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Lately, nearly every piece of economic data is judged based on the degree to which investors perceive it will encourage/discourage central banks from embarking on a new round of quantitative easing (QE). Generally, bad data and subdued inflation is good because it means the Fed has both cause and room to ease, while good data and higher inflation are bad as they eliminate the need for easing and increase the chance that any asset purchases may contribute to already rising prices.

Recently, I have noted that the tendency to judge economic data this way is wrongheaded for two reasons. First, the original intent of QE was to spark economic growth so the fact that market participants are wishing for bad data in the name of QE is perverse. Second, QE's effectiveness regarding the stimulation of the economy is diminishing and approaching zero, so hoping for more of it is just asking the central banks of the world to print money on which they will get no return (when 'return' is measured by economic growth). Nonetheless, the market is addicted and until the addiction is curbed, investors will continue to judge every data point and every development by reference to the effect they have on central banks' decision about whether to further stimulate the worlds economies.

The market needs to understand that this trust in QE is misplaced. First consider that when central banks purchase government debt they are sucking senior collateral out of the system at a time when good collateral is in high demand and short supply (hence the ECB's continual relaxation of collateral standards). The following chart shows collateral posted in U.S. triparty repos:

(click to enlarge)

Source: Fitch

Clearly there has been an increasing demand for high quality collateral since 2010. In Europe, the ECB is being forced to accept a greater and greater amount of low quality collateral in order to keep the region's banks afloat. This cuts deep in two ways: it hurts the ECB's balance sheet and the haircuts on the pledged 'assets' reduce the amount of cash that ends up in the hands of the banks who pledged it. Taking good collateral out of the market will only serve to impair its functioning. As Phoenix Capital Research puts it:

How would buying Treasuries or other sovereign bonds… thereby sucking collateral out of the system… help an already insolvent banking system (the world's $700 trillion derivatives market is backstopped by Treasuries and other senior assets)?

In order to get around this, U.S. banks for example could simply take the new cash (reserves) they receive from the Fed in the QE 'asset swap' and buy Treasury bonds with it. Thanks to the multiplier effect, the banks would in theory be able to buy many times as many Treasury bonds as the amount they turned over to the Fed by simply creating demand deposits in the Treasury's name and keeping just enough of the new money parked to cover the reserve requirement. This way, the banks would have many times as much good collateral as they had before.

This sounds too good to be true precisely because it is. The obvious problem with this (as Pater Tenebrarum notes) is that not only has the money supply been expanded, but the Fed would be indirectly funding the deficit. Technically, the Fed would only have exchanged cash for previous deficits (that's what existing Treasury bonds are after all). But in reality, if the banks go buy new Treasury bonds with the levered-up cash they received from the sale to the Fed of their old Treasury bonds, the deficit is indirectly being funded by the Fed and the money supply has been increased in the process.

In sum then, QE either sucks collateral from a collateral-starved system or, if the receiving financial institutions seek to replace that collateral, QE risks funding the deficit in an absurdly circular scheme. At the very least, the money supply expands and thereby increases inflation just when interest rates are low and investors cannot afford to give-up any real rate of return they have left. Eventually this policy must be abandoned. What isn't at all clear is what happens to equities when the printing presses go silent. One can only think the results would not be pretty. All of this points to one thing in terms of an actionable idea: buy gold (NYSEARCA:GLD).

Source: QE Is A Flawed, Lose-Lose Strategy