The Futility of QE

This is an attempt to explain what I believe will be the futility of another round of Quantitative Easing on the part of the Federal Reserve to do anything more than to merely provide another TEMPORARY boost to paper assets and by consequence, a short-lived blip in consumer confidence. As such, it is going to be much to the point without any rhetorical flourishes or attempts at refined writing.

I do wish to start this brief piece by noting that I believe the Fed is indeed going to act, sooner rather than later, unless they want to witness a meltdown of the equity markets. Practically, for them to stand idly by and do nothing to prevent it would be irresponsible. Yet for all this, the effort is doomed to failure.

Consider the original purpose behind the Quantitative Easing programs – QE1 was designed to purchase Mortgage Backed Securities which had plummeted in value resulting in a serious degradation of the balance sheets of the major banks and firms that held them as assets.

These “assets” had been originally valued on the balance sheets by marking to model. When the credit crisis began in earnest in the summer of 2008, the world quickly learned that these model-based values were a fiction. The real “market” value of this paper was a fraction of what the banks were claiming.

In order to prevent the credit markets from locking up due to insufficient capital on the part of these large lenders, the Federal Reserve decided to be the buyer of last resort and provide a market for these securities, taking them off the books of the banks and substituting high-quality Treasuries in their place. The idea was to shore up the balance sheets of the banks and give them the ability to lend into the economy for both business and consumer needs.

At the time QE1 was embarked upon, the yield on the Ten Year note had fallen as low as 2.03%.  The investment world reacted to QE1 by bidding up the price of both commodities and stocks and actually sending interest rates higher as the impact from this novel program was expected to be an inflationary one. Yields eventually reached 4% before falling back as the impetus from this first round of QE began to fade.

Fast forward to late 2010 – with the economy still sputtering and growth lagging, the Fed announced another round of Quantitative Easing, this time to the tune of approximately $900 billion. The express intention of this plan was to deliberately push down LONG TERM interest rates and increase the money supply in the hopes that it too would serve to stimulate business and consumer spending and borrowing.

At the time just prior to the commencement of QE2, the yield on the Ten Year had fallen as low as 2.33% as deflation fears were running wild once again. The S&P had lost 16% of its value in the matter of a few months time during the middle of 2010 leaving investors desperately seeking some sort of further action on the part of the Fed.

Oblige they did and once again the equity markets rallied as did the yield on the Ten Year which pushed back towards the ceiling of 4% as once again investors were anticipating an inflationary impact from the policy – which by the way it was deliberately designed to do. However, that was the peak in yields which began falling once again in early 2011 this time dropping below 2.0% before bouncing in a narrow range for a period of 7 months. The catalyst for this downward trend in rates was the knowledge by the entire investment world that the Fed was going to end QE2 in the month of June 2011. In other words, this was all it was going to get – look for nothing else.

Moving to the present time, as the European Sovereign debt crisis has worsened and the contagion effect has spread to China and elsewhere, rates on the Ten Year have now fallen below the critical level of 1.8%, which was acting as a floor. As of today, the yield on the Ten Year has plummeted below 1.5% closing into an all time low at 1.467%.

Here is the point – the purpose behind both QE’s was to improve bank balance sheets thereby facilitating lending, keep longer term interest rates low to stimulate borrowing and ramp up the money supply to produce an inflationary impact to offset the deflationary impact of excessive levels of debt.

One could say that it worked; however, it was only temporary. Operation Twist, which was the last pseudo QE that consisted of rolling the proceeds from maturing short-term Treasuries into longer dated Treasuries, has been an enormous flop as it has provided next to nothing in the form of any inflationary impact.

My question is simple – if interest rates at or near 2% on the Ten Year when the Fed has engaged in both former rounds of QE have been unable to sufficiently increase borrowing/spending for any sustained length of time, what makes anyone actually believe that another round of actual QE, when rates are already well below the 2% level (1.467%) will accomplish the least bit of good?

At some point, you end up with interest rates so low that the money might as well be free to borrow – however, no one wants to borrow or can borrow.

So the Fed can buy another $1 Trillion in Treasuries – how about $2 Trillion – why stop there – why not go to $3 Trillion. What good is all this excess money creation going to do if the previous combination of over $2 Trillion in both QE1 and QE2 has done nothing when all is said and done? Interest rates are already lower than at any point in my lifetime certainly. Has that increased business in the housing market or prevented foreclosures from occurring? Again, maybe for a while it has prevented things from worsening even further but as far as actually laying the groundwork for any lasting improvement, I certainly do not see it.

My guess is that when the Fed does act, and I believe the pressure to act is going to be too great to ignore for long, they are going to have to come up with something besides just Treasury purchases. Maybe they will actually buy stocks or stock indices. After all, if they can push the stock market higher and discourage any potential short sellers from entering, the rising stock market would do wonders for investors 401K’s and other retirement plans. Maybe we will get the same sort of “wealth effect” that we got from the stock market bubble of the late 1990’s. That should boost the Consumer Confidence numbers.

Of course I am being facetious here but if the stock markets begin collapsing as they did back in 2008, can anyone rule out the Fed actually buying stocks as part of a monetary policy response? After all, Japanese monetary authorities have discussed this possibility and been quite forthright about doing so.

On second thought - Why bother – why not just directly inject the money into the bank accounts of taxpayers and skip the usual round of injection through the primary dealers and hoping in vain for a multiplier effect.

One thing is certain – monetary policy alone cannot fix what ails the US economy or the Euro Zone for that matter. The problems are deep-rooted and structural and will require wise action, even painful action, by far-sighted statesmen. Short-sighted political leaders, at this point, are merely leading their nations to irreparable harm and will end up dashing them to pieces on the rocks.

In some sense, the public is partly to blame – they are the ones clamoring for all the government handouts and increased services forgetting that government has no money except that which it confiscates from its citizenry in the form of taxes or from the next generation of taxpayers by deficit spending/borrowing. When its lenders decide that they are no longer willing to lend their capital to nations which follow reckless fiscal policy, the gig is up.

Eventually the Piper must get paid his due.

In closing let me leave you with a graph from the St. Louis Federal Reserve showing why QE has produced no lasting effect....

Note that no matter how the Fed tries to expand the money supply, the Velocity of Money (the rate at which money changes hands in the economy) continues to plummet...

Gold Achieves that "16" Handle

Gold's reaction to the payrolls number this morning was instantaneous - it shot up as if it was fired out of a cannon! As stated in the post on the mining shares this AM, gold is now fully expecting the Fed to move forward with a round of QE3 Sooner rather than later. It is this anticipation of a Fed move that has it blowing the recent hedge fund short positions out. Not only that, the ability to capture this elusive "16" handle and HOLD IT, has fresh money that has been sitting on the sidelines or in Treasuries (obtaining next to nothing for yield) willing to come in on the long side of this market.

Note on the chart that it has run to exactly the 50 day moving average which also happens to correspond to the resistance zone near the $1625 level. A clear push past this level, and it will go immediately to $1650.

Downside chart support is now first at the $1600 level followed by the top of the recent tighter range near $1580.

Mining Shares Continue to Outperform the Broader Equity Markets

The last time we had a THREE CONSECUTIVE WEEKS during which the mining shares outperformed the broader US equity markets was in late October/early November of 2011.  While the  month of May this year has been attrocious for the S&P 500, it has been an excellent month for the miners. June is starting out on a good note to say the least as we witness today's strong upmove in the mining shares.

My interpretation of this event is that today's payrolls number, which was so horrible that it cannot have any sort of positive spin placed upon it, has jolted traders into moving more and more to the view that the Fed is going to act SOONER RATHER THAN LATER on the next round of QE.

New York Fed Governor William Dudley said earlier this week the following according to reports by Dow Jones:

"If the economy were to slow so that we were no longer making material progress
toward full employment, the downside risks to growth were to increase sharply,
or if deflation risks were to climb materially, then the benefits of further
accommodation would increase in my estimation and this could tilt the balance
toward additional easing."

Today's payrolls number, a sinking Continuous Commodity Index, a swooning stock market which is threatening to turn into a downside rout and interest rates plummeting to more than 60 year, if not all-time lows, has met every benchmark laid out in the above quotation.

This is what has gold soaring this AM and the gold shares moving sharply higher. Silver is being dragged higher by gold but has managed to at least climb back above the $28 level. I do not trust silver until it at the bare minimum gets back above the $29 level and STAYS ABOVE IT.

I still think the Fed would like to see gasoline prices move closer to $2.50/gallon at the benchmark Nymex contract (it is currently near $2.66 as I write this) but if the global equity market rout does not let up, they are going to have a full-fledged rout on their hands and thus may not have the luxury of waiting much longer.

The JUNE Fed meeting is obviously going to be a significant event for the markets.

Incidentally, the yield on the TEN YEAR NOTE has now fallen BELOW the 1.5% level. INCREDIBLE!

USDX Pushing Higher as Money Flows into Treasuries

The following chart I put together is interesting in the sense that it reveals exactly what is pushing the US Dollar Index Higher.

Normally, all things considered, the country which possesses the most solid fundamentals in terms of monetary policy, economic growth rate, fiscal policy and above all, YIELD or INTEREST PAID on its government debt, tends to have the strongest currency. At least that is the way it formerly was. These are broad principles and while there are always deviations, if two countries were pretty evenly matched in terms of the first three factors, the nation which had a higher yield on its government debt tended to attract more investment flows and thus had the stronger of the two currencies.

When we think about the US Dollar, we certainly do not think of a nation with sound monetary policy (reckless creation of nearly unlimited units of its currency called Dollars). Nor do we think of a nation with a strong economic growth rate (we were reminded of that today with the lowering of the original 1rst quarter GDP number). And lastly, fiscal policy here in the US is an unmitigated disaster given the enormous and never-ending budget deficits and huge amount of overall indebtedness (the US is now at levels on its GDP to Debt ratio of 100% or higher).

Why then the strength in the US Dollar? It is certainly not fundamentally based.

The truth is investors in Europe are terrified of what is taking place over there and have lost confidence in the bonds of many nations comprising the EuroZone. They are yanking their money and moving it into anything but the Euro which is giving the US Dollar the strength it is currently enjoying.

But how exactly is this being accomplished seeing that the US equity markets are sinking like a lead brick? Money flows from abroad are not moving into the realm of US stocks, that is for certain. The answer is that these investment/safe haven flows are moving into US Treasuries. In other words, there is unprecedented demand for US debt and this is producing the rally in the Dollar as all that foreign currency needs to be EXCHANGED (this is why the currency markets are known as FOREX - Foreign Exchange Markets) for DOllars to buy Treasuries with.

We can see this in graphic form by examining the following chart which basically charts the USDX and the Yield on the Ten Year Note and then charts the difference between the two to see whether or not the Dollar is rising as interest rates rise, falling as interest rates fall or RISING even as INTEREST RATES FALL. The latter is of course somewhat counterintuitive from a purely performance based perspective. After all, why in the world would investors deliberately put their capital into the currency of a nation where the yield they are receiving is actually going down?

Quite simply - we are living through times which are unique and unprecedented. There is almost a type of panic-buying of US Debt as a safe haven. Investors are willing to accept a paltry 1.58% on their money for the next TEN YEARS just to get it out of Euros and out of equities.

How this is demonstrated on the chart shows up as you look at the solid blue line. Note that there have been three occasions during which the Dollar has enjoyed great strength even as interest rates have fallen lower. The first was back in the middle of 2008. We all remember what happened then - the credit crisis erupted and there was a mad rush into the "safety" of the US Dollars, mainly in the form of Treasuries. That buying drove Treasury yields lower (remember- rising bond prices means lower yields).

We can see the same thing occurred in early 2010 when there was fear that QE 1 was ending and there was nothing to take its place on the drawing board. The rush back into Treasuries occured once again and up went the Dollar as interest rates were pushed lower by safe haven flows.
This third occasion can be seen to start in April of last year when it was assumed that QE2 was coming to an end in June. Ever since then, with a brief exception in October of last year, the Dollar has GENERALLY MOVED HIGHER even as INTEREST RATES HAVE MOVED LOWER.

This trend has accelerated in March of this year and continues at the present time as fears over the European Sovereign Debt affair have intensified. Notice how wide the differential has become. What this is charting is the FEAR of traders/investors over the preservation of their wealth. It is at an even higher spread than it was back at the peak of the credit crisis of 2008 even though the USDX is some 6 - 7 points lower than it was on both other occasions when this widening of the differential was taking place.

I would venture to say that if we constructed a chart of Yen, it would look quite similar over the last few months.

My thinking is that if the Fed does come in with another round of QE3, and it is of sufficient size to convince market participants that the threat of deflation has been suspended (at least for the time being), we will see the US Dollar move sharply lower narrowing this spread and will more than likely see longer term interest rates actually rise instead of falling as one might assume woudl occur, as deflation talk will give way to inflation talk and money will flow out of Treasuries pushing yields higher in the process.

Time will tell.

Monthly CCI Chart - May 2012

Monthly Gold Charts for May 2012

I do want to note that since we are facing a very similar set of deflationary factors at the current time as we did back in 2008 when the credit crisis first erupted, that time frame is an analogous year and for that reason provides at least some sort of frame of reference for a guide to price action.

Using MONTHLY CLOSING PRICES only, gold fell from a peak of $975 down to a low of $715 or a drop of 26.5% from it best monthly closing price BEFORE THE FED made clear that a round of Quantitative Easing would commence. You will recall that the purchases consisted mainly of Mortgage Backed Securities which were plummeting in value and wreaking havoc on bank balance sheets.

Fast forward to today - this time around it is Sovereign Debt out of Europe that is the culprit behind the destruction of the European Banks's Balance Sheets. Gold hit a monthly closing peak price of $1828.50. For the month of May it has closed at $1526.60 for a drop of 16.5%.

Worst case scenario would see a fall of another $183 from the current level or down towards $1344. Keep in mind however that back in 2008, the idea that the Fed would actively step in and actually buy up mortgage paper on the open market and serve as a buyer of last resort was a rather novel idea, even though it had been discussed in some circles as an academic type of matter. Now it is pretty much expected that not only will the Fed buy up such paper but also Treasuries themselves. I expect before this is all over, we might even see the Fed buying US stocks or at least stock indices.

Also, gold fell 26.5% from its peak back in 2008 while during the same time period the S&P 500 collapsed at whopping 47.7% from its May 2008 ClOSE to its February 2009 CLOSE. Does anyone really believe that the Fed is going to stand by and allow the US equity markets to lose nearly HALF THEIR VALUE before they act, especially during an election year??? I doubt it! Not when Bernanke and company are FAR MORE FEARFUL of ANY DEFLATIONARY event than they are of INFLATION.

Central Bankers are essentially confident that they can corral inflation if need be but they are terrified of having a deflationary mindset take hold. They will simply not allow the latter to happen, even if it means in engaging in another wholesale round of bond purchases and further money creation.

Again, we are all reduced to sitting around and waiting for signs of sufficient deterioration in the global equity markets and credit spreads to force the Fed to act. When they do finally sally forth, gold and silver will immediately bottom and begin to trend higher as trader sentiment then shifts away from deflation and back towards inflation.

We will also see interest rates reverse and begin rising, even if only for a while.

Gold Continues to Attract Buying at the Bottom of its Trading Range

Gold has once again attracted strong buying down near the bottom of its broad 8 month trading range and has now bounced higher for the day. Strength in the yellow metal has pulled silver up a tad which was sinking under the weight of a collapsing copper market.

While some are ready to pronounce gold DEAD as a safe haven asset, the chart picture denotes otherwise, especially given the broad weakness in the commodity sector as a whole and the rallying Dollar, which continues its technical march towards the 84 level on the USDX. Whenever I see gold moving higher alongside Treasuries and the Dollar, it tells me that all such talk about gold being useless as a store of wealth, is simply false. The chart will tell you more than all the pontifications of the short-sighted analysts and pundits.

To get any sort of excitement going beyond the continued value based buying of gold, it will need to push through the $1600 level and not falter.

The mining shares are defying the general trend of equity selling today which is aiding the cause of both metals. Note that for the last two weeks, it is the mining sector which has been the bright spot in the otherwise dim US stock market.

Rush into Treasuries Continues to Depress Rates

There is what feels like near-panic buying of US Treasuries at the moment, due to the implosion that we are witnessing in much of the European Sovereign Debt markets. Investors/traders are scared to death to own bonds from these problem nations and are rushing into both US Treasuries and German Bunds as safe havens.

The result has been to collapse US interest rates on the Ten Year firmly below not only the 1.8% level, but also below the intra-month spike lows near the 1.7% level. We have one more day left in the month of May but it certainly appears we are on track to set a new monthly closing low.

The flip side to this rush to Treasuries is that commodities are being thrown overboard, irrespective of any particular set of fundamentals, as hedge fund algorithms are whacking that sector, both liquidating long positions as well as instituting new bearish bets.

The question on the minds of many is when will the Fed step in to attempt to halt what looks like a growing tidal wave of deflationary pressures? My thinking is that they will not until they get the commodity sector, particularly the energy markets, more specfically the gasoline market, down to lower levels.

We are already at the 50% Fibonacci Retracement Level off the entire 2008 - 2011 rally. If the index cannot hold at this critical juncture, it will drop towards 465, which is the intersection of the bottom tine of the pitchfork and the 61.8% Retracement level. My view is that the Fed will act should commodity prices get to that level.

Keep in mind that while the Fed and the US monetary officials like these abnormally low interest rates ( it keeps loan rates cheaper and allows the US to continue borrowing and spending money at its drunken sailor pace), and while they are near gleeful at the prospect of falling food and energy prices, they do not want a deflationary mindset to take hold in the minds of investors or the public for that matter.

For investors, that will mean the equity markets willl collapse as they will dump stock holdings and for the public that means they will forego spending now on the notion that they can wait for prices to fall further. The last thing that the Fed wants is for consumers to rein in spending.

So, the question is, can the Fed get these stubbornly high gasoline prices to fall another 30 - 35 cents while holding off on any further stimulus or will the US equity market bears, force their hands?