Last week's equity market sell-off has come and gone, leaving us with an enduring mystery: why sterilized QE, and why now?
Within the mystery are wrapped two enigmas: Why did Jon Hilsenrath of the Wall Street Journal publish his article on sterilized QE the day after European markets lost more than 3%, and US markets nearly 2%? The article was a "scoop" if ever there was one. The day Hilsenrath's article was published, US markets recovered nearly half of what they had lost that Tuesday, and went on to climb to the highest level we've seen since the economic crisis began. Markets love talk of QE, there's no doubt about that. Coincidence? Impossible to prove, but equally difficult to refute.
The second mystery is more tangible: Why is the Fed considering sterilized QE, when Operation Twist amounts to the same thing, and more? To facilitate the analysis, let's dissect the two Fed operations.
Here are the steps that comprise sterilized QE:
--Fed prints money to buy treasuries
--Fed buys treasuries
--Fed sells T-bills to absorb cash from markets spent on treasuries
In other words, the Fed sells T-bills to buy treasuries.
With Operation Twist, the Fed sells its short-term treasuries to buy longer-dated treasuries. T-bills are simply ultra short-term treasuries. So under sterilized QE, the Fed sells T-bills to buy treasuries; under Operation Twist the Fed sells short-dated treasuries to buy longer dated ones. There is no particular difference between the two operations.
Then why bring up sterilized QE at all? This is especially curious given that Operation Twist is in fact a stealth form of additional QE. Remember that with Operation Twist the Fed sells short-term treasuries to buy long-dated ones. When the Fed does so, it swaps the bonds on a par-par basis. For every million dollars in face value of short-dated treasury notes it sells, it buys one million in face value of longer-dated securities.
But looking beyond face value, the shorter-dated securities are priced between par and 105, whereas the longer-dated treasuries have prices of between 125-140. The Fed buys 20-40% more than it sells in terms of price (dollars spent), so the effect is an additional injection of liquidity. Operation Twist is more stimulative than sterilized QE, since with sterilized QE all of the cash injected into the system is absorbed by the Fed's sale of T-bills.
Bernanke has proven himself to be a dove Fed Chairman, the biggest dove since...well, Alan Greenspan. If Bernanke wanted to undergo additional stimulus without raising eyebrows, he could opt for another round of Operation Twist, with at least 20% of the headline amount of the operation going to new liquidity creation. Instead, he seems to be opting for sterilized QE. Our dove Chairman? Why?
The answer could be the politics. Fed meetings take place about every 6 weeks, meaning that after Tuesday's Fed meeting there will be only five more meetings before the general election in November. Bernanke has been literally threatened by candidate Rick Perry of Texas, who said Bernanke was "almost treasonous" for "printing money." Perry won't be the candidate, but there is no doubt that Bernanke is sensitive to the politics of his policies. In particular, he cannot afford to be seen stimulating the economy too close to the election.
Enter sterilized QE, the perfect instrument for the job. If Bernanke is able to put this program in place, he will have created a sort of "shelf QE," to be implemented when he sees fit. When the Fed buys treasury bonds and sells bills, it is true that no new cash is injected into the system. But if those bills were later allowed to mature, that cash would enter the system. In fact, unless the Fed were to actively roll over its T-bill sales, the cash injection would be automatic.
So the Fed could control the sterilized QE money entering the system simply by tailoring its bill sales as it sees fit. There would be no need to announce new initiatives or call attention to its operations in any detail. For a Fed Chairman who never met a QE program he didn't like, this one would deserve a special place on his mantle.
The calculus of Tuesday's Fed meeting is complicated and very hard to discern. Ostensibly there is no particular need for more QE given the downward trend in the unemployment rate and a CPI that has remained above 2% for a solid year. But the timing of the WSJ article, and the detail of its content, suggests an imminent Fed initiative, if not tomorrow, then within the next meeting or two.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short S&P futures.