The Inevitability Of QE3

Includes: GLD, SPY, TLT, UUP
by: Poseidon One

Since 2009, the Fed has more than tripled the monetary base, buying up billions upon billions of dollars of treasury bonds and mortgage backed securities through two successive rounds of quantitative easing (QE). While prices for commodities and everyday household items have certainly reflected this, especially if one looks at the Shadow Stats CPI measure, which actually includes items like food and energy (you know, the things consumers care about most) that the traditional government measure conveniently excludes, there can be little doubt that there's been little bang for the buck. What I mean by that is that prices have not (yet?) risen to the hyperinflationary levels one might have expected given the huge amount of quantitative easing the Fed has pushed into the banking system. The primary reason for this is that the trillions of dollars Bernanke has printed out of thin air have gone into a banking system that is bruised, battered, and broken. Rather than lending that money out, the banks have been content to simply 'sit' on massive excess reserves. As a result, we have yet to see prices in the economy really take off.

Yet, as I said earlier, there has most certainly been a marked increase in prices for commodities and foodstuffs nationwide, and that means that a substantial portion of the Fed's QE has indeed leaked out of the banking system. The liquidity trap theorists may be half right; there is certainly a high demand for cash to offset future capital losses on banks' loan portfolios, but the other part of the theory - the notion that cash, given near 0% interest rates, will be hoarded as a store of value - seems dubious when one looks at the stunning correlation between the Fed's QE programs and the S&P 500 Index. In April, Adam Hamilton over at Zeal LLC put together a graphical overlay of this correlation that makes it quite clear what's been happening: while the banks may not be lending the Fed's newly printed cash into the real economy, they have been steadily funneling it into stocks. Stocks, though the US and global economy is still beleaguered, do represent claims upon real assets and real companies, and therefore offer a better alternative to holding billions upon billions of a currency that's being devalued each day. The chart from Zeal is displayed below.

Of course, the first thing one might notice is that the chart stops a few months ago. What's happened since then with respect to the Fed's balance sheet changes and the course of the stock market, however, only reaffirms the correlation. It is no coincidence that the recent sell-off in the market came as the growth of the Fed's balance sheet stalled, and then began contracting. The past few Thursday releases of the Fed's balance sheet show it trending sideways (see here).

I, however, do not believe that the Fed is capable of allowing any such contraction to continue for overly long. It is only a matter of time until we see some version of QE 3, and maybe more after that. The reason has to do with how we got into this financial catastrophe and this recession to begin with, and without a grasp of that, one will not be able to understand why the Fed has little choice but to continue with its money printing.

The proximate cause of the recession, though there were certainly magnifying factors aplenty, was the Federal Reserve's excessively loose monetary policy under Alan Greenspan, who cut rates to near 1% and held them there for some time, despite Americans saving less and less. All the new long-term projects the artificially low interest rates induced soon proved to be unsustainable; there simply weren't enough resources saved up to fund them to completion. When these projects exhausted the already insufficient supply of savings, interest rates were pushed back up, and what appeared to be profitable at first, under the artificially low rates, revealed itself as a malinvestment - a misallocation of resources across time. This is precisely what occurred in the American economy. Major banks and financial institutions poured their capital into the real estate markets and mortgages that were unsustainable and went south as soon as interest rates rose off their artificial lows. They were left holding a bag full of worthless and deteriorating securities - mortgage backed securities to be exact - on their books.

Nearly all investors know that the Fed embarked upon two successive programs of quantitative easing in a misguided attempt to re-inflate the bubble economy following the collapse these worthless investments precipitated, but what far less investors are aware of is that the Fed also engaged in qualitative easing.

In effect, the Fed attempted to strengthen and improve the major banks' balance sheets by taking the toxic mortgage backed securities off their hands. In return, the banks received comparatively high quality and highly liquid US Treasury securities.

So, in effect, none of the bad debt stemming from the mortgage market that imperiled the financial sector in the first place was liquidated; it merely changed hands. The Fed took one for the team, and now it's the one holding a bag of worthless debt. The Fed's qualitative and quantitative easing moves have, to this point, clearly succeeded in keeping the major banks afloat on life support, removing the most problematic of their assets from their balance sheets and stuffing them full of liquidity in order to offset continued losses from the remainder of their portfolios.

The obvious downside, however, is that the toxic assets are still in the system. What's worse, they are now on the Fed's balance sheet, meaning that they are the assets backing our currency, the US Dollar. Over the course of the past few years there has been much talk of what the Fed's exit strategy will eventually be for removing its monetary stimulus, whether or not it will be able to successfully do so before causing massive hyperinflation. Yet, if you look at it, the Fed has already shown its hand.

Since housing prices are the ultimate factor driving the value of these mortgage backed securities, the Fed needs the housing market to recover and home values to rise back to their astronomical bubble highs for them to be worth anything. But that is clearly not happening, as the Case Shiller Index below depicts.

If housing prices continue to remain depressed, 'undoing' the qualitative easing and giving these MBS back to the banks can hardly be the Fed's exit strategy. That would land us back at square one, reversing the Fed's attempts to rescue the big banks and put the financial system on life support, and I don't see Bernanke waking up to reality anytime soon and pulling a complete 180. The Fed actually seems to have backed itself up into a pretty tight corner; the only 'exit' strategy it has left is to attempt to re-inflate housing prices itself via continued monetary stimulus (printing money out of thin air).

The recent selloff in global equity markets, at least in part, can be attributed to the disappointment amongst investors that the Fed did not announce a new bond buying QE 3 program. All markets got was the 'Twist' operation, whereby the Fed will sell 400 billion dollars of shorter term securities and use those proceeds to purchase longer dated treasuries in an effort to push down longer term interest rates, which have a more direct impact on rates relevant to consumers (think 30 year fixed rate mortgages). That the markets sold off so steeply in response to the announcement of this plan, while perhaps understandable, is decidedly irrational from a longer term perspective. If anything, the lengthening of the Fed's portfolio's average maturity means that Bernanke will have an even tougher time raising interest rates as part of an exit strategy, since longer-term bonds are far more sensitive to changes in short-term interest. Such an exit strategy would therefore quite literally represent Mr. Bernanke shooting himself in the foot and directly diminishing the value of the assets backing the US dollar.

And, of course, the second part of the twist operation, the reinvestment of the proceeds from maturing securities back into mortgage backed securities further confirms the reality that the Fed has little choice but to continue down its path of inflationism. Indeed, the fact that the Fed has allowed its holdings of mortgage backed securities to diminish by around 20% since this time last year may be part of the reason why economic conditions have started to soften.

For investors, the implications are clear. Given the virtual certainty of continued inflation, holding onto cash and bonds - typically considered the safest and least risky of the major asset classes - is a surefire way to be fleeced. While they may indeed be less volatile than equity markets, they are, in actuality, the riskiest investments one could make, with losses in real terms guaranteed. Continued QE will, as the chart from Zeal above makes abundantly clear, buoy equity markets that are currently irrationally undervalued, as well as the precious metals of gold and silver, which are similarly undervalued from a long-term perspective.

Disclosure: I am long AAPL, DGP.