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Saturday, January 29, 2011

QE is not Inflationary, Thoughts on Risk Asset Instability

"QE is not inflationary". What are you smoking binv? Everything in the US from stocks, to oil, to junk bonds, to toilet paper is going up, so that must mean Quantitative Easing is inflationary ... right?

No. it's not.

It is not incompatible to have a non-inflationary QE program and a rising stock market (or really a rising set of any number of risk assets). And it is a far more dangerous long term scenario, that will lead to risk asset instability.

But first, let's tackle why QE is not inflationary.

'QE is money printing, which makes it inflationary'. Except that it's not. Quantitative Easing is an asset swap. At the end of the day, it is nothing more fancy than that. The Fed takes reserves and purchases Treasuries. The main goal of QE as stated by the Fed back in Sept/Oct was to lower long term interest rates, which will stimulate borrowing and then eventually stimulate the economy.

That is all that is taking place. This results in both intended and unintended (and I have rethought which was which in the past few months) consequences. But it is not inflationary. And the key to understanding this is to understand the role of the Treasury/Fed interaction. I have gone through this in detail here (The Matter of Deficits, Sovereign Default, and Modern Monetary Theory) and here (The US Treasury and the Federal Reserve: Redundant Institutions). Both of these pieces were influenced heavily by The Pragmatic Capitalist who I believe understands the current reality of Fed / Treasury operations better than anybody.

Here is the highly simplified and shortened version of the two posts above:

Treasuries do not fund anything. Once upon a time (prior to 1971) they did. But they are no longer a fiscal (financing) tool. They are a monetary tool. Treasury issuance is the mechanism by which the Fed maintains its overnight rate. The Fed purchases Treasuries in order to soak up excess reserves. That's it.

Think of it like a savings account vs. a checking account. Cash is an extremely short term asset (which is by definition a government liability) and a Treasury is a longer term asset. They are exactly the same thing other than interest and duration to maturity. The primary distinction being 'liquidity' and interest. So swapping one for the other simply moves money that institutions hold as a 'savings account' (longer dated Treasuries) to money in a 'checking account' (Cash). If you want to explore this in more detail, I would recommend here and here.

At the end of the QE transaction, the same amount of net financial assets is *exactly* the same (see here). Publicly held treasuries are swapped for cash.

This is the critical point that leads to two observations:

1) QE is actually deflationary since it takes an interest bearing asset away from the public and swaps it for cash.
2) There is more cash (a zero-maturity asset) -> There is more liquidity in the system

Now here is where we get to risk assets. The Fed stated that the primary goal of QE-II was to bring down yields on the long end of the curve by buying those Treasuries (thereby increasing demand and driving Treasury prices up). What has happened in reality? The exact opposite. Long Term Treasuries yields have actually been *increasing* since QE-II has transpired.

Strike 1 for Ben, right? Maybe. But just thinking like bond holder for a second, if a large institution (such as the Fed) with a huge amount of reserves was able to soak up a large amount of Treasury selling, then why not sell some now and purchase later? Think of it like this, if all the long term Treasury holders go to sell at the same time, prices will plummet and yields will skyrocket. But if a party steps in and says 'I am buying half a trillion or so of long term Treasuries', then why not sell part of your position and book some profits? If a number of people think think this, and it is larger than what the Fed is purchasing, then prices will drop based on the selling pressure. But it would be less than it would otherwise be since the Fed has announced that it is a large buyer. And since you are a bond investor, and you are smart, and you understand that QE is deflationary (from observation 1 above), then likely you will get a chance to repurchase your Treasuries at a better price sometime in the future (from the current selling activity) and prices will likely recover.

So with respect to the Fed, having failed at their primary reason for QE-II could be for two reasons: i) They did not understand that this would happen (unlikely) or ii) This was not in fact their primary reason for QE-II.

Which ties into observation 2 above: There is more cash (a zero-maturity asset) -> There is more liquidity in the system

Treasuries prices are falling and there is more liquidity sloshing around in the system. This means that risk assets are going to get a bid, and big time. And that is exactly what happened. There are many who called this, including most notably David Tepper, back in September and it is clear they were right.

A few things had to happen to this to play out. Excess liquidity by itself does not necessarily mean that all risk assets get a bid. But with stocks in particular, all of the dominoes did in fact line up:

a) There had to be actual GDP growth occurring (which there has been)
b) Earnings has to be growing (and they have been)
c) Corporate balance sheets had to be improving (and they did)

Those combined with the excess liquidity sparked a supercharged rally. Again, I give nothing but props to those that saw this setup manifest like this.

So, in retrospect, the real reason for QE-II was so that the Fed could add a Third Mandate:

To keep risk asset prices higher than they would otherwise be

So while I think that the next few years will likely see a continuation of this cyclical bull stock market (P/Es are in another expansion cycle right now, and the market is getting a goose from excess liquidity), this gets at the heart of why I think this is unstable over the long term.

I talked about many of these thoughts here: Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market?

For the short term, the psychological impact of QE2 has a huge boost on the stock market. And the FED can pump liquidity (and extra liquidity usually finds its way into risk assets) all it wants. It is, after all, the Central Bank. And over the short term and intermediate term, risk markets respond 'favorably' to this excess liquidity.

But over the long term, as economic fundamentals cannot support the revenue streams to generate the earnings that artificially inflated stock prices expect to keep growing, then we have crashes. The 2000-2002 crash was based on the unsustainable dot-com valuations. The 2007-2009 crash was based on unsustainable consumer spending due to the housing bubble bursting as well as deleveraging of financial assets tied to the housing bubble. The next bubble will form (and pop) due to excess liquidity sloshing around in risk assets that get completely divorced from sustainable fundamental economic drivers.

This makes this wave a bubble in motion, but I don't think it is at it's popping point yet.

Here are John Mauldin's thoughts on the FED's Third Mandate (which I completely agree with): (see: http://www.johnmauldin.com/frontlinethoughts/thinking-the-unthinkable)

The Fed has two mandates: keeping prices stable and creating an economic climate for low unemployment. I am sure I was not the only one to listen to Steve Liesman's interview of Ben Bernanke this week and shake my head at the spin he was giving us. First, let's set the stage.

In a paper with Alan Blinder early last decade, Bernanke made the case for the Fed to target a specific inflation number, and the number that came to be accepted as his target was 2%. In his famous helicopter speech in late 2002, he assured us that inflation could not happen "here," even if the short-term rate was zero, because the Fed would move out the yield curve by buying large amounts of medium-term bonds. This would have the effect of lowering yields all along the upper edge of the curve. This became known as quantitative easing. In Jackson Hole last summer, he made very clear his intention to launch a second round of liquidity-injecting quantitative easing (QE2). In that speech, in later speeches in the fall, and in op-ed pieces he said that such a program would lower rates.

Then a funny thing happened on the way to QE2: long-term rates began to rise all over the developed world. As Yogi Berra noted, "In theory, there is no difference between theory and practice. In practice, there is." It's got to be driving Fed types nuts to see the theory of QE, so lovingly advanced and believed in by so many economists, be relegated to the trash heap, along with so many other economic theories (like that of efficient markets). The market has a way of doing that.

So, Liesman asked Bernanke about one minute into the clip (link below) about the little snafu that, following QE2, both interest rates and commodity prices have risen. How can that be a success? Ben's answer (paraphrased):

"We have seen the stock market go up and the small-cap stock indexes go up even more."

Really? Is it the third mandate of the Fed now to foster a rising stock market? I wonder what the Fed's target for the S&P is for the end of the year? That would be an interesting bit of information. Are we going to target other asset classes?

Understand, I am not against a rising stock market. But that is not the purview of the Fed. And certainly not a reason to add $600 billion to the balance sheet of the Fed when we clearly do not understand the consequences. If it looks like they're making up the rules as they go along, it's because they are.

Here is the clip: http://www.cnbc.com/id/15840232/?video=1742165849&play=1

Excess liquidity is a very powerful blunt instrument. As I pointed out in Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR

First, we have the credit bubble bursting. In 2007, We are coming off a flat, and sometimes even inverted, yield curve in 2005-2006 and the curve begins to steepen. This is a sign of things to come. Financials are in horrible shape. Leveraged to the hilt and untrusting (LIBOR is at >5%), it takes only the exhaustion of bullish euphoria to start the avalanche. Financials lead the slide down, the yield curve continues to steepen, confidence and over-bullishness is replaced by fear.

Next we have the Great Deleveraging Event of 2008. It is clear the game is up and everybody has to liquidate their over-leveraged positions. We see some interesting behavior take place. The Dollar rallies, as people fly into Treasuries as a safe haven move (not unexpected). The Dollar doesn't rally because it is "strong", it rallies because it is "in the way" (by definition, you have to move assets into US Dollars to buy US Treasuries).

But we also have a very steep drop in LIBOR during the deleveraging crisis. Why is that? If everybody, most especially financials are scared, because there is a deleveraging and liquidity crisis, why would LIBOR go down?

Because the Fed was pumping the system with Dollar Swaps!!

**If you want the real reason for the "bottom" in March 2009, there it is.**

All arguments for compelling valuations are BS, or "once in a lifetime buying opportunities" are BS. We stopped the freefall NOT because the market said "no mas", but because the Fed stuck an inflatable pool halfway underneath the cliff divers trajectory. It forced liquidity into the system as it was seizing up. If you really want to understand this issue, read Kristjan Velbri's excellent post Dollar Liquidity Swaps & The Financial Crisis.
[ edit: His site looks like it has expired, that is a shame :( ]

The FED is playing a dangerous bubble game here. The term 'papered-over' has become overused. But it is still apt. The idea is that a rising stock market will create a 'wealth effect' and encourage people to spend more and take on more debt to generate economic activity. I think this continues to be a bad assumption. The consumer is deleveraging (and *needs* to). House prices are still depressed. We are still in the midst of a private sector balance sheet recession. The consumer will not lead the way to a major economic upturn. So a rising stock market without fundamental backing is destined to be simply another countertrend rally (just like 2002-2007 was).

But that is for the long term. Intermediate term (the next couple of years), there is no reason why this (unsustainable in the long term it may be) can't be fuel for a continued cyclical bull market rally.

Obviously there are other factors at play, but I would consider this to be a checkmark in the bull's column for now.

The Fed wants a risk asset rally, and it got it. And it wants the cyclical bull market to continue, and I think it will do that too. It's primary goal is to create a 'wealth effect' from a rising stock market. While that might have some short term impact, it has a very dubious long term impact: http://pragcap.com/robert-shiller-debunks-stock-market-wealth-effect.

But keeping asset prices 'higher than they would otherwise be' will create instabilities. Which means before this cyclical bull market is over we will see another very volatile period like 2010.

Make no mistake however, excess liquidity does not equal economic activity. It will amplify stock market signals (rallies) based on economic growth (which there is), but will also amplify downturns when said growth stalls (and it will). Feedback works both ways, as any signals engineer will tell you.

QE, while not inflationary, does create excess liquidity which acts like an amplifier. Which means that there exists the increased potential for instability. And I don't think many people are appreciating that fact.

For some thoughts on how that could manifest, see this: Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'
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