With Friday's disappointing jobs number, the price action of stocks and precious metals, and chairman Bernanke's job security dependent on the reelection of President Obama, almost the entire investment community expects the Fed to announce a third round of quantitative easing. However, in all likelihood, bullish investors will be disappointed. Outside of the conspiratorial bent of the corruption over reality driving central bank action, there is no real reason to do more asset purchases. For why this is the case, I have broken down, the primary economic reasons why the Fed will not add more QE in the list below.
1. Food and Energy Prices Already High
Additional QE will only spur on further inflation in food and gasoline prices. Since a relatively small portion of the population owns enough stocks or commodity futures to offset the loss in discretionary income created by commodity inflation, further easing will result into a significant drag on the economy. Oil (DBO) is currently at over $96 per barrel and grains such as wheat, corn, and soybeans are at or are near all time highs. Higher grain and energy prices are not in isolation as they increase the costs products and services such as shipping of imported goods, electrical power, meats, anything that uses plastic, and capital intensive products with high energy costs. As a result, commodity inflation will spill into core inflation numbers. More QE would compound food and energy inflation to the point of transforming a stagnating economy to a stagflationary recession.
The other side of the food inflationary coin is geopolitical instability. An example of this was last year's Arab Spring. The media likes to argue that it was the aspiration of democracy was what triggered these revolutions, but the reality was that QE2 drove food prices up to the point where the lower classes in these countries got desperate enough to rebel. With food a much larger percentage of citizens budgets in the developing world versus the West, expect QE driven higher food prices to increase civil unrest and geopolitical risk globally. A more unstable world is a headwind to the global economy.
2. The Fed will Be Out of Credible Bullets, QE4 will create hyperinflation
QE3 is the Fed's last real shot at restoring the economy for those who thinks it would work. If QE3 fails to create significant real income and job growth, markets will no longer react to positively to rumors of easing. With continuous ZIRP policy, financing costs for credit worthy individuals and business are already at bare minimums. QE fails to spur lending not because of a lack of liquidity, but the combination of the lack of credit worthy borrowers and economically profitable projects give banks incentive to use funds on carry trades instead of lend. More QE would just increase dollar carry trades into Treasuries or bank reserves in foreign currencies such as the Australian dollar. If QE3, ends up being lackluster on the economy outside of stock prices (which is expected), any other attempts of further easing lack creditability and will instantly trigger higher inflation expectations.
3. QE3 will Cause Severe Questioning of the Independence of the Federal Reserve
With movements to audit the Federal Reserve already taking place within Congress, many voters and investors are starting to lose faith in the credibility of the independence of the Federal Reserve. With the US debt to GDP ratio over 100%, trillion dollar deficits, and no political will to resolve them, additional easing to buy Treasuries can easily be interpreted as a covert method of monetizing debt to finance government operations. Even before QE3, the Fed owns 19% of all Treasury debt receives 43% of interest payments on US government debt. With no politically realistic way of solving the national debt problem without money printing, additional easing creates an easy way for the Treasury to run budget deficits without having to pay them back. As a result, Investors will perceive the Fed as a mechanism of state financing rather than an independent central bank serving the best interest of the US economy.
4. QE has no track record in causing any real GDP, real income, or job growth
Despite the positive effects on stock prices, commodity prices, and inflation expectations, Fed action does little to improve the real macro-economy. The reduction of the unemployment rate is solely due to people dropping out of the workforce as job growth fails to match population growth. Record of numbers of Americans on food stamps and disability claims do not help QE's case either. Real incomes in the US have also been stagnant since the launch of QE 1 in 2009 and GDP growth has been modest.
In fact it could be argued that Fed policy has hurt long term economic growth. ZIRP limits the spending of retirees as they have limited options to collect fixed income yield. As a result, retirees lack discretionary income to spend into the economy, or lack enough interest income from assets to retire in the first place therefore preventing job growth for younger Americans.
5. The Fed owns too much of the long term Treasury market to make QE3 viable without eliminating bond market liquidity.
The Fed owns all but $650 billion worth of long dated Treasury bonds. With QE2's size being $600 billion and investors expecting QE3 to surpass $1 trillion, there is not enough bonds out in circulation for the Fed to buy without eliminating liquidity in the bond market. As a result, diminished liquidity will result in severely higher interest rates when either a large private investor or if the Fed itself ever plans on reducing its balance sheet. QE3 would basically trap the Fed from ever raising interest rates and reversing its current path of bond buying without sever disruptions to the market.
6. Printing Money has Never Historically Created Real Wealth
When in history has a large scale currency debasement has resulted in renewed economic prosperity. If it did, countries such as Argentina, Zimbabwe, Weimar Republic Germany, 1990's Russia, would have been the most prosperous countries of the past century. Instead these country were hyperinflationary basket cases.
It may have a new name in quantitative easing, but currency debasement is not new. Ever since the Roman's filled silver coins with base metals in the 200's AD, monetary debasement has alwayed ended in high (US in 1970's from breaking of gold standed to Volcker) to hyper inflation as in the cases mentioned previously. All this does is destroy wealth in favor of debtors and governments both historically and currently are the world's largest debtors.
7. QE has diminishing returns and may already be fully priced in by equity markets.
With the S&P 500 surpassing QE2 highs of April 2009, equities have already priced in a significant portion of quantitative easing. What else to equity investors have to be optimistic about if QE3 occurs? Economic data in the US, Europe, or Asia does not point to a rosy picture and earnings outlooks are pointing towards an earnings recession. The chart below shows the direct results during the tenures of QE1 and QE2. Equity performance diminished sharply between each of the first two rounds with hard sell offs following each one in 2010 and 2011. I do not expect more easing to break this trend. With bullish sentiment and technical indicators such as RSI on risk assets such as the Euro, US and European equity markets, gold and silver reaching severe overbought levels and the performance of the US dollar and the VIX showing extreme levels of complacency, it seems like QE3 is priced into the market. It also interesting to not that Treasury yields have diverged noticeably from risk markets.
Overall, all economic reasons point to that fact that further QE has a negative expected value to the US economy and therefore will not be pursued. The one risk to my thesis and hope for bullish investors is the corruption factor. The degree of corruption within the US government has risen substantially since 2000, and the need for politicians to preserve cushy jobs and pensions probably outweighs any concern for the American people as a whole. In addition, the federal government has no realistic way to pay off it debts other than taxation through inflation. However, as long as the Fed is truly independent, QE3 will not happen.
Disclosure: I am short DBO.