Last week, Ben Bernanke announced the Fed's decision to employ 'Quantitative Easing' (QE), the 'nuclear option,' to save the credit market and the economy. On the news that the Fed will buy back up to $300-billion worth of long dated US treasury bonds, and acquire an additional $750-billion of mortgage backed securities, the US dollar plunged, the euro surged, Treasury yields nose-dived, gold bullion exploded, and stocks, oil and commodities gained handsomely.
We know what the immediate reaction has been to this, but what does it all mean in the longer term?
The main design of QE is to supply the money, by printing it, that is required to fulfill current demand for money arising from the deleveraging of balance sheets. Buyers need to be able to access credit and cash in order to purchase assets from distressed vendors. If purchasers cannot be facilitated via the market, the bids for the assets will keep falling until they can. QE means to provide the stop-gap measure. The other purpose of QE, is to make it possible for the Fed to enlarge its own balance sheet by assuming or acquiring 'toxic' assets in return for retiring debt from banker debtors, so that they can be freer to resume lending.
Until now, the deleveraging of market assets in favour of debt reduction has resulted in strong demand for cash, such that it has given the dollar a disproportionate boost - hence the strangely strong dollar.
Prior to the Fed's move last week, this quote describes the current nature of the strong US dollar, from FT.com:
Hans Redeker at BNP Paribas said under normal circumstances, a rising deficit works against the domestic currency. “However, in this environment, deleveraging by institutions in order to clean up balance sheets will provide the dollar with a natural bid,” he said.
This deleveraging helped create a dollar shortage that drove the US currency sharply higher against the euro after the collapse of Lehman Brothers last September. Analysts said a similar situation seemed to be developing as equity markets plunged below their lows from last autumn.
The following is an excellent tutorial from Marketplace.com on Leveraging and Deleveraging:
Leveraging and deleveraging from Marketplace on Vimeo.
Quantitative easing supplies the cash via the printing press to those institutions in need of cash in return from the sale of levered assets, in the form of credit for buyers of liquidated assets. With credit for the purpose of re-purchasing distressed assets unavailable to would-be buyers, the market for those assets has suffered immensely; stocks, bonds, real estate, etc. As for the CDOs, only a daring breed of investors have shown interest, but they too may find it hard to get the credit to make it worthwhile, or the concessions and covenants.
The following is a tutorial from Marketplace.com on Quantitative Easing:
Quantitative easing from Marketplace on Vimeo.
Effectively, when you sell (or short) assets, the end result is that you end up long the cash. For those seeking to reduce debt, the cash disappears into the money pit, returning to the lender's balance sheet. For those selling assets because they are risk averse, the money ends up for the time being in now zero-interest treasuries and short term cash equivalents. Therefore you end up with a strong dollar. When the market was over-using credit, it was short the dollar and the dollar was weaker. Now that the market is in a debt-reduction or deleveraging mode, it is long the dollar, therefore the dollar gains strength.
The Feds decision to employ the 'nuclear option' of QE sends a signal that there may be a great deal more deleveraging in store for the economy and there is substantial need to supply the money.
The immediate reaction is the weakening of the dollar, but that just provides temporary breathing space until the subsequent rounds of deleveraging sop up the slack created by QE, and what follows is a revitalized dollar, strengthened yet again by the deleveraging.
Graduated QE will periodically and gradually weaken the dollar, as it is dilutive, but the take up created by graduated deleveraging will gradually renew dollar strength. Ideally, if all the central banks in the G6 resort to this, there will be balance, but the timing may at times prove to be skewed by the independent agendas of the UK and the ECB.
The bottom line is that this first round of QE is just that. The first round. Bill Gross, Managing Director, PIMCO, points out that while it is a good move, it may not be enough, and that the Fed may have to expand its balance sheet to $5 or $6-trillion, as it takes $4 of debt to generate $1 of GDP growth.
Bill Gross: No, I agree with all of that. Its just a question, Kathleen, of ‘how big of a kick?’ There are a number of ways of looking at this. Goldman Sachs has approached it from the standpoint of the Taylor Rule, the deficiencies of output relative to their own particular index.
We look at it a little bit differently at PIMCO, we look at it from the standpoint of the amount of debt that’s required to produce a dollar’s worth of GDP growth. And up until 12-18 months ago in terms of our existing economy, that was about $4 of debt for $1 of GDP growth.
This $1-trillion dollars to our way produces $250-billion of GDP; that’s just under two percent real growth. That`s good, that produces in our opinion about 1-million jobs, but we need more than that.
KH: Is it enough to avoid the mini-depression you were talking about last month when I joined you for an interview out there at Newport Beach?
BG: We think so, you know yesterday’s move by the Fed were in recognition of this recessionary economy that could have resembled a small depression unless credit markets and risk taking were revived. And in fact the Fed labelled their policies ‘credit easing’ and you mentioned the obvious intent to lower mortgage rates to homeowners and lower credit card rates, auto loans, commercial rates as well so, you know, its very much of a positive push. We have sense that the $1.8-trillion balance sheet that the Fed has, that’s now growing to $3-trillion, probably will have to grow to $5-trillion and $6-trillion in order to keep us on a trend line that produces positive as opposed to negative growth.
Because QE measures may not yet be sufficient to completely overcome the problems facing the banking system in terms debt reduction the outlook continues to be tilting towards deflation. As long as the need to deleverage balance sheets exceeds the availability of credit, assets could continue to deflate. Therefore, our sense is that the Feds first QE move is preliminary, and primes the pump for more QE in the next 6-12 months.
So, is the Fed's move a signal that we are at an inflationary or deflationary inflection point for the moment? Watch the debate unfold between Hugh Hendry, and Liam Halligan. Then you decide...
We like to err on the side of reason and validity.
At the moment the political will to carry out this process fully, and further, faces significant opposition, especially to the idea of bailing out Wall Street and the US banking system, and is hobbled by the public outcry against the AIG bonuses debacle, and government has done as much as it can to suitably convince constituents of what it needs to do, for now. Today, the US Treasury announces a $1-trillion 'public-private investment programme' to absorb the toxic assets into what amounts to a 'bad bank.' One of the big issues is the competence of those in the private sector (which is meant to be a checks and balances component) to price these assets. Another issue remains whether or not this will get banks to release their chokehold on credit and resume business as usual in the lending business. The White House is expected to follow up this week with its comprehensive financial plan. This administration's public relations programme has reached a crescendo; 60 Minutes, Jay Leno. Will they be able to finally stop talking and actually get down to work on it?
Does Geithner have the political ammunition to take further measures? Geithner must convince the market and constituents that this move will complement the Fed's quantitative easing.
From today's Globe and Mail: Nobel Prize-winning economist and Princeton University professor Paul Krugman blasted the strategy as a rehash of former treasury secretary Henry Paulson's discredited solution to the banking crisis, first proposed six months ago. "It's not new; it's just another version of an idea that keeps coming up and keeps being refuted," Prof. Krugman wrote over the weekend on his New York Times blog.
"It's just horrifying that [U.S. President Barack] Obama - and yes, the buck stops there - has decided to base his financial plan on the fantasy that a bit of financial hocus-pocus will turn the clock back to 2006."
The only way out of the banking crisis is for the government to offer a sweeping guarantee of problem debts and to seize control of banks with too few assets to cover their debts, Prof. Krugman argued.
The current crisis, he argued, isn't just a panic, but a fundamental realignment of a financial system that foolishly bet big that house prices and consumer debt would continue rising forever.
For these reasons, QE and other measures will be a gradual process and could work, but only if taxpayers are willing to be saddled with the burden.
