June 26, 2011

Why QE2 failed & why its end will bring lower Treasury yields

June 26, 2011

Why QE2 failed & why its end will bring lower Treasury yields

Some folks think that because the Federal Reserve will soon stop its daily purchases of Treasuries per Q2, Treasury prices will go down and yields and mortgage rates go up. I think this view is completely inaccurate.

As QE2 ends, let’s to try to figure out what it did. Quantitative Easing-Round 2 was a $600 billion increase in the money supply.

This worked by having the Federal Reserve create money each day and use that to buy Treasuries on the open market. The first order result is that the Fed has the Treasuries and the people who previously owned them have cash. Essentially all of that was redeposited into the banking accounts of those who previously owned this debt. This created an immediate increase in money supply.

The idea is that putting money money into play stimulates the economy. Is this what happened? Absolutely not.

What happened to the QE2 dollars?

Something like this: the Fed creates money and buys Treasuries. These dollars are now in a bank account of the previous owner of the Treasuries purchased by the Fed. The client who the had those dollars may have purchased equities or commodities with them increasing the price of the equity or commodity and passing those dollars along to the previous owner of the equity or commodity. Those dollars keep moving a few times and the effects were:

(1) higher commodity prices,

(2) a weaker dollar, and

(3) higher equity prices.

The dollars all wind up as excess reserves but these are not dead dollars. They are still available if the account holder wanted to bid up equities or commodities (or something else.) The buying up of commodities was done by wealthy individuals, hedge funds, and commercial banks. Those folks, mutual funds, and individuals also contributed to buying up of equities.

QE2 (1) pumped up equities,

(2) increased commodity prices,

(3) weakened the dollar (consequently increasing GDP), and

(4) prevented deflation.

At the point where equities and commodities were bid up to the point where no one was stupid enough to believe they would go up any more, the bidding up of equity and commodity prices stopped.

Whatever QE2 may have been it was not stimulus. Interestingly, this past week Bernanke increased his estimate for inflation slightly. The cause of this inflation was QE2. The bidding up of equities created a bit of good feeling but little wealth effect (when people spend more because the value if their assets increased.)

What will the end of QE2 mean?
Lower commodity prices, lower equity values, and a stronger dollar which will after 6 months weaken exports and increase imports lowering GDP. A weak dollar caused by QE2 helped GDP by increasing exports and decreasing imports.

QE2 did not result in more bank lending.

The net amount of bank loans which were closed during QE2 was about half the size of QE2. Bank lending is not the root cause of economic stimulation but marches hand-in-hand with it. The cause of economic growth is a combination of consumer confidence and new things such as the commercialization of the Internet. Banks will make loans when there are profitable loans to be made.

In a sense what the end of QE2 means (and I thank Jim Grauer for formulating this) is a move from commodities to paper.

With the economy flat and commodities being bid down there will be little to no concern about inflation and we will see that Treasuries are bid up and the 10-year yield move down near 2.5%. The fact that the Treasury techs are bullish indicates that investors are already presuming this.

Treasuries will become a safe-haven because:

(1) commodity prices will fall, (2) The dollar will be strong,

(3) confidence in the economy is weak,

(4) alternatives (the Euro and the Yen) have their own problem.

Treasuries will be the “best of the worst.”

Bill Gross and many other folks have assumed that the values of Treasuries would go down and gotten out of them or even shorted them. If Jim Grauer’s view is accurate then Gross will have a lot of ‘splaining to do.

The sad part of QE2 was that by weakening the value of the dollar and increasing commodity prices (which are all priced in dollars) the average guy was hurt by higher energy and foods costs. In addition the increase in the value of equities was offset by the weaker value of the dollars in which they were priced. This could result in increased public distrust of the Federal Reserve. This will become another song for politicians desperate for reelection.

In addition that $600 billion is now parked as the Fed as excess reserves. For now this is not a problem but it makes more difficult drawing down the money supply at some future date when it becomes necessary to stem inflation.

Look at this Federal Reserve report of aggregate banking reserves

When QE2 started, the 4th column Excess Reserves parked at the Fed was $972 billion. On June 15 excess reserves parked at the Fed was $1.610 trillion. Since the start of QE II excess reserves went up $638 billion. This is larger than the $600 billion QE2. While the money from QE2 wound up back at the Fed, it did not get there directly but was spent several times pumping up equities and commodities but not the economy. That money is still out there and available to the owners of the banks’ deposit liabilities to deploy. They are unlikely, in the next couple of quarters to be deployed into commodities or equities.

If the sum of Bernanke’s case for QE2 was that it prevented deflation my reaction is “Yeah, right.”

I do not believe that we were ever in danger of a deflationary spiral. The only significant deflation has been in home values but that is a correction of the damage done by the National Homeownership Strategy, bad lending practices by banks and bogus mortgage secutitization assumptions by the (then) three debt rating firms.

The economy will not grow until the consumer has more confidence. Right now there is nothing (in the short term) to feel confident about. The citizens have near zero confidence in the President and Congress regarding fiscal policy and little understanding of the role of the Fed. The folks in D.C. have been given a blueprint for fiscal sustainability (Simpson-Bowles) but see their own reelection as being more important. Simpson-Bowles is not an austerity plan. It is a blueprint for substantial changes in the tax code and fiscal policy in general.

We are faced with an extremely ugly situation: a dead flat economy which will likely become a prolonged slump and massive deficits. The worst part is that because Japan is hurting and there is a sovereign debt crisis in Europe Treasury yields are low and the pain of these massive deficits is being deferred. Absent some budget balancing plan such as Simpson-Bowles the pain in 2-3 years will be much worse that what we are seeing at present. The national deficit will be a lot higher and the cost of borrowing could rise considerably.