If one thinks of all the money that global Quantitative Easing represents, one can easily imagine a global hyper-inflationary scenario. After all, the US and its Federal Reserve are not the only players in this "global money printing" business, nor the first. It is debatable whether November 2008 or August 2010 is the beginning of QE in the USA. The Bank of England started its QE in March 2009, and "technically" halted it a year later -- even though you will see from the BOE's balance sheet that this is not entirely true. The Bank of Japan has its own QE, which it is continually expanding. It is worth noting here that the BOJ has been the leader in this QE business, as shown in this article by the SF Fed, and this article by the Fed. The ECB, of course, is a player.
A nice 2010, multiple central banks expose by staffers of the BOJ can be found here.
To visualize the scale of the "money printing" involved, you will need to realize that the Fed's balance sheet stands at $3.85 trillion -- up from less than $1 trillion before the financial crisis. The BOE's balance sheet stands at 400 billion GBP, while the BOJ's will reach 270 trillion JPY by the end of year 2014. Additionally, the ECB's balance sheet broke through 3 trillion EUR earlier this year.
Hence, a scary thought should have daunted upon you by now: Where will that money eventually go?
The answer is: It will return where it came from, nowhere.
That is, the money will simply disappear.
Let me walk you through the logic, and you will undoubtedly agree with this thesis, regardless of how disturbing or comforting you think this answer is.
If a central bank, and let me use The Fed as an example, writes you a check, that check will never bounce. It will simply be cashed, and you will receive the money, anywhere the USD is recognized as an acceptable currency. If the money happens to be for a loan, then you are expected to pay interest on that loan as well as repay the principal at some point in the future. The interest you pay to the Fed becomes part of their revenue, as is the case with conventional bank loans. The Fed will use some of the revenue to run its business, while the surplus, or profit, will be sent to the US Treasury as usual. The US Treasury will use the money to meet its obligations, including paying for interest on treasuries the Fed bought! The principal you repay to the Fed will simply go into oblivion: it will disappear. That is, the Fed will reduce their balance sheet with the amount of principal you paid. Effectively, the money will disappear exactly where it came from!
In summary, if a loan the Fed owns is performing, then the excess interest will go to the US Treasury, while the principal will disappear. On the other hand, if the loan is not performing, then the Fed will have to choose one of many options, including writing-off the loan -- read it, making it disappear. Alternatively, the Fed can choose to keep the non-performing loan on their balance sheet for years to come. Eventually, such loan disappears once accounting rules for write-off are satisfied.
Compare the above to a conventional loan you draw from a bank. Here, the interest you pay, beyond expenses, will be reported as income. Such income will be taxed by the US Treasury. The after-tax profit will become part of the bank's capital or reserves, hence affecting the stock price of the bank. Further, excess reserves will, usually, be distributed to shareholders as dividends. That is, your typical bank loan will affect the normal economic cycle. As for non-performing conventional loans, these will cause the bank to revalue or write-down the underlying assets. At some point, reserves will be maintained by the bank to account for the possibility of default. If the loan does eventually perform, such reserves will be moved into income. Otherwise, the loan will eventually be written-off, and whatever reserves available will be used for the write-off.
As such, central bank loans can best be viewed as "time buying vehicles." What I mean here is that such loans do buy banks in particular time to deal with non-performing and non-valuable instruments, while affording the general economy time to heal.
The license to drive such time-vehicle was given to banks in Q1, 2009, through the changes to accounting standards. At the end of that quarter (April 1st, 2009), FASB issued a directive that gives banks leeway in valuing non-valuable instruments. Think of an old car, say a BMW, with no blue book value, yet, is running great! As the utility of keeping the vehicle exceeds that of selling it for almost nothing, you do keep it. Now imagine if, on your books, you are allowed to price such vehicle at the original cost of purchasing it as new! This is exactly what banks can elect to do with their non-valuable assets, for which the markets disappeared. This "arbitrary" valuation will still be FASB compliant.
How do such actions help the general economy? Well, as the Fed buys treasuries -- effectively, lending the government-- it is keeping the overall interest rates in the fixed income market artificially low. Further, when the Fed buys mortgage backed securities (MBSs), it is allowing banks to free the money they have tied to underlying mortgage loans, and hence banks will be able to offer new loans to the general public. Actually, the Fed is becoming the biggest mortgage lender of its kind, dwarfing the size of any mREIT you can think of. As cautioned by Annaly (NYSE:NLY), one such mREIT:
Using the historical average of $25 billion per month of reinvested principal as part of the System Open Market Account (SOMA) and QE3 of $40 billion, the federal government will end up owning the overwhelming majority of monthly mortgage origination.
Such Fed actions keep the economy going, while offering the overall real-estate market time to heal. As property prices rise -- because of the active market underwritten by the Fed -- banks will afford to wait-out their nonperforming or severely underwater loans. Additionally, due to the improving real-estate market, banks are able to keep their non-valuable MBS-based assets, which in many instances are still paying some interest and principal.
Yet, a central bank's job is mainly to control inflation and not to create it. After all, there will be profits that banks make from this "artificial" money injection, and such excessive profits may create inflationary pressures. Initially, less fortunate banks will use such profits to build non-performing-loan reserves. Little by little, such banks will start getting rid of their "old BMWs" at market price, as such markets re-emerge, or simply start writing-off such investments without seriously affecting on-the-books capital. Later, as more profits are garnered from this cycle, and especially by healthier banks, more capital requirements will be enforced by central banks to assure that such "easy money" does not make it back into the economic cycle.
The above has been going on since the Financial Crisis, and if you are wondering why $3 trillion dollars of new money the Fed added on its books did not affect inflation beyond the current 1.2%, then I hope you agree with my reasoning: The money never made it, and never will make it, into the conventional (pre-October 2008) economic cycle!
As such, it is my strong belief that most of the hype relating to the ill effects of Fed tapering is just that: hype. What I believe will happen is that there will be "talk" about tapering. Later, as loans mature, real-estate markets recover, and banks get healthier, the Fed will then, and only then, buy less and less MBSs. I believe that the amount of reduction will be proportional to the health of the banking sector, as measured by the ever more stringent stress-tests. Further, the Fed will never have to "sell" what they already own, as that money will simply disappear one way or the other. Additionally, I believe that as the stronger banks actually make profits, such profits will be sucked through higher mandatory reserves and regulatory penalties -- read the recent JPMorgan (NYSE:JPM) news. The weaker banks will not have to fork their profits initially. Instead, such profits will be turned into non-performing loan reserves, which will get utilized upon write-off of such loans. In effect, such money will disappear.
There is a major complication that central banks need to work through, though. After all, they need to manage a longer-than-usual bust-boom cycle. Historically, we should have reached the end of the current 6-year cycle, considering the bust started in early 2008 and the boom started at the end of Q2 2009.
Is this too simplistic? As the mandate of a central bank is to primarily keep inflation down, you would agree with me that they would have tapered a few trillion dollars ago, if there was a real risk of hyper-inflation anywhere on the horizon. As such, I believe that the observed multi-country central bank actions do support my conclusion that this is a highly-engineered, and well under control, global operation.
If you agree with the above analysis, then you may agree with my current course of action. As an individual investor, I have accepted the eventuality of 10-year treasury yields reverting to their historic means of 1-3 percentage points above inflation rate. With 2% being the expected spread, this will translate, today, into an above 3% treasury yield. The first effect I see, due to this normal and healthy rise, is that gold (NYSEARCA:GLD) will eventually tank. Precious metals are clearly a negative-return asset class, and as such, I will avoid PMs in general, and gold in particular. After all, I cannot justify holding such an asset class if a risk-free instrument, such as the 10-year treasury, is yielding above 3%.
I also see high-yielding equities fluctuating between good-buy and good-sell. These news-driven mood swings will be anchored around inflation fears and hype. As I am mainly an equities trader, it is my intention to take advantage of the technical signals and profit from such cycles. On this front, I intend to hold to, but not increase my REIT holdings. REITs will be very sensitive to the hype, and will not reasonably recover until the Fed actually starts to taper off their MBS purchases. Once tapering does take place, you will see long-term MBS rates rising faster than short-term borrowing rates. This will present itself as a good buy-opportunity for the already depressed REITs. I still like Annaly on that front, but the whole sector requires extra care.
As for other financials, I will be awaiting clarity on how the government intends to "punish" the healthy banks -- to withdraw their "easy money" as described above. Once clarity on that front is gained, I believe healthier banks will present themselves as an excellent long-term buying opportunity. As such, I would be electing to go with specific banks, such as JPMorgan, Wells Fargo (NYSE:WFC) and Goldman Sachs (NYSE:GS), rather than investing in the sector through an ETF, such as the Financial Select Sector SPDR (NYSEARCA:XLF). The following chart confirms this view.
Finally, as economic fears begin to settle, I see retail as recovering first, and then the industrials. Yet, I will continue to watch out for the cyclical nature of these holdings. For retail, I believe that an ETF, such as the SPDR S&P Retail ETF (NYSEARCA:XRT) offers a better opportunity than individual retailers. Similar argument applies to the Industrial Select Sector SPDR ETF (NYSEARCA:XLI). This chart, summarizes the performance of both relative to the S&P 500.
In any case, I will not be looking into becoming a long-term investor until the Fed tapering has actually started and the hype in the interest-rate market has somewhat subsided.
Disclosure: I am long JPM, NLY. 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.