If you open the QE medication box, it will be written on the leaflet that the drug will replace long-term ill debt of various types with interest-bearing healthy reserves thereby substituting long-term duration risk with short-term assets. The patient -- the US economy -- will recover swiftly as the new demand for long-term assets will reduce long-term borrowing rates and kick-start a healthy new recovery as investment and spending accelerates, which will in turn finally lead inflation expectations to rise and the housing market to recover. As for the posology, just take as much as needed until you feel the results described; there are no limits whatsoever in our capacity to produce ever larger quantities of this drug. No wonder the equity markets are on steroids.
Facts? On the first dosage, 10-year treasury yields rose by 70 basis points, 30-year mortgage rates rose by 110 bp and on the second dosage by 80 bp each. Side effects were slower economic growth, a wave of speculation on the back of a sinking dollar and a rapid acceleration in the record divide between high and low income categories. Patients? They can’t get enough of it and are begging for a third dosage. I can only guess that the placebo effect is the result of a complete misunderstanding of these new policy tools. I will try to bring an infinitesimally small contribution to break the myth a little further.
I will focus on those most relevant in understanding what these actions have done and what the discontinuation of these could mean going forward. But before dwelling on all that QE does not perform, it has one clear and almost indecent advantage: The government is paying no interest at all on the securities held by the Fed as it returns the interest to the Treasury.
Until early 2009, the Fed only provided reserves that were in one way or the other temporary and “borrowed” (meaning that they were provided through liquidity facilities). They addressed liquidity concerns and did so pretty well. These Credit Easing actions were clearly a success and avoided a full-blown liquidity crisis.
QE, however, is a different story. Its objective is not to provide emergency financing but to address solvency and growth issues: Solvency by purchasing unconventional assets ($175 billion of agency debt and $1.25 trillion of MBS) and growth by purchasing Treasury securities. Purchasing agency securities to increase the availability of credit by removing risk and duration from the private sector (mainly the banks) makes sense. What makes no sense at all is the purchase of Treasury securities “to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate”.
Here we swim in a sea of myths and other fallacies of composition. First there is the illusion of large numbers that are useless unless they can be put into perspective with others. By the end of June, the Fed will have purchased a little over $1 trillion of Treasury securities between QE1 and QE2 with the intention of lowering interest rates. As we have seen, the exact opposite has happened with rates rising between 40 and 90 b.p. with each QE. So apart from squeezing a little more every household with a mortgage, the exact opposite of what was intended, there has been no tangible result on rates.
Could it be that being so focused on the flow of new debt they missed that the stock of US government debt held by the public is $10 trillion? Doubtful. So if the Fed knew the amount of its purchases would be dwarfed any day by the simple rotation of market participants from one asset class to the other -- and that it could not influence the level of long term interest rates -- what was it seeking to do?
On the other side of the Fed’s bloated balance sheet of debt securities sits a banking system flush with excess reserves. The monetarist nightmare is that by some sort of impossible trick (i.e. Increasing demand during a balance sheet recession), these reserves are multiplied through the fractional reserve system in a rising tsunami of money supply. Of course the Fed completely overlooks the fact that it is only loan demand and not reserves supply that determines total lending. I can’t stress enough that the Fed has never limited the quantity of reserves available; this has never been a policy tool.
Until the real policymaking revolution took place under the interest-bearing overnight facility included in the Emergency Economic Stabilization Act of 2008, which enabled the Fed to pay interest on reserves, the Fed had to continuously adjust the supply of reserves with open market operations to keep the cost of reserves in the interbank market at its desired Fed Funds Rate target. With the opportunity cost of holding reserves now gone, banks can hold whatever amount of reserves they wish.
Contrary to popular opinion, open market operations do not seek to adjust the amount of lending and excess reserves don’t entice lending -- a lower fed funds rate does. The Fed must always make sure to provide enough reserves to meet known reserve requirements. The only purpose of adding or withdrawing reserves was to control the fed funds rate. Now that the Fed introduced interest payment on reserve balances it can dissociate the amount of reserves it wishes to provide the system from the interest rate policy. This also solved once and for all the issue of loosing control of short-term interest rates when providing exceptional amounts of liquidity to the banking system. Under this new floor system, banks will only lend excess reserves if they can get a rate above the rate offered by the Fed -- so in effect, the amount of excess reserves is irrelevant and may simply increase the interest paid on reserves when it wishes to tighten its monetary policy. It has no need to reduce or sell any of the $1.5 trillion it added to its balance sheet. There is no causation between QE and inflation.
How can adding to what is now $2.4 trillion of non-interest bearing cash and bank reserves promote growth? The theory is that with rates at essentially zero and an ocean of available excess reserves, bank lending would pick up speed and leverage would stop contracting. Clearly not: Consumer credit was $2.478 trillion as of the end of 2009, and is $2.407 non-seasonally adjusted today. The only accounting line which has grown from $100 billion to $350 billion are student loans, most certainly an artifact of the inclusion of student loans in the Direct Loan program (April 10 analysis by the Consumer Metrics Institute). Take the $250 billion “manufactured” demand out of the total and consumer credit has contracted by over 13% during the past 15 months of QE.
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The assumed relation between money supply and loan growth has broken down, so much so that whilst M2 is growing at 4.9% on an annualized basis, consumer credit has fallen over 20% from its peak. The divergence is due to the switch from consumer credit to government borrowing. As long as the government continues running budget deficits, the Treasury debt issuance will pick up the slack and support money supply.
Remember the fallacy of new government debt supply crushing demand? Can’t happen. The debt is issued, the recipient deposits the proceeds at the bank, which then buys more government bonds, as it has no one else to lend to. So here we see that it's not the excess reserves that are keeping the money supply in positive territory but the deficits run by the government (Bill Gross has appears to have made an ill-advised bet against government debt). Even a hundred trillion in excess reserves will do nothing to promote lending.
And yet there's more. Only a willingness by the private sector to lever up further its already bloated balance sheet will do the trick. The double hit of equity losses earlier this decade followed by housing losses more recently are unlikely to inspire such behavior any time soon. The myth of low volatility era driven by the Greenspan put on asset prices and economic activity is dead and buried. The 10-fold surge in financial sector debt (peaking at 127% of GDP in 2008) and doubling of household debt (98% of GDP in 2009) has contracted to the tune of around $3.3 trillion since peaking in 2008. It is only the offsetting by over $3 trillion of accumulated deficits that have prevented a money supply contraction and therefore the economic growth path of the United States, not quantitative easing or the level of excess reserves.
So if QE served no purpose for growth and jobs and at best a marginal role in suppressing interest rates, why is everyone so concerned it might be ending?
The concern apparently is asset prices. There is no doubt that there has been an extreme correlation between the rise in asset prices and the pace of quantitative easing. To be perfectly honest, I had significant doubts that this correlation would prove so resilient. I clearly underestimated the capacity of investment banks to sell this idea to investors as well as completely underestimated the Presidential cycle effect that drives equities in Year 3 (shame on me and congrats to Jeremy Grantham). The mechanism by which asset purchases by the Fed may support asset prices is best described by John P. Hussman in the Iron Law of Equilibrium. By purchasing (absorbing) almost all the newly issued Treasury debt and replacing it with newly created bank reserves, the Fed is reducing the outstanding quantity of assets that must be held. As someone must hold every security until its retired, by reducing the size of the pool, you support its value. The by-product of these purchases, zero interest bearing bank reserves, drive all near-substitutes of cash to merely zero as banks try to shift their holdings from non-interest bearing cash to T-bills. This results in making all short-term investments unattractive and induces some investors to seek returns in riskier and longer-term assets (equities, gold, commodities, emerging market debt). This inclination is pushed to extremes of complacency by the “helpers” of the financial industry, always eager to increase their trading commissions with great investment ideas. In parallel our “helpers” will provide leverage for speculation as the excess reserve balances satisfy margin requirements and enables them to lend to the wealthy with practically no risk. This might be supportive of asset prices at the margin, but again, one has to put these figures into perspective. During the latest round of QE, the Fed has limited the pool of assets form growing by $600 billion (with QE2 approximately equivalent to the amount of Treasury securities sold to fund the budget deficit). The market for publicly traded US equities alone is between $15-20 trillion. Add in the commodity markets and you reach a figure close to $25 trillion. Difficult to believe that by purchasing less than 3% of assets, without even reducing the size of the pool, the whole pool level rises by between 10-15%. So again, one can't really deny that QE may "support" asset prices, but by such a ridiculous amount that it is completely dwarfed by the placebo effect that it has had on greed. The Commitment of Traders report suggests such speculation is running wild and the market is now awash with margin debt and leverage, a perfect recipe for a disorderly exit of crowded trades and a large increase in volatility.
So what now? Will the Fed launch QE3, 4, 5? Who really knows? It appears for now unlikely, at best a reinvestment of maturing securities so as to not shrink its balance sheet an maybe some support down the road to the housing sector by trying to reduce the supply of foreclosed properties. But who cares? The honeymoon period extended by the placebo effect is running its course. If one excludes the contribution of government spending from real GDP, private sector GDP is 11% below the 2007 peak, back to its level of 1998.
This public spending which has supported the economy for over two years now is all in the rear view mirror. In front are austerity, higher taxes and declining government employment. The mainstream focus on GDP and the fact that its back to its highs completely overlooks that this was only achieved through massive government spending and borrowing. None of the structural issues have been resolved. The combination of rising commodity prices and falling house prices (the largest net worth asset on the consumer balance sheet) has only worsened the extreme divide between high and low-income earners. Private employment is today 2% below where it stood 10 years ago and the job loss over that period is the highest ever. The average duration of unemployment is now almost 40 weeks, a new record high just achieved in May. One in every six Americans is on food stamps.
These are clearly not part of the wealthiest 10% who account for 40% of total consumption but the prospects for this income group is deteriorating also. The only decrease in the unemployment rate last month was for teenagers (16-19) and the only decrease in the unemployment rate by educational attainment was for those with less than a high school degree or a high school degree. I wonder what happens to an economy that is wholly dependent on the spending of an ever-shrinking middle and upper class when they are precisely the ones loosing jobs in favor of low-paid teenagers with the least amount of education. How about inflation? As we have seen, there is no doubt that the placebo has engineered an incredible adrenaline shot in asset prices, however, one should remember that in our developed countries, changes in prices of goods and services only represent 1/3 of all prices in an economy, wages are the other 2/3. Real average hourly earnings have fallen by 1.2% over the past year.
Forget inflation, at least for now. Home equity loans and cash-out-refinancing’s are unlikely to fuel any consumption either. Personal consumption expenditure rose by 3 trillion since 2003 whilst US households extracted 2.3 trillion of equity from their homes during that same period. The inventory of about 4 million homes, 1.5 million above the average 2.5 million working level. The US is currently building about 700 thousand new homes and destroys about 300 thousand. Overall with a supply of about 2 million and with the population growing by about 1 million households (a population growth of 3 million and an average 2.77 people per household) it will take 4 years at a minimum to work through the excess inventory. With such an inventory depressing prices for the next few years it is pretty clear that prices will drop at least by another 20% to their long run trend. This fall alone spells another recession considering that 46% of all mortgages have less than 20% equity in their homes.
The ISM has just started to fall, plummeting from 60.4 to 53.5. This fall is the largest point fall since 1984. The same holds true for the ISM New Orders index, which has fallen to 51.0 from 61.7 in April, in line with the fall witnessed in 2001. In confirmation, the Dallas Fed manufacturing Index fell to a reading of -7.4 from a +10.5 in April. And if any confirmation was necessary from the Greatest Capital Misallocation in the world, the Chinese PMI survey fell to 52.0 in May in a clear down trend ever since it reached a post-crisis peak of 56.6 in December 2009. A peak in late 2009 is pretty disappointing considering that the Chinese elephant to remain on its bicycle had just spent $600 billion (three times the size of the US stimulus package relative to the size of its economy) with not even the excuse of US mortgage backed securities its banks balance sheets and no signs of any softening in its housing bubble.
The combination of the absence of further QE placebo, a world economy slowing fast, a Chinese reckoning, record leverage in crowded trades and an amazingly persistent sense of denial have created the perfect conditions for a deflation bust scenario. A deflation bust offers fantastic investment opportunities. The most attractive of these are in derivatives with 5-year CDS trading at insanely low levels (Italy trading at 149, Spain at 240, Japan at 85, China at 70 and France at 66bps). Even if you can't trade derivatives there are still many other attractive trades. You can short the Canadian dollar by shorting the FXC tracker. Australia has enjoyed the largest housing bubble of any nation in the world and is extremely leveraged to China (30% of its exports). In addition, mortgage debt in Australia, as a percentage of bank assets are higher than it was in the US before the financial crisis and the private sector debt accounts for 300% of GDP. Another way of playing the bursting of the real estate bubble is to purchase 10-year government bonds (now at 5.25%) as these will crash on the back of falling housing prices to levels now witnessed in the US. In a deflation bust environment you still want to be long the TLT, short the JPY but before doing anything else, it is still time to take of the risk trades you still have on. You don’t want to be anywhere near equities and commodities, which happen to be the most crowded trades at this time, if anything you want to go short these (with tight stop losses or better still options).