QE Summary: Creating a Different Kind of Depression

Week in review: This week I covered a few topics which are worth combining, since they get to the heart of the inflation/deflation debate, and how the Fed is acting to creating a different sort of depression. The bottom line is that the world has gone on a credit expansion binge since the end of WW2, and the direction of this one way train around will drag the global economy into a depression. Clearly, the Fed is doing all that it legally can, to avoid such an outcome. Along a similar situation, one could say that Japan has been in a depression since 1990, as their over-heated, and debt financed property markets peaked in 1989, and have been slowly unwinding this situation for the last 20 years. Throughout this, the Japanese government has been running budget deficits as a tool to get the country out of its economic malaise, and the Bank of Japan (BOJ) has tried all sorts of easing strategies, which have kept interest rates in Japan, the lowest on the planet. All this notwithstanding, Japan is still mired in a very slow growth environment, and the cumulative deficit now is a 200% of GDP.

I mention Japan because our government is pursuing similar strategies to combat our economic malaise. What is missing in the US and Japan’s response is to deal with the idea that the build-up of debt requires some process to unwind this debt. There needs to be some sort of way to create a balance in the economy, given all this debt, and the fact that the global economy has reached a point where we are running into limits on how much debt the world can carry, and service. Usually the cure involves a cleansing of bad debts and a work out process, something our government has been diligently trying to avoid. Hint – the US government will not be able to pull us out of this depression by the traditional methods which have failed in Japan.

This brings me to the consider what the likely scenario will be going forward:

Point #1> The Fed could keep printing money and replace all the debt in existence with new cash (see Monday’s blog). While this seems ludicrous, some version of this is slowly happening, and the Fed is involved in a PR campaign to grease the skids for undertaking more money printing. The article linked in Monday’s blog is an extreme version of what is actually going on, but helps explain in a very simplistic way, as to what such a future might look like.

The collapse in the mortgage markets and the 27% drop in housing prices since 2006 has had severe effects on the global economy and financial system. Government’s around the world have had to substitute their credit and guarantees to prop up many large financial firms since 2007.

Point #2> The depressed housing market has belatedly started to influence the US’s CPI, and is likely to exert a deflationary influence on all prices in the US for quite some time to come. In turn, this will give the Fed leeway to continue to embark on all sorts of quantitative easing. As Tuesday’s blog illustrates, it is likely that the decline in the housing markets could affect US CPI for a long time to come, regardless as to what the Fed does. In other words, the Fed will be in an easing mode for a very long time, which further supports point #1, that the Fed will systematically replace debt with new cash. That is how the Fed puts new cash into the economy, by purchasing debt securities, and notably, US treasuries for the foreseeable future.

The arrangement of international finance has created a conundrum between the US and its trading partners. With real interest rates at negative levels in 3 of the 4 BRIC (*) countries for instance, money in those economies is being directed toward real assets which will appreciate with the higher pace of inflation. Alternatively, in the US, where real interest rates are positive, money is content to stay invested in financial assets, and out of the real economy. This is especially relevant because much capital is flowing to the developing countries, and away from the US. The flow of capital away from the US to developing countries is also evident by the persistent trade deficit the US is running with the developing countries. Instead of sending these dollars back to the US, our trading partners are hoarding their dollar stash. With money leaking out of the US at some a prodigious rate, it is no wonder that US inflation remains low, and is likely to stay low. As the reader’s comment pointed out yesterday:

“The rational reaction to a debasement of the US dollar should be for nations sell their dollar reserves to preserve the economic rent they have extracted by running many years of surplus. Instead, what do they do? They buy more dollar (financial) assets in order to offset the FX movement driven by the Fed’s money printing. What I find amazing is that the US can’t solve the structural imbalance because it is driven by the irrational actions our trading partners. They have structural financial repression via negative real rates as well as structurally undervalued currencies that are maintained via holding “reserves” – all for what? China’s central bank is accumulating something that the US can create at will: dollars.”

Point #3> In order to create incentives for money to move from financial assets to real assets, the Fed will need to either stoke inflation, bring interest rates to zero, or both. This supports the thesis presented in points 1 and 2 above, namely, the Fed’s ambitious plans to continue to print money.

Point #4> In yesterday’s blog, a reader raised the topic of the Taylor rule, which is a methodology to determine what the real interest rate should be in order to create a balance between inflation and full employment. According to this methodology, the Fed will need to put another $1.5 to $2 trillion of new money into the financial system, and as the reader points out, if the Fed wants to over-shoot its target, as it has in the past, then as much as $4 trillion will be injected into the financial system.

* Conclusion – by many metrics, it appears inevitable to me that the Fed will have to print more money, ultimately into the trillions, and engineer much lower interest rates. Throughout the 1940s, the Fed kept a 2.5% cap on long term interest rates, even though inflation ran at 12.5% for 2 years. Even if the Fed has to support the treasury market in the face of foreigners who might want to sell our debt, to the tune of trillions of dollars, they can do so, and has shown this resolve in the past.

* Tactics – if you have been following this blog’s recommendations, you will recall that I was bullish on bonds in April, when the 10 year treasury rate was near 4%. Unfortunately, I only stayed the welcome into the very low 3s, and have missed the last 50 bps or so of the move. In the current environment, there is such tremendous optimism about what the Fed will do when they meet next week, that it seems to me that being long bond duration is a crowded trade. Bullish consensus numbers from the futures markets has recently showed 90+% readings, another sign that this is a crowded trade. My best recommendation today is to wait until the Fed’s meeting next week, and look to buy duration on a market pull-back, following the Fed’s announcement, which in my opinion, will not match the optimism built into the current level of interest rates. The Fed should announce some form of QE next week, but it will fall short of expectations of $500 billion to a $1 trillion of new bond purchases/money printing. And when all the fast money leaves this trade, yields will likely be 10-30 bps higher, and that will represent a better time to buy bonds/duration.

* Blog Humor #1 – see attached

* Blog Humor #2 – check out this reader’s comment:

“(Here is my) theory of relativity: as interest rates approach zero, investor intelligence approaches dumbness.  When interest rates reach zero, investor intelligence reaches absolute dumbness.  No investment strategy can go beyond absolute dumbness.  Mathematically, the theory can be written as

D=r/1 where D=dumbness and r=interest rate.

I hope to expand upon this theory in an upcoming issue of financial analyst journal and if all goes well, you may see questions pertaining to this ‘profound theory in level 3 of the CFA exams.” (end of reader’s comment)