“Woe to the land whose king is a child and whose leaders are already drunk in the morning. Happy the land whose king is a nobleman, and whose leaders work hard before they feast and drink, and then only to strengthen themselves for the tasks ahead”. (Eccl 10: 16-17)

"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat

Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput

Friday, June 1, 2012

The Futility of QE

This is an attempt to explain what I believe will be the futility of another round of Quantitative Easing on the part of the Federal Reserve to do anything more than to merely provide another TEMPORARY boost to paper assets and by consequence, a short-lived blip in consumer confidence. As such, it is going to be much to the point without any rhetorical flourishes or attempts at refined writing.

I do wish to start this brief piece by noting that I believe the Fed is indeed going to act, sooner rather than later, unless they want to witness a meltdown of the equity markets. Practically, for them to stand idly by and do nothing to prevent it would be irresponsible. Yet for all this, the effort is doomed to failure.

Consider the original purpose behind the Quantitative Easing programs – QE1 was designed to purchase Mortgage Backed Securities which had plummeted in value resulting in a serious degradation of the balance sheets of the major banks and firms that held them as assets.

These “assets” had been originally valued on the balance sheets by marking to model. When the credit crisis began in earnest in the summer of 2008, the world quickly learned that these model-based values were a fiction. The real “market” value of this paper was a fraction of what the banks were claiming.

In order to prevent the credit markets from locking up due to insufficient capital on the part of these large lenders, the Federal Reserve decided to be the buyer of last resort and provide a market for these securities, taking them off the books of the banks and substituting high-quality Treasuries in their place. The idea was to shore up the balance sheets of the banks and give them the ability to lend into the economy for both business and consumer needs.

At the time QE1 was embarked upon, the yield on the Ten Year note had fallen as low as 2.03%.  The investment world reacted to QE1 by bidding up the price of both commodities and stocks and actually sending interest rates higher as the impact from this novel program was expected to be an inflationary one. Yields eventually reached 4% before falling back as the impetus from this first round of QE began to fade.

Fast forward to late 2010 – with the economy still sputtering and growth lagging, the Fed announced another round of Quantitative Easing, this time to the tune of approximately $900 billion. The express intention of this plan was to deliberately push down LONG TERM interest rates and increase the money supply in the hopes that it too would serve to stimulate business and consumer spending and borrowing.

At the time just prior to the commencement of QE2, the yield on the Ten Year had fallen as low as 2.33% as deflation fears were running wild once again. The S&P had lost 16% of its value in the matter of a few months time during the middle of 2010 leaving investors desperately seeking some sort of further action on the part of the Fed.

Oblige they did and once again the equity markets rallied as did the yield on the Ten Year which pushed back towards the ceiling of 4% as once again investors were anticipating an inflationary impact from the policy – which by the way it was deliberately designed to do. However, that was the peak in yields which began falling once again in early 2011 this time dropping below 2.0% before bouncing in a narrow range for a period of 7 months. The catalyst for this downward trend in rates was the knowledge by the entire investment world that the Fed was going to end QE2 in the month of June 2011. In other words, this was all it was going to get – look for nothing else.

Moving to the present time, as the European Sovereign debt crisis has worsened and the contagion effect has spread to China and elsewhere, rates on the Ten Year have now fallen below the critical level of 1.8%, which was acting as a floor. As of today, the yield on the Ten Year has plummeted below 1.5% closing into an all time low at 1.467%.

Here is the point – the purpose behind both QE’s was to improve bank balance sheets thereby facilitating lending, keep longer term interest rates low to stimulate borrowing and ramp up the money supply to produce an inflationary impact to offset the deflationary impact of excessive levels of debt.

One could say that it worked; however, it was only temporary. Operation Twist, which was the last pseudo QE that consisted of rolling the proceeds from maturing short-term Treasuries into longer dated Treasuries, has been an enormous flop as it has provided next to nothing in the form of any inflationary impact.

My question is simple – if interest rates at or near 2% on the Ten Year when the Fed has engaged in both former rounds of QE have been unable to sufficiently increase borrowing/spending for any sustained length of time, what makes anyone actually believe that another round of actual QE, when rates are already well below the 2% level (1.467%) will accomplish the least bit of good?

At some point, you end up with interest rates so low that the money might as well be free to borrow – however, no one wants to borrow or can borrow.

So the Fed can buy another $1 Trillion in Treasuries – how about $2 Trillion – why stop there – why not go to $3 Trillion. What good is all this excess money creation going to do if the previous combination of over $2 Trillion in both QE1 and QE2 has done nothing when all is said and done? Interest rates are already lower than at any point in my lifetime certainly. Has that increased business in the housing market or prevented foreclosures from occurring? Again, maybe for a while it has prevented things from worsening even further but as far as actually laying the groundwork for any lasting improvement, I certainly do not see it.

My guess is that when the Fed does act, and I believe the pressure to act is going to be too great to ignore for long, they are going to have to come up with something besides just Treasury purchases. Maybe they will actually buy stocks or stock indices. After all, if they can push the stock market higher and discourage any potential short sellers from entering, the rising stock market would do wonders for investors 401K’s and other retirement plans. Maybe we will get the same sort of “wealth effect” that we got from the stock market bubble of the late 1990’s. That should boost the Consumer Confidence numbers.

Of course I am being facetious here but if the stock markets begin collapsing as they did back in 2008, can anyone rule out the Fed actually buying stocks as part of a monetary policy response? After all, Japanese monetary authorities have discussed this possibility and been quite forthright about doing so.

On second thought - Why bother – why not just directly inject the money into the bank accounts of taxpayers and skip the usual round of injection through the primary dealers and hoping in vain for a multiplier effect.

One thing is certain – monetary policy alone cannot fix what ails the US economy or the Euro Zone for that matter. The problems are deep-rooted and structural and will require wise action, even painful action, by far-sighted statesmen. Short-sighted political leaders, at this point, are merely leading their nations to irreparable harm and will end up dashing them to pieces on the rocks.

In some sense, the public is partly to blame – they are the ones clamoring for all the government handouts and increased services forgetting that government has no money except that which it confiscates from its citizenry in the form of taxes or from the next generation of taxpayers by deficit spending/borrowing. When its lenders decide that they are no longer willing to lend their capital to nations which follow reckless fiscal policy, the gig is up.

Eventually the Piper must get paid his due.

In closing let me leave you with a graph from the St. Louis Federal Reserve showing why QE has produced no lasting effect....

Note that no matter how the Fed tries to expand the money supply, the Velocity of Money (the rate at which money changes hands in the economy) continues to plummet...

FRED Graph

Gold Achieves that "16" Handle

Gold's reaction to the payrolls number this morning was instantaneous - it shot up as if it was fired out of a cannon! As stated in the post on the mining shares this AM, gold is now fully expecting the Fed to move forward with a round of QE3 Sooner rather than later. It is this anticipation of a Fed move that has it blowing the recent hedge fund short positions out. Not only that, the ability to capture this elusive "16" handle and HOLD IT, has fresh money that has been sitting on the sidelines or in Treasuries (obtaining next to nothing for yield) willing to come in on the long side of this market.

Note on the chart that it has run to exactly the 50 day moving average which also happens to correspond to the resistance zone near the $1625 level. A clear push past this level, and it will go immediately to $1650.

Downside chart support is now first at the $1600 level followed by the top of the recent tighter range near $1580.

Mining Shares Continue to Outperform the Broader Equity Markets

The last time we had a THREE CONSECUTIVE WEEKS during which the mining shares outperformed the broader US equity markets was in late October/early November of 2011.  While the  month of May this year has been attrocious for the S&P 500, it has been an excellent month for the miners. June is starting out on a good note to say the least as we witness today's strong upmove in the mining shares.

My interpretation of this event is that today's payrolls number, which was so horrible that it cannot have any sort of positive spin placed upon it, has jolted traders into moving more and more to the view that the Fed is going to act SOONER RATHER THAN LATER on the next round of QE.

New York Fed Governor William Dudley said earlier this week the following according to reports by Dow Jones:

"If the economy were to slow so that we were no longer making material progress
toward full employment, the downside risks to growth were to increase sharply,
or if deflation risks were to climb materially, then the benefits of further
accommodation would increase in my estimation and this could tilt the balance
toward additional easing."

Today's payrolls number, a sinking Continuous Commodity Index, a swooning stock market which is threatening to turn into a downside rout and interest rates plummeting to more than 60 year, if not all-time lows, has met every benchmark laid out in the above quotation.

This is what has gold soaring this AM and the gold shares moving sharply higher. Silver is being dragged higher by gold but has managed to at least climb back above the $28 level. I do not trust silver until it at the bare minimum gets back above the $29 level and STAYS ABOVE IT.

I still think the Fed would like to see gasoline prices move closer to $2.50/gallon at the benchmark Nymex contract (it is currently near $2.66 as I write this) but if the global equity market rout does not let up, they are going to have a full-fledged rout on their hands and thus may not have the luxury of waiting much longer.

The JUNE Fed meeting is obviously going to be a significant event for the markets.

Incidentally, the yield on the TEN YEAR NOTE has now fallen BELOW the 1.5% level. INCREDIBLE!