally expansionary either, the effectiveness of QE on general business conditions becomes even more questionable, which is exactly the conclusion the Federal Advisory Council (composed of banks from 12 regions) came to in May.
Banks may hold securities in their own account. These are likely to experience a large loss in the event of a QExit. However, if interest rate normalization is viewed as inevitable, then the losses from a potential QExit will be viewed as unavoidable. The strategy would then be to minimize exposure before rates start rising.
4) New Debt
With a low risk-free rate and tight spreads across different credit qualities and instruments, the interest rate earned on debt becomes low. This creates a potential for large losses once rates rise across the board.
5) Financial Activity
A high level of financial activity (issuance volumes can be used as a proxy variable) increases profits for large financial intermediaries that have an investment banking division.
The cost-benefit analysis
Financial sector's gain from more QE= 1)Mortgage value gain + 2)Business & consumer loan value gain + 3)securities value gain - 4)potential loss from new debt at low interest rates + 5)profits from financial activity
Since marginal gains from additional QE are small for the first three, especially compared to the potential loss from new debt issued at low interest rates, it becomes clear that the costs of QE outweigh the benefits.
The Banker's Dilemma
The financial sector faces a banker's dilemma. Due to forward guidance on interest rates and open-ended purchases, as well as shock after shock (from the European debt crises etc), it had become impossible to anticipate when QE would end. But since the individual participant is still judged on what he/it is achieving today, there's a strong incentive to engage in yield-chasing and ignore the almost-certain consequences down the road. This dilemma is presented in the following chart. The solution is to press for an exit to QE and let the risk-free rate rise to a more normal level. This will allow the financial sector to issue debt at interest rates that will drastically lower interest rate risks in the future.
The Impossibility of Hedging
Hedging is only possible when the amount of "risk" in dollars won't bankrupt the existing counterparties. Normally banks and other major lenders can lend money at low fixed interest rates and attempt to swap it for a floating rate or something. But the potential move from interest rate normalization is huge. Assume an abstract $1 trillion 10 year fixed 5% debt are owned by major financial institutions. An increase in 2% in the risk-free rate and another 1% increase in the risk premium for a total 3% increase in the yield implies a 20% loss in the value of that bond. That's a $200 billion hit. I'm not sure how many counterparties can absorb such losses.
The longer QE goes on, the more debt is issued at low rates that will eventually lose a lot of money once rates normalize. Hedging on a large scale is futile as it took a federal bailout to get AIG to payout $60 billion in CDS payments. Other than the major financial institutions, where else are you going to find the capital to absorb all that risk?
This may be why the Bank of International Settlements repeatedly admonitioned that "Interest rate risks expressed as potential losses relative to (economic output) are at a record high in most advanced economies, and these losses when they do occur will be spread among financial institutions, households and industrial firms. Sophisticated hedging strategies may shift these risks across institutions, but they don't eliminate them."
In short, the game has changed. The Fed and the banks are no longer entirely focused on propping up asset prices and have switched to preventing new debt going forward from suffering major devaluations and this is why QE will definitely end. This has little to do with the lackluster employment situation depicted as improving or economic growth ranging between moderate to modest. For years the blogosphere and pundits have been talking about asset bubbles from the Fed's QE, but now there are actually strong demands from industry to end QE. It's cost-benefit analysis pure and simple.
QExit will likely send the risk-free rate to a whole new level, which is bad for TLT (TLT) and HYG (HYG), but good for the dollar. US stocks (SPY) are in denial now, hoping things will finally work out but I'm afraid reality will come crashing through once emerging markets (EEM) are in distress. The Japanese yen (JYN) will weaken at first on a stronger USD but then reverse as risk appetite falters.
Additional disclosure: Long USDJPY and EURCHF for now. Sell when there is widespread panic. Will switch to short South African Rand etc very soon.