Quantitative Easing 2.0- What It Means for the Investor
It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning. — Henry Ford
What is Quantitative Easing?
Perhaps the single hottest phrase to come out of the Financial Crisis of 2008 has been "quantitative easing." While the phrase sounds technical, quantitative easing is actually easy to understand. Simply stated, quantitative easing is a form of monetary policy where the Fed purchases securities in the secondary market. The primary difference between "quantitative easing" and normal "open market operations" conducted by the Fed is what types of securities are bought. In the course of conducting daily monetary policy initiatives, the Fed may buy or sell $Billions of Treasury securities. This buy/sell activity is called "open market operations." When the Fed buys securities that are not issued by the Treasury, we call this "quantitative easing." The intended result of both operations is to inject money into the economy.
When the Fed buys securities, it will create money ex nihilo (a great Latin euphemism for "out of thin air"), and, in exchange for the securities it buys, it will funnel newly printed money to the financial institutions that sold the securities. It's a way of injecting liquidity into the capital markets and is, therefore, considered a stimulant for the economy much like a triple shot of espresso is considered a stimulant for the human body. It may be helpful to imagine the following transactions taking place at many banks across the country:
Quantitative easing, or "QE" for short, has been tried once before recently. "QE 1.0," as the first version is cleverly referred, entailed a $1.7 trillion purchase of mortgage-backed securities and Treasuries that ended in March of 2009.
Why are Capital Markets Expecting More QE?
While the jury is still out on exactly how much QE 1.0 helped the economy, the idea of a second round of QE surfaced when the Fed announced at its early August 2010 Federal Open Market Committee (FOMC) meeting that it would "continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature." They also intend to reinvest proceeds from maturing mortgage-backed securities. The official press release contained the following explanation: "The pace of recovery in output and employment has slowed in recent months" and the Fed would "continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability." QE is certainly one of the Fed's "policy tools." And, the Fed was concerned about the deceleration of the recovery over the summer. The statement was signaling a willingness to act in some way to revive a sluggish economy.
At the Fed's September 21st FOMC meeting, the Fed kept rates unchanged and announced no new program to buy Treasuries. However, they did take pains in their public comments to analyze the current low levels of inflation and persistently slow economic growth. The Fed appeared to make the case that as long as inflation expectations remained stable, they could proceed with alternative measures to stimulate the economy. And that's a key point – QE is inflationary. It leads to the printing of money out of thin air. Eventually too many dollars end up chasing too few goods and prices escalate. As long as inflationary pressures remain contained for the moment, the Fed can consider money printing a relatively safe option.
But if the statement from the September 21st FOMC meeting made any point exceedingly clear, it was that the Fed remained concerned about the tepid recovery. The following chart of the Index of Leading Economic Indicators shows what the FOMC members were seeing at that time – low prospects for future growth.
Knowing that the economy was decelerating, the Fed statement in September seemed to indicate a willingness of the Fed to embark on "QE 2.0." You may have heard the financial media and blogosphere refer to the next round of QE as "QE Lite" or "QE 1.5." Apparently, the markets do not expect QE 2.0 to be the size of QE 1.0. However, there is no indication of the size of the intended purchases. It could be more or less than QE 1.0. All we do know is that the Fed is concerned about the pace of the recovery and that they are ready to act.
Will QE 2.0 "Work"?
Before any prescription is given to a patient by a doctor, the doctor first diagnoses the patient. How else would the doctor know how to proceed with treatment? The same is true with policy makers at the Fed. They will want to know what ails the economy. Thankfully, it is apparent that the Fed knows that the core of the US economic problem is unemployment. Further, the Fed is aware that even the employed consumers in the US are undergoing a massive deleveraging. People who are not employed do not create demand for goods and services. Similarly, employed people who are paying off debt do not create demand for goods and services. So the question should be whether creating money out of thin air will help create jobs and demand.
The answer, we think, is "no." Our current problem is not a monetary one. The financial system does not need more liquidity.
Banks are not using the money they do have to create loans, as the chart above depicts. Note that "excess reserves" are dollars that banks could lend if they wanted. Currently, banks in the US could lend $1.1 Trillion if they were so inclined. But those dollars are not being loaned. That could be due to the unwillingness of banks to supply the market with loans, or it could be that consumers are not demanding loans currently. It really doesn't matter, however. Adding a supply of loanable funds into a pool that is lying idle will have absolutely no impact on the real economy whatsoever.
What Effect Will QE Have, Then?
We're confident that the Fed knows QE will not impact the real economy. It will only impact the financial markets. The Fed is probably hoping financial markets will help generate economic growth indirectly. This can be accomplished in two ways: (1) through the "wealth effect" and (2) through dollar destruction.
The "wealth effect" explains the propensity of consumers to spend more when they feel like they are wealthier. For example, when a consumer's 401(k) through his employer is worth $250,000 he is likely to spend more than he would if his 401(k) had dropped to $100,000. The consumer cannot spend his/her 401(k) until retirement, yet still the feeling of wealth contributes to his willingness to consume now. QE will lift all financial asset prices and this will ultimately lead to higher 401(k) balances. In this way, QE can act as an indirect stimulus to consumption spending.
Another indirect way to stimulate the economy through QE is to destroy the value of the US dollar. If the supply of a currency is increased (and that's what QE is all about), all other things held constant, the price of the currency will drop. A sinking dollar will increase prices on all assets denominated in dollars – stocks, houses, bonds, commodities, bread, gold, etc. This would obviously contribute to the "wealth effect" mentioned earlier, but it would also ignite more risk-taking. And economic risk-taking can create economic growth. At the very least, no economic growth can occur without taking risks.
The potential impact QE 2.0 can have on the financial markets can already be seen when we examine what has happened since the September 21st Fed statement. We would expect stocks, bonds, commodities and gold to appreciate and we would expect the dollar and interest rates to depreciate. That has indeed been the case since the markets became convinced that QE 2.0 was right around the corner.
But we would be remiss if we did not show the following chart which tracks the behavior of interest rates during QE 1.0. Note that even though the intent was to keep interest rates low (especially mortgage rates) the actual result of a $1.7 Trillion QE project was that rates actually went up after a brief one-month retreat. There is always the risk that other economic factors will outweigh the Fed intervention.
And as if the risks themselves were not enough to warrant a second opinion on the need for another foray into the land of the Fed bond-buying, consider this: since July 2010, the Treasury Department has auctioned off $200 Billion in 7-, 10-, and 30-year Treasury securities. If the Federal Reserve now intends to buy, say, $500 Billion in QE 2.0, we're not sure the left hand knows what the right hand is doing. Why would the US policy makers want to add $500 Billion in liquidity to a system that is actively removing about $70 Billion per month from that very same system? One would have to conclude that it is now apparent that even the Federal Government knows that liquidity is not the problem and that there are, therefore, limitations on what impact QE 2.0 can be expected to produce. We're sure that Henry Ford, quoted at the top of the first page, would be at a loss to explain this seemingly contradictory behavior.
QE will not directly help this country out of its economic doldrums. It will, however, inflate certain asset prices to the extent that a bubble may result. If there is no direct economic benefit we must wonder if the little reward is worth the risk of sparking inflation.
Another point of concern is that the Fed said that it will be targeting longer-term Treasuries to reinvest in. This would prop up the value of longer-term Treasuries and, therefore, reduce the yield on those securities. Banks make a significant portion of their profit from the difference in yields on long- and short-term interest rates. QE will compress that difference and, therefore, the profit of banks. After the financial regulatory reform bill becoming law and the new international banking standards being passed at Basel, Switzerland, one could legitimately argue that the unintended consequence of weakening the US banking sector would more than offset any benefit from the QE. And it is difficult to envision a robust economy coming out of an environment where banks are struggling.
Additionally, markets may take QE 2.0 in a perverse way. Now that the markets expect QE 2.0, at least some of those expectations are already reflected in the price of assets. It is now possible that good economic news would actually upset the markets because the stronger the economy, the less the need for QE. Strong economic news may indicate less willingness on the part of the Fed to continue with QE 2.0 at its previously intended levels.
Based on the results of QE 1.0, the markets have already factored in $500 Billion of QE 2.0, according to Deutsche Bank AG. A surprisingly good employment report October 8, or any other pleasant surprise, is likely to trigger a significant reversal of what has already been factored into financial market prices.
It is a dangerous game that the Fed is playing and in our opinion, one not worth playing at all. But if you are an investor that has put off purchases of hard assets or other "inflation plays," now might be a great time to look at how your portfolio would perform in an environment of artificially induced price inflation. QE is, after all, inflationary. Investors should know that history shows that the Fed is not very good at taking away the punch bowl before too many people get tipsy.