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Since
the Fall of 2008, Ben Bernanke and his co-pilots at the Federal Reserve have loaded
around $1.8 trillion of paper money, or its electronic equivalent, on
helicopters, dirigibles and whatever other flying machines they could find.
Yet despite all the monetary aviation, very few pieces of the funny green
paper called Federal Reserve Notes have fluttered to the ground.
So
much for hyperinflation! What went "wrong"? More importantly, what
is helicopter Ben going to do about it (next)?
What
went "wrong" is simply that the Federal Reserve can print all the
money that it wants but it cannot make banks lend or the private sector
spend. We could discuss various methods for measuring money supply or
inflation but let's just cut to the chase: total
credit market debt in the United States stood at $52.4 trillion at the
end of 2008 compared to $52.6 trillion earlier this year. That's a stagnant
credit market at best with the figures arguing against inflation regardless
of how it is measured or defined.
Yet
we think our Fed chief still has some tricks up his sleeve. QE1 and QE2 -
so-called quantitative easing that literally increases the quantity of
monetary base -- consisted primarily of the Fed expanding its balance sheet
by monetizing the federal deficit. These were helicopter drops, simple as
that. Let us make a mental note that helicopters are slow flying machines
that specialize in transporting things from place to place; the Fed uses them
to transport securities from the banks' balance sheets to the Fed's balance
sheet. In these transactions, the banks are essentially acting as middlemen
since the Fed cannot bid directly at Treasury auctions. Excess reserves are
flown back in exchange.
QE3
we suspect is going to consist of the Fed coaxing banks into expanding their own
balances sheets by monetizing the federal deficit. This may also involve the
Fed swapping some of its assets - for example Treasury securities maturing in
1 to 5 years - for bank assets of lower quality, thereby improving the banks'
regulatory capital ratios. Then again, Standard & Poor's is rating
a subprime mortgage-backed security AAA after having downgraded U.S. debt
to AA+, so who the heck knows what "quality" means anymore?
In
any case, the difference is subtle but important. QE1 and QE2 had the effect
of increasing the quantity of money; QE3 will focus on increasing the velocity
of money. The "Q" in QE3 will likely be "qualitative"
instead of "quantitative".
So
it turns out Helicopter Ben might no longer need those slow choppers; he'll
want something instead that can make money fly fast. Thus the arrival
of QE3 could usher in a new central banking legend: Fed Bennie
and the Jets.
Say, Candy and Ronnie, have you seen
them yet?
But they're so spaced out, Bennie and the Jets
Oh but they're weird and they're wonderful
Oh Bennie she's really keen
She's got electric boots, a mohair suit
You know I read it in a magazine
Bennie and the Jets
Some
people might prefer this subtlety-free version but we think
the classic is sufficiently apt: QE3 will be weird and wonderful ... just
like the 1970s! What's that? You don't think Bennie's really keen? Wait until
you see the wild, destabilizing swings that are in store under QE3! They
could make QE1 and QE2 seem like a kindergarten re-enactment of the chase scene from Bullitt.
Specifically,
during QE1 and QE2 the Fed was in full control since it could determine when
and what securities to buy. Moreover, the Fed was prepared to freeze all of
the excess reserves it had created. This could be accomplished simply by
increasing the interest rate paid on those reserves. By contrast, QE3 will
likely feature the banks deciding for themselves when and what securities to
buy while the Fed tries to maintain some semblance of remote control as a sort
of monetary puppet master. Or more aptly, that man behind the curtain.
So it's "Fed Bennie and the Jets of Oz" then!
Seriously
though, the risk with QE3 will simply be that $1.6 trillion of excess
reserves are now held by the banks. These excess reserves represent the
"electronic equivalent" of Federal Reserve Notes created by
literally running the printing press. Excess reserves are high powered money
because there are no bank liabilities associated with them and therefore they
can be fully leveraged under a fractional reserve banking system. Each dollar
of high powered money can generate at least 9 dollars of deposits and in some
cases an infinite amount.
The
expansion in bank balance sheets, however, is not by itself what should worry
us. There is a limited amount of uses to which banks are likely to put excess
reserves in the near term - mainly shorter-dated U.S. Treasury securities in
the 2, 5 or 7 year maturities. Therefore the banks are unlikely to expand
their balance sheets at a pace much faster than the U.S. Treasury Dept. will
be issuing these maturities during its weekly auctions in the future. As
already mentioned, the Fed can also boost the pace at which excess reserves
are leveraged by the banks. Doing so would involve a qualitative
easing whereby the Fed exchanges Treasury securities maturing in 1 to 5 years
that it owns for various assets that the banks are (more) loath to own.
Still, if credit continues to contract in the private sector, the monetary
system will essentially be treading water.
The
worry, rather, is about systemic stability. When high powered money goes from
idle to circulating, it is impossible to control its initial velocity.
Normally the majority of high powered money consists of paper currency held
by the public. The public changes its savings preferences slowly over time --
for example, deciding to stuff some money under the mattress just in case.
This results in gradual changes in the velocity of money in part because
relatively small sums are involved - a few billion dollars here and there.
The
banks, however, don't have preferences that change slowly over time when it
comes to excess reserves.In fact, they have
absolutely no reason to keep excess reserves on the books if they can instead
buy assets that earn a superior yield and still are sufficiently
liquid and safe. So while the amount of assets that are appropriate for banks
to buy with excess reserves might be in limited supply, the nature of excess
reserves once un-moored from frozen idleness is very much that of a hot
potato - nobody wants to hold on to it but somebody has to.
Indeed, it is the hot potato effect that allows even a small temporary
addition or draining of reserves (a mere few billion dollars) to have a large
effect on bank lending and money markets during normal times.
But
clearly we are not in normal times with $1.6 trillion of excess reserves
sitting on the banks' books. If only a few billion dollars of these reserves
were to become "hot potatoes", the Fed would need to scramble in a
very expeditious manner to prevent collateral damage in the money markets or
elsewhere. What would the Fed need to do if the hot potato was a cool $100
billion? $1 trillion? One limited course of action would be for the Fed to
drain its own balance sheet in order to sterilize hot potato reserves - for
example by trading away the aforementioned Treasury Notes maturing in 1 to 5
years. But that can only go so far (specifically as far as the Fed owns the
right assets to be traded away). If the banks refuse to buy whatever the Fed
decides to hock after exhausting its supply of the good stuff, what then? We
don't know, and we don't want to find out.
Importantly,
we believe the initial preparations for a round of "jetting around in
Oz" have already been made by Bennie under the pretext of extending zero
short-term interest rates indefinitely (or at least until mid-2013). The
crucial result of this monetary accommodation is the elimination of duration
risk from most short- to medium-term debt. Duration risk is simply the risk
that the market value of a bond yielding a fixed rate of interest falls as
interest rates rise. With short-term rates already near zero and the yield
curve at historic lows, duration risk is one of the key considerations for
managing bank balance sheets. In no uncertain terms, duration risk was a key
reason why the banks sold assets in the first place to the Fed under QE1 and
QE2 in exchange for excess reserves. Eliminating duration risk could
therefore start to thaw some of the currently-frozen excess reserves, even if
just at the margin.
Indeed,
we need only point to the massive $100 billion (roughly 16% in one week or
830% annualized) jump in demand deposits
between July 25 and August 1 as a proof of concept for our "Fed
Bennie and the Jets of Oz" hypothesis. Along with recent wild moves in
the Treasury markets that have made even Bill Gross of Pimco
blush, this is precisely the type of action we expect to regularly see going
forward as excess reserves thaw out and enter circulation in dribbles from a
dead stop to terminal velocity in a matter of moments. Several days of raw
volatility will then be followed by weeks of relative calm as the monetary
shifts and imbalances resulting from banks passing the hot potato are
gradually sorted out. And then, bam! It happens again. And again.
Other
things we expect, or at least wouldn't be surprised, to see as QE3 unfolds:
1.
Extreme volatility with an upside bias in the gold
market and to a lesser extent in silver, commodities, emerging markets, hard
currencies and hard assets;
2.
Large daily or weekly (5 to 10 full points) moves in
Treasury prices followed by long periods of chart consolidation as the banks
monetize the federal deficit in fits and starts while the Fed desperately
attempts to assert some control from behind the curtain using the repo market
and other levers at its disposal;
3.
A liquidity trap or two requiring emergency action as
the payment system freezes up during wild swings in Treasury and money
markets, during which periods we may see short episodes of "all-market
selloffs" similar to, but not nearly as severe as, late 2008;
4.
Inflationary pressures to start building by the end of
this year or early next; at first slowly and then accelerating as it becomes
obvious to the market what the Fed is up to (we note that economists at JP
Morgan and other investment houses have probably figured it out already, leading to
their bullish calls for $2,500 gold);
5.
No hyperinflation as overall growth in credit and
economic activity remain anemic, resulting instead in stagflation similar to
the 1970s;
6.
The U.S. dollar remaining in its multi-year trading
range as credit contraction places demands on its legal tender status for
settling all debts, public and private;
7.
A tough go for equities in general with a few bright
spots especially in the resource, technology and alternative energy sectors.
We'll have much more to say on this
topic in the future including a look into several other factors to watch out
for as well as what reports and indicators we are monitoring to assess the
progress of QE3. Meanwhile subscribers will
receive exclusive insights such as ideas for gold stock investing and
speculative plays such as the call options that we recently parlayed into
2000% to 5000% gains.
Tom Szabo
MetalAugmentor.com
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