NIGHT AND DAY / PRUDENTBEAR.COM

Night and Day

Doug Nolan

At least so far, markets seem fine with a pathetically dysfunctional Washington. The question arrived via Prudentbear.com and appeared simple enough: “Can you explain how QE funds are inflating the asset markets if these monies are being parked back with the Fed, collecting interest? Can they be in two places at the same time?”

The impact of the Fed’s experimental quantitative easing (QE) program is an issue of great interest. In his talk yesterday, Federal Reserve Bank of San Francisco president John Williams noted that considerable Fed resources have been devoted to researching the issue. Mr. Williams spoke of initial findings, stating the impact on Treasury yields in meager basis points. A cacophony of Fed comments leads me to believe Federal Reserve analysis is oblivious to the key impacts of its ongoing monetary inflation.

In early CBB’s, I was fond of employing my old CPA skills, as I used scores of debit and Credit journal entries (“double-entry bookkeeping”) to illustrate the “infinite multiplier” potential inherent to contemporary non-bank Credit expansion. In particular, I remember a rather exhaustive (exhausting) series of debit and Credit entries explaining how the growth of GSE IOUs (debt) intermediated through the money market and hedge fund channels was behind unconstrained growth in New Age “money” and Credit. I was convinced at the time this atypical monetary inflation was fundamental to a historic Credit Bubble and myriad attendant asset price and economic distortions. I still believe it was among some of my most insightful analysis, and I’ll note that it did seem to resonate strongly with perhaps a handful of readers (including Ed McCarthy, who became a dear friend).

I'll spare readers a tedious debit & Credit exposition. I will instead highlight “Flow” analysis in an attempt to illuminate some of the myriad systemic inflationary impacts from the Fed’s QE laboratory.

Let’s begin with a brief look at the Fed’s balance sheet – where Assets (as of 6/30: $3.526 TN) essentially equal Liabilities ($3.499 TN). On the Assets side, the Fed holds $34.3bn of “U.S. Official Reserve Assets.” There is also $228bn of “Other Miscellaneous Assets.” Yet the vast majority of Fed holdings are within its $3.214 TN portfolio of “Credit Market Instruments.”

As of the end of the second quarter, the Fed held $1.937 TN of Treasury notes and bonds, up from $476bn at the end of 2008. Fed holdings also included $1.277 TN of “Agency- and GSE-Backed Securities,” up from 2008’s $20bn. While the Asset side of the Fed’s balance sheet has ballooned in historic proportions, its holdings are for the most part straightforward.

Things tend to get murkier on the Liability side. The Fed is on the hook for tons of Federal Reserve notes - $60bn of “Vault Cash of Depository Institutions,” as well as $1.134 TN of “Currency Outside Banks.” The Fed also ended Q2 with Liabilities “Due to Treasury General Deposit Account” of $135bn and “Due to GSEs” at $20bn. Yet, at $2.013 TN (up from $21bn to end ’07), the Fed’s largest – and fasted growing – Liability is “Deposit Institution Reserves.”

The surge in Fed “Reserves” has in recent years been a hot topic. The conventional view holds that these Reserves, for now resting harmlessly in the bowels of the banking system, create a potential inflationary tinderbox once the recovery and bank lending gain a head of steam. The Fed has gone to great lengths to explain how it will contain potential inflation risks, most directly by increasing the interest-rate it pays banks on these reserve balances (hence incentivizing retaining Fed reserves rather than lending them in the real economy).

I don’t completely dismiss their inflationary potential, but the whole bank reserve discussion misses more salient points. First, there are the more immediate impacts Fed purchases have been cultivating throughout the financial markets. Second, with contemporary unfettered Credit having expanded outside traditional constraints (i.e. bank lending restricted by reserve and capital requirements) for years now, it’s difficult for me to get all worked up about so-called “latent” inflationary firepower. Again, I would argue the key inflationary effects are here and now – and today’s analytical focus should be fixated on the present.

It might be helpful to remind readers that what we’re really discussing here are electronic debit and Credit entries within an immense global “general ledger” accounting system. This globalized Credit system comprises myriad domestic and international relationships interconnected by various asset, liability and equity relationships. For the most part, innumerous financial, governmental, institutional, corporate and individual debtors have electronic IOUs that are the electronic assets of innumerous lenders.

The U.S. banking system's assets “Reserves at the Federal Reserve” – are simply the liabilities of our central bank – aka Federal Reserve IOUs. When the Federal Reserve goes into the marketplace to purchase Treasuries and MBS, it creates brand new Fed IOUs in the process. And these IOUs are in the form of electronic debit and Credit entries that, importantly, create immediately available new purchasing power in the system.

The conventional view holds that since these reserves are sitting inertly on bank balance sheets, they are basically having no inflationary impact. I would counter that they by definition exist only on bank balance sheet accounts, yet this in no way indicates that they haven’t had major pricing impacts. Think of it this way: when the Fed creates its new IOUs in the process of purchasing securities in the markets, this new electronic purchasing power is unleashed upon the system, initiating potentially a series of transactions (the Fed buys from A, A takes proceeds and buys from B who uses the “money” to buy From C, and so on).

As these various trades/transactions settle, the Fed’s electronic IOUs must make their way to institutions that have a direct accounting relationship with the Federal Reserve. The Fed’s newly created electronic purchasing power might in its journey be an electronic payment to a hedge fund, a home seller or even Samsung. But since they don’t have deposit accounts with the Federal Reserve, a series of debit and Credit entries will flow through various (“correspondent”) financial relationships until balances finally arrive at an institution within the Fed’s payment system (i.e. a U.S. bank or U.S. branch of a foreign financial institution). Reserves might not be at two places at the same time, but they can certainly make their way through multiple places and transactions along the way.

By definition, when the Fed creates new electronic (as opposed to paper currency) liabilities, the other side of the ledger is the creation of an asset within its system of electronic relationships – and this asset is identified as “bank reserves.” Importantly, however, this is only a static (level/“stock”) recording of accounting relationships at a point in time - and in no way indicates a lack of inflationary effect. Indeed, the creation of new system purchasing power has myriad (“flow”) impacts, both direct and indirect.

I have attempted to differentiate the impact of current QE operations from that of initial “QE1.” I have explained how the Fed’s original QE was essentially an operation that accommodated de-leveraging/de-risking. The Fed intervened in the marketplace, purchasing securities from banks, Wall Street firms, “special purpose vehicles,” hedge funds and the GSEs that needed to significantly pare back leverage after suffering major market losses. In one impactful operation, the Fed’s collapsing of interest rates incited a major refinancing boom for problematic “private-label” mortgages. Many of these newly refinanced mortgages were intermediated (guaranteed) through the GSEs, and then conveniently shifted from troubled institutions and speculators to the Federal Reserve (as agency-MBS).

Basically, the Fed accommodated a historic transfer from impaired leveraged players to the Fed’s impenetrable balance sheet. In that circumstance, much of the new purchasing power created by expanding Fed IOUs was used immediately to retire market borrowings (“securities finance”).

In the case of QE1, newly created Fed purchasing power/liquidity was largely “extinguished” – one could say it went to “money heaven” – as market-based (i.e. “repo”) borrowings were retired in a major collapse of speculative leverage. Hence, overall inflationary effects were muted, especially considering the unprecedented scope of the “liquidity” operations. The “flow” of purchasing power/liquidity analysis is rather short and Fed statistical studies of this period – focusing on Treasury bond yields – have come to the conclusion that quantitative easing measures are by and large benign.

Since mid-November (just prior to the Fed commencing its $85bn monthly QE), the Biotech index is up 56%. The small cap Russell 2000 has returned 42%. The InteractiveWeek Internet index is up about 41% and the Semiconductors 40%. The Securities Broker/Dealers index has surged 70%. The Mid-Caps have returned about 34% and the S&P500 27%. Treasury yields, well, they’re up about 1% (100bps) and benchmark MBS yields about 1.2% (120bps).

I have posited that today’s QE is having altogether more powerful inflationary effects than QE1. First and foremost, the Fed’s current monetary inflation is not accommodating financial sector de-leveraging – i.e. newly created Fed liquidity is not immediately extinguished through the retirement of securities speculative leveraging. Indeed, I would argue that the Fed’s $85bn is injecting new liquidity directly into the securities markets, while also incentivizing further risk-taking and speculative leveraging. 2009 QE is Night and Day to 2013 QE.

Today, when the Fed goes into the marketplace to purchase Treasury bonds, they create immediately available funds that the seller can then use to purchase other securities. A Fed transaction with a hedge fund, for example, would provide purchasing power for whatever asset class the manager believed offered the best (immediate) return opportunity. Importantly, if the Fed chooses to inject liquidity into a speculative marketplace, the new purchasing power will not gravitate to low-risk strategies. Indeed, some years ago I would write “Liquidity Loves Inflation,” noting the strong proclivity for liquidity to chase (outperforming) asset classes demonstrating the most acute “inflationary biases.” Since mid-November, SunPower is up 614%, Tesla 480%, Netflix 302%, Green Mountain 224% and Facebook 128%. Treasury and MBS prices are down slightly.

The Fed is delusional if it doesn’t believe QE is inflating speculative Bubbles. In a highly-charged “risk on” backdrop, QE converts to rocket fuel. And, amazingly, this rocket fuel is flooding into the markets at about a Trillion dollar annualized clip. The inflationary impact on various asset prices can be gauged to be in the multi-thousand basis points rather than the few contended by Fed research. Not only is there the direct impact of hedge funds using the proceeds from Treasury or MBS sales (to the Fed) to purchase outperforming stocks, there is the issue of the Fed’s liquidity backstop incentivizing leveraged speculation in higher-yielding junk, corporate bonds and leveraged lending more generally. The resulting ultra-loose market liquidity backdrop furthermore spurs aggressive mergers & acquisition activity.

Less directly, but no less importantly, the Fed rate and QE backdrop has created self-reinforcing investor flight away from lower-risk deposits and other low-yielding instruments out in search of higher market returns. These days, Fed QE purchases work to accommodate flows out of bond bunds and into equities. And if it had been up to household savings (as opposed to Fed monetization) to finance the massive surge in federal debt, it would be a very different financial landscape today (much higher Treasury, MBS and corporate yields - and significantly lower equity and asset prices). Pension funds wouldn’t have to rely on hedge fund and private-equity leverage in order to meet return bogies. And without all the speculative leveraging throughout fixed income, there’d be a lot less liquidity available to flow effortlessly into equities.

How many Trillions have flowed into higher-yielding corporate debt and equities, EM, various ETFs, commercial and residential real estate, leveraged lending, hedge funds, private equity and basically any investment that provides a yield after Fed QE and rate policies pushed the entire yield curve to such artificially low levels?

The Fed apparently does not buy bonds directly from the Treasury. But let’s say the Fed purchases Treasuries in the open market from a hedge fund or Wall Street “primary dealer” that had recently acquired these securities at Treasury auction. In this case, the Fed’s newly “minted” liquidity would flow to a speculator or dealer that could use these funds to acquire Treasuries at the next auction. The Treasury would then use this liquidity/purchasing power to make disbursements throughout the economy (i.e. federal worker and armed forces compensation, jobless and veteran benefits, social security, and Medicare), in the process boosting incomes, spending and savings. This spending boosts GDP, right along with corporate cash flows and earnings.

“Savings” (that indirectly originated with Fed purchases) then flow predominantly as buying power for risk market assets. Meanwhile, inflated corporate earnings/cashflows coupled with general loose finance (i.e. abundant inexpensive marketplace liquidity) spur corporate borrowing and stock buybacks. Corporate buybacks then work to inflate stock prices, directly as well as indirectly through inflating earnings per share growth along with increasing the attractiveness of speculative buying (i.e. a leveraged hedge fund increasing its equity allocation because of the bullish perception that ongoing stock repurchases significantly improve the equities market risk vs. reward calculus).

And if Fed liquidity injections and market backstops are ongoing, this ensures that speculative flows and trading dynamics become deeply entrenched in the marketplace. The bulls become more emboldened and the bears increasingly impaired. The chips shift to one side of the poker table, ensuring that the bulls raise the stakes and try to force the bears out of the game. Targeting the bears – with resulting “rip your face off” short squeezes - works to transform the marketplace into a speculative casino. Over time, QE ensures an unsound marketplace bereft of stabilizing supply/demand dynamics and typical checks and balances (including the shorting of over-valued securities). The upshot are market Bubbles with destabilizing inflationary biases. The Goldman Sachs Most Short Index is up 58% since November 15, 2012.

In a replay of the late-nineties, over-liquefied markets help enrich hundreds of thousands of insiders and fortunate employees at scores of companies enjoying hot stocks. Delving into more “flow” analysis, think of the Fed buying MBS from a hedge fund, and the fund then using this newly created liquidity to boost holdings of its best-performing positions. The sellers – say, employees from Tesla, Netflix, Facebook and Google cashing out of stock option grants – use sales proceeds for cash purchases of million-dollar three-bedroom homes in hot California real estate markets. The home sellers can then use this “cash” to pay down debt, as a down-payment for a larger home, or perhaps to take their own dive into the risk markets. And let’s not forget the Bubble’s impact on local, state and federal tax receipts, a temporary bounty quickly extrapolated and spent.

A rather long book could be written on this subject matter. My QE inflationary effects analysis would be lacking without at least brief mention of international consequences. I would argue that QE has had particularly momentous effects on global finance. QE worked first to reflate U.S. incomes and, more recently, to further inflate them. This has spurred spending and sustained large trade deficits. The weak dollar and resulting enormous trade, investment and speculative flows into the emerging markets (EM) worked to inflate historic Bubbles.

Mortgage finance was the “fledgling” Bubble that acted as an increasingly powerful magnet for liquidity and speculative excess during the Fed’s post-tech Bubble reflation. After the bursting of the mortgage finance Bubble, EM was the fledgling Bubble. Of late, serious cracks have formed in some emerging markets and economies, fragility that I believe has played a role in QE decisions over the past year. Over coming weeks and months we’ll stay focused on the comings and goings of “flow” analysis. Does the Fed’s ongoing QE help to reverse liquidity flows back to EM and their struggling economies? Or perhaps that’s just so 2012, with current animal spirits keener to play Bubbling U.S. stocks and corporate debt.