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Quantitative Easing: What Needs To Happen

|Includes: SPY, iShares TIPS Bond ETF (TIP)

I'm writing this from the airport in Chicago without WiFi or outlets, so I have no external information at my disposal, nor do I have an endless power supply. Don't even start me on why this airport has ZERO outlets, it doesn't make sense, and is counter-intuitive.

I am writing this because I need to update everyone on what's going on. There is so much unprecedented, bubble-creating stimulus popping up so I feel that there's a need to enlighten you, as it affects the future of our undeniably globalized economy.

Ever since the financial crisis of 2008, central banks across the globe have decided that unprecedented monetary stimulus (Quantitative Easing, or QE) is the solution to reigniting consumer confidence. If you look at the facts, it does nothing. QE is completely unnecessary. Let me back up. Here's the structure of how quantitative easing works:

1) The Federal Reserve prints money so that it can purchase $45 billion worth of US Treasury Bonds, and $40 billion worth of mortgage-backed securities (these numbers are on a monthly basis).

2) There are certain financial institutions that package these products, and those institutions sell these securities to the Federal Reserve.

3) At this point, you would think that the banks that receive $85 billion a month would turn around and lend this money, or at least somehow inject it into the economy. Nope. The money these institutions are receiving from the Fed is being stored away somewhere. Where? The Fed. They money doesn't even move. These banks just keep it there. So much for reducing unemployment and raising inflation, right?

As you can see, QE doesn't do anything to ignite demand whatsoever. This program just makes the rich wealthier, and provides a cushion for the stock market. Nay, QE straps a rocket launcher to the waist of the S&P500 Price-earnings ratio (P/E). Markets just don't stop. As long as QE stays on course, the market will keep on reaching for the sky. The S&P500's P/E multiple is expanding too fast and nobody wants to admit it. Market experts claim that people are betting on the long-term future of the economy. That's simply not true. There isn't any data that supports the claim of a flourishing US economy in the long term. Unemployment is only decreasing because we are in midst of the lowest employment participation environment in decades.

On top of the runaway train that is the S&P500, we are currently experiencing a HUGE reflationary disconnect (the graph below illustrates the ratio between inflation expectations (NYSEARCA:TIP) and the S&P500 (NYSEARCA:SPY), if you see a falling ratio, it means the denominator is outperforming the numerator):

In a normalized economy, inflation expectations and the equity benchmark are supposed to have a positive correlation somewhere around 1. Obviously the correlation will never be exactly one, but if you observe a 1-2 year graph of inflation expectations vs. the equity benchmark, you will see that they are somewhat positively correlated. Not only are they not directly correlated at the moment, but they are negatively correlated (currently -0.82, as seen in the bottom of the graph labeled $SPYX Corr(20))! Inflation expectations are moving downward while the S&P500 is going up! Historically, these instances have always been followed by an equity benchmark crash. I'm not suggesting there will be a crash, just simply pointing out that the S&P500 is not supposed to reach for the clouds while very real deflationary pressures loom.

The only thing that could make this situation even more ridiculous is if we were currently implementing ZIRP (Zero-interest rate policy). Wait, what? WE ARE? So, you're telling me that ZIRP and QE can't inflate our economy? Apparently not. ZIRP has helped the United States achieve nothing but the creation of another credit bubble, which hasn't even spurned inflation. You would think that lending exuberant amounts of money to consumers with no cost to them would encourage spending, but it hasn't. Nothing has.

My temporary solution to low inflation: Implement a negative Fed fund rate. What would a negative Fed fund rate accomplish? This is how it works:

- Right now, the reason that banks stash their QE money away at the Fed is because they make 0.25% on it for letting it sit there. They aren't doing anything with it.

- Say we implemented a -0.25% Fed fund rate. This would give banks incentive to take the money out of the Federal Reserve because if they kept it there, they would actually owe -0.25% to the Fed, instead of the Fed owing them.

- If there is policy that can be implemented to ensure the ethical use of the newly withdrawn money (I.e. lending it to the public), then I believe this could give inflation the little boost it needs.

- This could also help ease hyperinflation worries that economists have been expressing.

The current reflationary disconnect is dangerous, and it needs to be avoided.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.