QE2 AND THE LIQUIDITY “BLACK HOLE”

I’ve been harping on this for months now and it looks like the message is getting across just in time.  Yes, just in time for the end of QE2.  As I mentioned over 6 months ago, QE2 is a monetary non-event.  It adds not one penny of extra liquidity or money to the banking system.  And it looks like Wall Street is finally beginning to realize this (as the evidence now clearly shows).  This note from Deutsche Bank describes (in retrospect), what I discussed back in August 2010 (courtesy of FT Alphaville):

“The $2 trillion in purchases have literally gone down a black hole. Required reserves haven’t been required to increase and the Fed reserve add has literally simply been hoarded as cash. Excess reserves at the Fed have subsequently soared by the same. In short, QE has been a spectacular disappointment in its impact on bank lending, whether via whole loans or securities. It was as if the banks conducted the very sterilization of QE that many thought perhaps the Fed should do to “contain” inflation expectations.

Risky security prices have risen since QE but not Treasuries, the main instrument of QE2. Yet banks’ balance sheets have gone sideways. Effectively investors have marked asset prices higher and circumvented the banks. It is as if the first purchase by the Fed from an investor simply triggered a series of deposit for security switches through the investor base with banks never making an additional loan. This is consistent with a greater concern for risky asset post QE2 end, than Treasuries. The danger for investors is that they confuse the result of higher asset prices as reflecting excess liquidity rather than “irrational” exuberance given that actual liquidity (as broadly defined by the banking system) hasn’t gone up at all.

For all the worries about the end of QE2, the focus should be on how we came about the “risk on” trade and elevated asset prices. It was not through revitalized bank lending. There is no banking system that is standing on its own two feet and propelling growth forward. It remains like a herd of deer in the headlights – ready to hand the cash straight back to the Fed when asked for. If risky asset prices were elevated because of the expectation of a kick start from the banks, they are at risk of falling. Treasuries are immune because no one could buy them as the Fed purchased them. There is no call on loans that funded Treasury positions through QE2. Moreover if the banks slowed the pace of deleveraging (deposit destruction) because of the safety of their cash hoard, there is a risk that they may become even more recalcitrant.”

I should add that there does appear to be an increase in lending in one area – the borrowing of funds for purposes of speculative investments! Other than that, this note sounds all too familiar.  Never in the history of markets has there been a program more misguided or misunderstood….

Source: FT Alphaville

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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