Someone who knew a thing or two about math, equations, and probabilities reportedly once said that the definition of insanity was doing the same thing over and over again and expecting different results. This Wednesday Chairman Bernanke will hold court and the FOMC will likely decide on the future course of monetary policy, and more specifically, the scope of the QE policy, which by all accounts will be a continuation of the same large-scale asset purchase program.
With Operation Twist due to expire at the end of the year and because the Fed is essentially out of short-term bonds with which to finance purchases, it is virtually assured that they will opt for outright purchases financed with printed money. The question for investors is what, if any, impact a continuation of this uber-easy money policy will have on economic activity, and more importantly, asset prices in 2013.
In Sunday’s New York Times Strategies section, Jeff Sommer addresses The Next Move for the Fed:
Since 2008, the Fed has engaged in three rounds of unconventional large scale asset purchases, known as quantitative easing. In the first round, QE1, from November 2008 to March 2010, it bought $1.75 trillion in long-term Treasuries and other securities, the Richmond Fed said. In QE2, from November 2010 through 2011, it bought $600 billion in long-term Treasuries. QE3 has been under way since September 2012, with the Fed buying $40 billion each month in mortgage-backed securities.
Now, said Ned Davis Research in a report last week, the Fed is likely to replace Operation Twist with purchases of Treasuries, perhaps in the $45 billion a month range, bringing its total monthly purchases to $85 billion.
Quoting Kathy Jones, fixed income strategist for the Schwab Center for Financial Research:
This is all about signaling – about using language and numbers to persuade investors, consumers and people in business that money will be cheap and plentiful for a long time to come.
During the worst phase of the financial crisis, the Fed’s extraordinary expansive monetary policy was intended to prevent the economy from plunging into a possible depression. These days, it is intended to help restore vigor to the economy, with mixed results so far. The November survey of Blue Chip Economic Indicators, for example, showed that economic forecasters expected gross domestic product growth of only 1.7 percent in the fourth quarter, along with 2 percent annual growth in 2013.
Saying the results have been mixed is putting it lightly. I would say you would be hard-pressed to find any evidence that QE has worked at all. In fact I think you could argue QE hasn’t even been successful in lowering long-term interest rates or raising stock prices to levels that they otherwise would be if there were no intervention.
If QE were able to raise stock prices via reflation or a lower discount rate, you would assume that would be in the form of a multiple expansion -- but that hasn’t happened. Multiples have, at best, been flat if not contracting as the S&P (INDEXSP:.INX) has rallied 100% off the lows. In 2007 when the S&P was at these same levels in the low 1400s, the price-to-book ratio was closer to 3x book vs. today’s level of 2.15x book. Today’s S&P 500 book value of $662.44 is the highest as a ratio to nominal GDP in over a decade, yet the multiple for that equity is near the lowest over the same period. In terms of interest rates you can see by looking at a weekly chart of the 10YR yield that the two largest declines in yields occurred when the Fed actually abandoned the market. When the Fed ended QE I in March 2010 the 10YR yield fell from around 4.00% to 2.50% during the stock market flash crash and the co-debacles of Greece and the Gulf of Mexico. When the Fed walked away from QE II and blew up the asset reflation trade the 10YR fell from 3.00% to 2.00% in about two months. Now with the 10YR at 1.60% the Fed is claiming victory for lowering interest rates when in reality their biggest contribution to lower rates was actually when they weren’t buying.
So if the Fed’s QE isn’t responsible for raising stock prices or lowering interest rates, then what are they doing? If we asked Chairman Bernanke that question in private he might say that they are trying to stimulate credit creation by forcing banks out of their bloated securities portfolios, which in turn should increase the velocity of money.
In How QE Is Impeding the Economic Recovery I tried to find evidence that QE was stimulating credit creation and velocity.
There has been much discussion on the intentions and effectiveness of QE. It has been my contention that the main objective is not to reflate asset prices but rather to stimulate credit creation and the velocity of money. According the Fed’s H.8 Release banks are holding over $2.6 trillion in cash that's sitting idle on their balance sheet in securities portfolios.
Bernanke is trying to flush the banking system out of these bloated securities positions and into extending credit by lowering bond yields to levels where banks can no longer afford to hold them. As banks replace securities with loans credit expands, the velocity of money increases which in turn will increase economic activity, employment, and corporate profitability.
Is it working?
When the Fed launched QE the aggregate loan-to-deposit ratio (LTD) of the US banking system was 90% with most of the balance of their assets in securities. As a comparison, in 2008 the LTD was over 100% and banks held very little in securities. Despite three rounds of QE and Operation Twist that was designed to flatten the yield curve today, the LTD is 79% -- the lowest in over 30 years of tracking it -- and continuing to fall. Not coincidentally, in Q3 2012 the velocity of money (M2) made a 50-year low.
When I ran into Michael Sedacca this weekend at Minyanville's Festivus party, right before he handed me a shot of Patron he asked me my thoughts on this week’s FOMC meeting. You talk about someone who can multitask. I don’t know many people who think about monetary policy and tequila at the same time. I told him I thought they were trying to increase consumption like it was the 1990s, but that this was a different consumer. Baby boomers are running this economy, and for 20 years they were leveraging consumption which could always be stimulated by lowering interest rates. Now they are deleveraging and increasing savings, which is the polar opposite. Sedacca astutely responded, they are fighting the last war. Exactly.
Perhaps the best way to stimulate a deleveraging saver is to actually increase the return on that savings. Call me crazy but maybe the best way to stimulate consumption demand is to actually raise interest rates. Savers will require less principal in order to generate the same income which will free up billions in spending power that is currently locked in zero-percent time deposits. Think about the difference between a CD at 25bps vs. a more normalized 2.50%. You are talking about 10x the spending power. OK, that’s not going to happen… maybe ever. Why? Because Bernanke is trapped.
Again, from How QE Is Impeding The Economic Recovery:
The problems that are impeding the economic recovery are not due to the lack of federal agency-backed mortgage loans that wind up in securities. What is impeding the recovery is the continued contraction of US bank balance sheets. For lenders to extend credit they must weigh three basic risk variables that make up the total cost of credit: credit risk, interest rate risk, and collateral risk. What Bernanke doesn’t seem to appreciate about this equation is that the benefit of a negative real interest rate to the borrower is the cost to the lender in a negative real return.
The lower interest rates fall, the higher the interest rate risk becomes. By reducing credit risk in the form of low interest rates Bernanke has raised interest rate risk. From a lender’s perspective the balance sheet risk is the same. So perhaps it’s not credit and collateral risk that is holding back lending; it's interest rate risk. Maybe bank balance sheets continue to contract because they can’t earn a positive risk-adjusted real return by making a loan.
After three years of zero interest rate policy and QE, the banking system is now loaded with very low and mostly negative coupons. It is unlikely that a bank owns many bonds that have not been called and all the reinvestment has gone into securities that carry a tremendous amount of interest rate and balance sheet risk. The minute the bond market gets a whiff that the Fed is beginning a tightening cycle the curve is going to explode to the upside and those mostly negatively convex, negative coupon, long duration assets will massively extend and be rapidly discounted.
Bernanke won’t admit it but the truth is the US banking system is a powder keg. It wouldn’t take a very large move in the long end of the curve for that $2.3 trillion in securities to suddenly be worth $1.8 trillion and the $500 billion discount would be trapped on balance sheets because bankers would not be able to afford to take the loss.
So what is the endgame? I don’t see how we break this vicious cycle. Bernanke thinks he is fighting a liquidity trap but from my perspective he is causing the liquidity to be trapped. I’m not saying he should hike to 5.00% but a modest normalizing of the cost of money or more importantly the return on savings might go a lot further than a continuation of what we know isn’t working.
I once compared Bernanke to Steve Martin’s Medieval Judge character on Saturday Night Live because his monetary policy effect on the banking system was akin to a bloodletting session.
Theodoric of York: Well, you'll feel a lot better after a good bleeding.
Drunkard: But I'm bleeding already!
Theodoric of York: Say, who’s the barber here?
As an investor and strategist it sure would be refreshing to see some creativity from our central bankers. As it stands today, they continue to tell us that they know what is best for the economy and that we should trust that they are doing everything within their powers. However it appears they are content to fight the last war with bloodletting and blunt instruments -- whether it works or not.