Wednesday, November 17, 2010

QE2, QE3? - Ari Paul

On November 4th, the Federal Reserve announced a second round of quantitative easing (QE2). Bernanke will buy an additional $800 billion in treasury bonds; this represents roughly 100% of all new treasury issuance. Over the following week, equities rallied about 3%, while gold and most commodities surged higher out of inflation fears. China and Germany loudly criticized the US for deliberately debasing the dollar in a currency war. The newly elected Republican majority in the House began applying political pressure to prevent the Fed from printing more money. Will the combination of external and internal political pressure be enough to reduce the Fed's credit easing? Over the last few days, equities have sold off moderately and commodities have collapsed as interest rates have risen. Some market participants are speculating that either the Fed's easing will be insufficient, or they will not be able to continue easing for political reasons.

The other big story has been the continuing collapse of the EU. It never ceases to amaze me how for most people, "out of sight" equals "out of mind." Early in the year there was widespread talk of how an EU breakup may be inevitable because of the huge differential in labor productivity across EU countries. The IMF announced a nearly unlimited bailout of the PIIGS and the talk vanished, but the fundamental problem remained. Now, Greece has already violated the terms of their bailout by running too high a fiscal deficit, and Ireland is teetering on the brink of bankruptcy. I continue to believe that there are only two feasible outcomes: a very sharp devaluation of the Euro, or a break up of the Euro. The third path that we are currently on would require a new massive bailout every few years. Eventually, German voters will get sick of continually providing "emergency" support to their neighbors.

Back in the last quarter of 2008, many pundits predicted imminent inflation, because the Federal Reserve had just doubled the monetary base. I quoted Milton Friedman who wrote that there's generally a 2 year lag between money printing and its effects. Well, here we are two years later, and we're starting to see significant inflation in just about everything. Food prices, gold, healthcare costs, rental prices etc, are all rising faster than the fed's inflation mandate. The official inflation gauge, the CPI, is a poor model at best and chronically understates inflation. Moderate inflation is here. Some brilliant hedge fund managers like John Paulson believe it will escalate quickly and become double digit inflation in the next couple of years. Others like John Hussman believe that moderate inflation is sustainable, while others like Chanos believe the world will soon experience further deflationary shocks.

My focus remains on the credit cycle. This time last year I thought the credit cycle was near its peak. I failed to anticipate that Bernanke would launch a second round of quantitative easing equal in size to the entire monetary base that existed in early 2008. At the time, the idea that the Federal Reserve would buy 100% of new treasury issuance seemed extremely unlikely to me for political reasons. Bernanke has proven his willingness to print an unlimited amount of money, so we return to the question, will the external pressure from China and Germany, and the internal pressure from the House Republicans, be enough to halt the credit expansion? Without QE3, and QE4, I believe the equity market and risk assets in general will perform poorly.

With 10 year bond yields still below 3%, we are likely much closer to the end of the credit easing cycle than its beginning. The trend of cheap money (and the desire to bid up risky assets that comes with it) is likely close to an end. Unfortunately, I have no particular insight into whether the tightening cycle began this week or will begin in two years. Even if credit expansion has peaked, there remains the risk that inflation could surge out of control and become self-sustaining.

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