GUEST CONTRIBUTION: THE GREAT QUANTITATIVE EASING FAIL
Reader Rodrigo was nice enough to send us his excellent thoughts on quantitative easing:
A key announcement was made yesterday regarding the Fed’s Quantitative Easing program.
Quantitative easing is the practice of purchasing Treasury securities (thereby creating a demand for Treasuries) from the open market. To purchase them, the Fed creates dollars, which go out on the market. Fed purchases would keep 10 yr yields (and thereby interest rates) low in order to stimulate the housing market and spark consumption.
At the same time, this practice has weakened the dollar substantially thereby causing hard assets such as oil and gold to rise. Additionally, it also created an inflation premium in the market as investors expected large inflation down the line if the recovery did indeed take hold.
The fed has announced that the plan would be suspended as planned in September. This announcement, while mostly underreported and unnoticed, could have profound consequences over how the market reacts in the next couple of months.
Due to the implicit drop in demand for Treasuries from the gov’t, two important impacts could take place. For one, interest rates will have one big reason to go up from here if the recovery does indeed begin to take hold. A decrease in demand for Treasuries, coupled with continued massive issuance from the gov’t should send yields rising. However, this in itself creates the very force that would doom the recovery. An increase in 10 yr yields will surely increase borrowing costs for consumers ranging from mortgage rates to credit card bills. The stabilization in housing could be undermined and consumption would be curtailed.
A second factor to consider would be the effect the decision would have on the dollar. The dollar, which has weakened considerably over the last couple of months, would have a large bullish catalyst at it’s back, a substantial decrease in the amount of dollars printed.
These two reasons, when joined together, could set up the market for some downward pressure in the next couple of months. Inflation expectations would recede, causing the value of oil, hard assets, and even the stock market (which has priced in an inflation premium) to go down. Couple this with a stronger dollar and this would further strengthen the argument for lower commodity prices. Frankly I believe that this latest bull market has largely been a result of liquidity, not actual fundamental improvement.
Shut off the dollar spigot, and we could truly see if this rally is real or not. Only time will tell, but in my view, I believe the Fed has removed the band-aid on a would that has yet to heal.
Source: RCS
TPC – Thanks for sharing this.
Excellent summation.
As I recall, the news report regarding Fed QE mentioned that the Fed was giving serious consideration to ending QE in September – that news report did not indicate that this was definitive. Since this was “leaked” to the press, it might be safe to conclude that the decision has been made, and that markets are getting the heads up. However, you may have a source that indicates the decision is in fact definitive. If so, a link to that site would be very much appreciated.
QE is one source of “liquidity” injected into the financial system. The buying of mortgage bonds and GSE paper also results in liquidity injections. The Fed, has planned, considerably more purchasing of mortgage bonds and GSE paper. Together, this is “liquidity in search of a home,” to quote S. Roach. The home being, of course, commodities and stocks.
Next week, the Treasury will be auctioning off $75bn Ts, roughly half at the long end. Yesterday’s jobs/unemployment report resulted in a massive sell off of Ts. combined with a significant jump in the dollar. This, especially as it regards the dollar, may only constitute a one day event. Next week should reveal more.
If the sentiment really is that the US economy is on the road to recovery, pressure on T. yields will likely increase (can the same be said for the dollar – flight to risk would suggest otherwise). Granted, with the growing fiscal deficit, massive supply will require massive purchases of Ts through 2009 and likely through 2010. (As an aside note: Declining corporate profits and especially deleveraging restrict capital expansion and run up against Fed efforts to pump liquidity; while the Fed and government have for the time succeeded in keeping deflationary forces at bay, the effort will very likely slip over time. Thus, I expect that at some point, likely next year, QE will be back. To facilitate this, risk and panic will be required to support the need to do so. Since crisis is clearly seen as opportunity in the Obama adminstration, as well as in the Fed, this outcome could very well develop. Pull the liquidity, test the waters, and then lets jump back in.)
Another point: I find it ironic that it is believed that US domestic savers will (and in fact they have been for much of this year), be buying up much of this massive supply of Ts (offsetting a more recent decline of foreign purchases), thus keeping yields from rising too high – yet this saving runs against the grain of the effort to bolster consumer demand.
If the Fed does formally announce next Wednesday that it will end the QE program, one of course has to wonder as to the effects on the stock market. I have my doubts that enough “liquidity” is flowing globally to keep T. yields (not only in the US but globally), from rising significantly while at the same time keeping the stock market climbing. It may be that a rotation out of stocks (though this might take a while to occur), into T.s may be required to keep yields at bay. I assume that the Fed and Treasury have no problem seeing the ten year yield above 4.00, within certain limits. High rates attract buyers. Higher yields also re-enforce the impression of economic recovery. Consequently, any rotation may be limited unless yields exceed 4.00 fairly substantially.
I am of the opinion, and I have no basis on which to assert this – other than an assumption – that commodities will come off before US stocks do, which as a result implies something less than (globally, at least), recovery, which is of course at odds with the prevailing belief. (There exists a contradiction here – added to the one noted two paragraphs previous – that reveal the extent to which liquidity distortions override global economic fundamentals – the later of which are less than supportive of this “belief” in recovery, or at the very least, a sustainable recovery. Instead, this recovery could very well turn out to be anemic as some have postulated. At some point, I expect that the tension between a liquidity driven “belief” in recovery, with evidence of a less than sustainable recovery, will be the primary issue and sentiment driver, very likely before the end of the year.)
Getting back to commodity prices. Commodity price declines, should they occur and should they be substantial enough, would likely carry over to stocks. The key here is the dollar. A strengthening dollar would support this assumption, indicating that liquidity is pulling back.
These are only my thoughts, intended for further speculation.
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