Seeking Alpha
Recommended for you:
Long/short equity, deep value, special situations, contrarian
Profile| Send Message|
( followers)  

Since Bernanke first uttered the word "taper" in mid-May, the financial media circus cycle of "they'll taper this time around" has been repeating itself before every FOMC meeting and after the subsequent release of the FOMC meeting minutes. And yet, the Fed continues to defer reducing its QE policy after every meeting despite constant overtures to the contrary. The truth is that reducing the level of QE right now would likely cause a repeat of the 2008 near-collapse of the financial system, hurling the economy into a serious depression.

The best way to understand what's really going on is to examine the Monetary Base and the Excess Reserve account of the banks, which are both updated on the Fed website every two weeks. Definitionally, the monetary base is the sum of the reserves kept by banks at the Fed plus total currency in circulation with the public. This graph shows the expansion in the monetary base, which approximately measures the amount of money that has been injected into the banking system from the QE program. The red arrow is close to the point in time (May 22, 2013) when Bernanke first mentioned the idea of a taper. This chart unequivocally does not reflect the actions of a Federal Reserve that is intent on reigning in the growth of the money supply (sourced from the St. Louis Fed website linked above, with my edits in red):

(click to enlarge)

What's even more interesting is to understand where this money is going since it doesn't seem to be going into the economy other than somewhat into the housing and stock markets. This next chart shows the Fed's "excess reserve account." Definitionally this account is the total reserves held at the Fed by banks less their required reserves. In a sense, the excess reserves are "vault cash" that can be used for lending activities. In examining this chart, you can see that most of the QE ends up as "vault cash" held by banks at the Fed (this chart was sourced from the St. Louis Fed website linked above, with my edits in red):

(click to enlarge)

We can verify that QE is primarily going to the "vault cash" account of the big banks mathematically (you can click on the links above to access the data I'm using for this exercise). Bernanke gave his "taper" speech on May 22. On May 1st, the Excess Reserve account of the Fed was $1.75 trillion and the Monetary Base was $3.03 billion. As of November 13, the last date for which the two numbers were reported, the Excess Reserve account grew to $2.38 billion while the Monetary Base grew to $3.68 billion. In other words, despite all the noise and the Wall Street predictions of when and how much the Fed would taper, the Monetary base has been increased during this time by $648 billion, or 21%. That is, more than one-fifth of the total QE over the last five years has occurred in the last seven months. Furthermore, the excess reserves - i.e. the cash held by banks sitting in the Fed's vault - has grown by $627 billion. This means that 96.7% of every dollar printed since Bernanke's "taper" speech in May is being held by banks at the Fed.

One more little detail to add to this before we try to figure out why the Fed has been ramping up its supply of money to the banking system since May and why I do not believe that the Fed will taper any time soon. "Soon" meaning "for the foreseeable future." The two primary mechanisms by which the Fed creates QE is by purchasing Treasuries and purchasing mortgage securities. Currently the Fed is printing $85 billion per month, $45 billion (53%) of which is used buy Treasuries (they're actually buying more by rolling interest into more purchases but that complicates the math for purposes of this analysis). From May 1st to November 13th, the amount of outstanding Treasury debt (Treasury Direct link) has increased from $16.895 trillion to $17.149 trillion, or $344 billion. During this time period (7 1/2 months) the Fed would have purchased $337 (7.5 x $45) billion in Treasuries (the buying by everyone else would represent the rolling over of existing maturities - the $344 billion is new issuance). As you can see, the Fed is de facto buying 97% of all new Treasury issuance.

The data presented above shows that the QE is being used primarily to keep interest rates artificially low in order to provide low-interest financing to the U.S. Government and to homebuyers. This is currently part of the stated policy of the FOMC (increasing employment is the other). But even more important, given the size of the growth of the excess reserves being held by the big banks at the Fed, it would appear that the Fed feels compelled to keep banks flooded with a massive reservoir of liquidity. At this point, without going into exhaustive analysis of the Too To Big Fail bank financial statements, it would only be speculation to present why this is likely the case. However, I would suggest for those who want to study the issue further that, in my view, the cash being injected and accumulated into the Excess Reserve accounts of these banks is required to satisfy derivatives counterparty collateral demands and the anticipation of another possible cycle of impending large-scale credit market problems.

Notwithstanding whether or not my view about the liquidity situation of the banks is correct, if you go through the exercise of "playing the tape forward" using the assumption that the Fed will actually taper, it would most likely cause another big spike higher in interest rates, thereby increasing the interest expense by a considerable amount for the U.S. Government and it would choke off the housing market even more than has happened since Bernanke's taper speech in May (see my articles on housing for this analysis). The consequences of this would severely impact the economy, the Government's spending deficit and the entire financial system. The latter because the value of all fixed income securities held as assets by the big banks would decline in value, thereby causing the need for more capital to satisfy mandatory capital reserve requirements, etc.

In other words, even a small "taper" by the Fed, in my view, will create huge systemic problems. The rapid and massive spike higher in interest rates and spike lower in the stock market after Bernanke's speech in May is direct evidence of this. This is why, despite all the commentary to the contrary, the Fed has yet to taper 7 1/2 months and four FOMC meetings since Bernanke's taper speech.

The point of my analysis, in the context that I do not expect the Fed to taper anytime soon, is that trading profits can be had by taking advantage of the negative market reactions whenever the "taper scare" resurfaces, as it did after Wednesday's release of the FOMC meeting minutes. While jumping into S&P 500-connected ETFs (NYSEARCA:SPY) is one way to play this, I would recommend using the hit on the precious metals yesterday and today that has been directly connected to the taper scare as an opportunity to buy into what I believe is a significantly undervalued sector. This specifically makes sense because as QE continues at this level - and possibly is even increased - the devaluation effect on the dollar will ultimately translate into a much higher valuation for the price of gold and silver. I recommend starting with adding to or starting a position in physical gold/silver bullion. After this, a good way to play a snap-back in gold is to buy the Market Vectors Gold Miners ETF (NYSEARCA:GDX). In fact, in doing so you would be in company as George Soros recently reloaded his position in GDX.

Source: Don't Fall For The Taper Talk Again: Buy Gold On This Related Decline

Additional disclosure: The fund I manage owns physical gold, silver and mining stocks