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The Federal Open
Market Committee (FOMC) announced on November 3, 2010
that it would purchase longer-term Treasury securities at a pace of $75
billion dollars per month through the Federal Reserve’s Permanent Open
Market Operations (POMO) facility by the end of the second quarter 2011 and
potentially beyond. The Quantitative Easing Two (“QE2”)
program, championed by Ben Shalom Bernanke, Ph.D., Chairman of the US Federal
Reserve, is expected to total at least $600 billion and the program may total
more $600 billion, if Dr. Bernanke and the FOMC deem it to be
necessary. Currently, QE2 is expected
to continue until the end of 2011, i.e. up to
$1.2 trillion, although there is ongoing
policy debate within the Federal Reserve amidst growing
fears that the
policy may backfire.
Monetary inflation is one result of QE2 because when
the Federal Reserve buys US Treasuries it injects newly created money into
the financial system, which, in turn, reduces the value of the US dollar (due
to the increase in the quantity of dollars). A lower US dollar could
stimulate US exports but could have unintended consequences, such as creating
excess liquidity that could lead to asset price bubbles in the US.
Low interest rates are already fueling a US dollar carry trade that seems
likely to create asset price bubbles abroad. In 2010, borrowing in the
US and investing abroad yielded significant returns,
thus, there is a profitable carry trade in the world’s reserve
currency, which has been called the mother of all
carry trades by New York University economist Nouriel Roubini
because of the US dollar’s increasingly tenuous status as the world
reserve currency.
Global Outcry
Against QE2
The announcement of QE2 touched off an international
firestorm of controversy. QE2 has been
widely criticized by financial and political leaders representing US
creditors, exporters and emerging economies. Nobel laureate
Joseph Stiglitz has become an outspoken critic of QE2,
warning that it poses a risk to emerging
economies where asset price bubbles are already apparent.
European Central Bank (ECB) President Jean-Claude Trichet expressed
the same concern. The growing consensus on the part of emerging
economies, such as Brazil,
India, China,
Argentina, Taiwan,
Thailand, South
Korea, Peru
and Indonesia,
is that capital controls are
necessary to prevent excessive capital inflows, which can be highly
inflationary. The International Monetary Fund (IMF), which bailed out a
number of smaller countries in 2008, has supported capital
controls since February 2010. The
dilemma for exporters is that they must seek to control inflation, e.g., by
raising interest rates, but must also debase their currencies to maintain
their exports. The only other option is to institute capital
controls. One of many critics, Brazil’s
Finance Minister, Guido Mantega, warned that the US-led
currency war “…is turning into a trade war.”
The growing consensus is that inflation in Asia
will damage Asian economies before Western countries, which are debasing
their currencies, fully recover from the
recession that began in 2007. The trade relationship of the US
and China
is in the eye of the storm and fears of a trade war are growing.
Debasing the US dollar reduces the value of China’s
US Treasury holdings while China
relies on exports to the US,
totaling between $200 and $300 billion annually. For exporters, QE2 is
a doubly destructive policy since capital inflows are inflationary while
exports are reduced due to currency appreciation. The potential effects
of a downturn in manufacturing resulting from falling exports, coincident
with the bursting of an asset price bubble, is a formula for disaster.
As more countries begin to conduct international trade without using US
dollars, the world could be split into two camps. For example, talks are taking
place between the US and Japan regarding the establishment of trans-Pacific
free trade.
Interestingly, QE2 has the potential to “cash
out” favored holders of US Treasuries in exchange for US dollars at
their current value, i.e., before the US dollar declines further. China, Russia and
Brazil are already reducing their US Treasury holdings and
could be favored sellers of US Treasuries to the Federal Reserve (through its
intermediaries). However, given the size of the US
federal deficit, the simplest explanation is that the Federal Reserve is
simply funding the US
government.
Keeping the
Wolfpack at Bay
While it may stimulate US exports and help to create
conditions for renewed economic growth in the US
(rather than relying mainly on the stimulation of consumer spending), QE2 represents
a debasement of the US dollar and suggests that demand for US
debt may be weakening. The current facts regarding the US
economy do not justify the AAA rating of US
sovereign debt. In February 2010, Moody’s
publicly warned that it might have to cut the rating on US government debt.
The warning was
reiterated in December, while American politicians
debated tax policy, and surfaced again in January.
Until the US economy
shows stronger growth, and until the US
federal government gets its budget deficit under control, confidence in US
sovereign debt and in the US dollar will continue to deteriorate.
US Treasury yields began to rise after the
announcement of QE2 and, in December, US Treasuries
experienced an unprecedented sell-off causing
speculation that the US may become the next target of the so-called
wolfpack, comprising short sellers of sovereign debt that are also OTC
derivatives (credit default and interest rate swaps) traders.
Artificial demand for US Treasuries created by QE2 could potentially head off
the shorting of US Treasury bonds to generate credit default and interest
rate swap related profits. Short sellers seeking to drive up yields run
the risk that the Federal Reserve will step in and buy aggressively to drive
yields back down, thus QE2 may preempt the wolfpack. The United
States is not immune to such predatory
practices might because the notional value of OTC derivatives is currently
more than $605 trillion (approximately 10 times world GDP).
Artificial demand for US Treasuries could hold down
bond yields thus supporting an inflationary monetary policy but the Federal
Reserve’s own Primary Dealers forecast
higher bond yields for 2011. The
Federal Reserve’s control over US Treasury bond yields appears to be
limited, ironically, as a consequence of currency debasement. Even if
US Treasury bond yields rise, however, QE2 might still provide a means of
keeping the wolfpack at bay.
Let them Eat
Dollars
While QE2 has been generally positive for equities
in the short term, the FOMC announcement in November 2010 triggered a sharp
rise in commodity prices with gold closing over $1400 and silver closing over
$30 at the end of 2010 and with the Commodity Channel Index (CCI) and global food
prices at new highs. Rapidly rising global food
prices pose an escalating risk of food shortages or worse, particularly in
poorer countries, leading analysts to conclude that the world is
one poor harvest away from chaos.
President of the World Bank, Robert Zoellick, warned that rising food prices
are “a threat to global growth and social stability.” Food riots, for
example, have already begun to break out in Africa.
In the US, consumers and
businesses paid an additional $25 billion for gasoline
between September 2010 and January 2011 and gasoline prices
have continued higher.
Since the corrosive effects of expanding the money
supply in excess of the rate of increase in sustainable economic activity,
i.e., inflation, could not so quickly have resulted from QE2, QE2 seems to
have damaged global
confidence in the US dollar and in US
Treasury debt. The January pullback in gold and silver showed that the
sharp rise in prices after the announcement of QE2, in November 2010, was in
part reactionary. Nonetheless, the strengthening of the US dollar can
be largely attributed to the ongoing debt
crisis in Europe and the ongoing bull market in commodities and
precious metals points to a continuing influx of capital and to a reduced
preference for the US dollar and US Treasuries. Had it not been for the revelation of
Ireland’s economic troubles along with
those of other European countries, the US dollar would certainly have fallen
further compared to the Euro towards the end of 2010. What is more important
is that the Euro, the US dollar and the Japanese yen have the same
fundamental problem in common, which is a combination of high debt levels and
economic fundamentals that, in the best case, do not inspire confidence.
All other things being equal, if the QE2 program
were terminated, the US dollar would certainly rally and demand for US
debt would certainly strengthen, lowering demand for commodities and precious
metals. The termination of QE2 or an announcement of its impending
termination is a potential short term risk for investors. Conversely,
as QE2 continues indefinitely, the current commodities bull market, which has
been amplified by the weakening US dollar, will continue And precious metals
prices, which are currently consolidating, will move higher.
The emerging pattern since the announcement of QE2
is bullish for commodities and precious metals. Episodic flights to
safety have tended to cause the US dollar to rally, despite poor economic
conditions in the US, i.e., in response to economic instability in countries
such as Dubai, Greece, Ireland or Spain. The pattern of US
dollar-centric flights to safety has begun to break down, suggesting that
investors may increasingly favor commodities and precious metals over US
dollars and US Treasuries as hedges against inflation and sovereign debt
risk.
Diminishing US
Credibility
The credibility of the US
government and the Federal Reserve is gradually deteriorating. In the worst
case, a total collapse of confidence could trigger a race to divest of US
Treasuries and to shed US dollars, i.e., a hyperinflationary currency
event. The declining US dollar and the diminishing desirability of US
debt and of the Federal Reserve’s credibility bode well for commodities
and precious metals while warning away any sane investor from US Treasuries.
In the face of indefinite QE2, it remains unclear
(1) when the disintegration of the US dollar’s status as the world
reserve currency might accelerate and a new reserve currency will be
established, (2) if and when holders of US Treasuries seeking a way out might
reach critical mass potentially triggering a proverbial rush to the exits
(i.e., a collapse of US Treasuries despite the Federal Reserve’s
artificial demand), or (3) if and when a race, whether global or domestic, to
shed US dollars in favor of equities, hard assets, alternative currencies,
precious metals or other real goods might begin. The first and second
processes (removal of the US dollar’s world reserve status and the
divestment of US Treasuries) are already under way and the Federal
Reserve’s current policies are on track to eventually trigger the
third.
Fundamentally, the Federal Reserve cannot prevent
rising prices while the US dollar moves lower due to QE2 and due to the US’
deteriorating creditworthiness and credibility, nor can it control the flow
of liquidity resulting from its actions or, therefore, resulting asset price
bubbles, whether in the US
or abroad. In light of the Federal Reserve’s current policies, it
seems likely that, in the next 12 months, global economic volatility related
to inflation, currency debasement and, potentially, developing currency and
trade wars will increase while the financial stability of the US
and of the Eurozone countries continues to decline and while commodity and
precious metals prices continue to move higher.
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Ron Hera
Hera Research
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