Quantitative Easing

The latest dismal GDP data probably will cement an official kick-off of Fed's QE2 on Nov. 3. However, as more quantitative easing could further dilute the value of the dollar, pushing up the commodity prices, the system could be pushed beyond its limit into a possible “demand-pull stagflation” scenario.

Notwithstanding persistent headwinds in the global economy, ranging from sovereign debt fears in Europe to double dip risks in the US, equity markets had their best September in over seventy years. This may be largely attributed to the expectation that in order to prop up a flagging recovery the US Federal Reserve will soon embark upon a second quantitative easing (QE) program, as further evidenced by recent US dollar weakness and gold reaching historical highs (in nominal terms). This expectation seems to be getting traction. According to a leading financial blog (1), Goldman Sachs recently sent a note to its clients stating that the Fed will announce $500 billion in asset purchases at the November 2-3 meeting. Even prominent hedge fund managers are publicly proclaiming that QE is a sure thing, and that this will put a floor under equity prices. But will the Fed implement a sizeable QE program over the near-term? And how much is actually needed to keep equity markets humming along?

For the little guy or the economy as a whole, that is ... But it's GREAT for the people who really matter

D'oh!

Keynesian stimulus can't be examined in a vacuum.

Back in April investor bullishness was at extremes. Consequently, Wall Street ramped stocks first upwards (the usual predilection) to shank the puts… only to swiftly reverse the action in the middle of the week to shake out the calls. This whole system occurs courtesy of the Federal Reserve which openly and blatantly pumps the market on options expiration week. I’ve shown the below chart before. It’s staggering that no one in Congress or any of the regulators actually bother following up on this. How much more obvious does Bernanke need to get?

Simply copying the US style of Central Bank Crisis mitigation is a bad idea, particularly since I believe the US has not mitigated the problem at all, but simply kicked a soda can down the road until it gained the unstoppable momentum of a dumpster. Now, the ECB is actually trying to kick that dumpster, and appears to be stubbing its toe!

"Ben, keep up the rah rah if you have to, but I think you need to accept that folks are beginning to see the post-Lehman global recovery for what it was - a 1 yr wonder driven by the most extraordinary policy response ever seen in history at the global economy level. And folks are now beginning to accept that a slow down is on its way, with policy makers pretty much all-in. All that's now left, as I have said before, is for the Fed to shift to a USD5trn or so new QE programme, likely in co-ordination with a bunch of other central banks, which in total may give us USD10trn or more of new QE. But this isn't happening until much much later this year or, more likely, next year."- Bob Janjuah

If you needed any confirmation that the next round of QE is just around the corner, here it is. Just headlines for now. As the US is in a pretty "bad downturn" right about now, it is only a matter of time before Bernanke flips the turbo-print switch. Recall that Bob Janjuah expects the Fed to launch a new $5 trillion QE version by early 2011. The odds of him being right just went HFT caught in a short squeeze. Bullard also noted that QE will be removed eventually and in due course, which he presumably equated with a 5 year period. Expect ZIRP to last through 2015 at least. By then US debt/GDP will be around 100x (not %).

This isn’t a “call to action”. Nor is it a brow-beating for those who care about the political institutions of this country. It is just an indication that when a national/global economy toilet-bowls there are neither easy nor satisfying answers. The powers that be are going to do what is necessary to prolong their survival. This is applies very generally. You can see this in the source materials of democracy, the original material.

When it comes to the framing minds of the United States of America, you can keep that ideologue Jefferson. The real genius was James Madison: pragmatic and driven by strategic reasoning married to direct observation. The whole structure of governance depends on his notion of checks and balances. He also had some things to say about monetary policy in extreme circumstances.

The Fed's response to the financial meltdown was twofold: Interest rates were effectively set at zero, and the monetary base was increased 140%. While it is not known exactly what formula the Fed used to arrive at the 140% increase of the monetary base, the expansion from roughly 800 billion to 2.2 trillion roughly correlates with the asset backed securities since purchased by the Fed. Quantitative easing is nothing new, as between 2001 and 2006, Japan used QE to gradually increase the monetary base by about 70% in an attempt to spur loan growth and promote inflation. The extra liquidity provided by the Bank of Japan did increase lending and promote inflation, but once the liquidity was withdrawn, the deflationary pattern resumed. Apparently liquidity alone did little or nothing to promote long-term price stability.

The Federal Reserve's assets were at $2.27 trillion as of February 25, jumping by $6 billion sequentially. Securities held outright: $1,975 billion (an increase of $62.6 billion MoM, resulting from $59 billion increase in MBS and $3 billion in Agency Debt), or $8 billion increase sequentially. The fed has completed $169.1 billion of $175 billion in the agency MBS program, or a 97% completion, and 96% complete with purchases of Agencies. The Fed has completed $1.21 billion of its $1.25 billion MBS debt purchase program, or 97%, through February 25. There is just $45 billion left in QE. Net borrowings: $103 billion. The monetary base increased by $81 billion in the past fortnight to $2.14 trillion. The ratio of total assets to Monetary Base declined slightly to 1.06x. Float, liquidity swaps, Maiden Lane and other assets: $191 billion. The CPFF program was at $7.7 billion. FX liquidity swaps are now at zero: we are carefully keeping an eye on this metric as any increase presently would indicate banks are again experiencing a dollar funding shortage. Maiden Lane I and Maiden Lane II increased and were $27.2 and $15.5 billion, while Maiden Lane III as always continues pretending it has value and came flat at $22.4 billion.

One topic that has caught the mainstream media's attention is the recent surge in Direct Bid take down participation in Treasury auctions, which as we pointed out previously (3 Year auction, 10 Year auction), has jumped from sub 10% average well into the double digit arena. Today the Financial Times dedicates an entire article to questioning just who may be going all out in their purchases of Treasuries as a direct bidder. We suggest that this "bid" is none other than China funding Direct covert purchases of Treasuries as an extension of the Fed's Quantitative Easing policy.

A stunner to end the Black Friday news flow. It appears the race to the hyperdeflationary bottom just shifted into overdrive.

Economic observations courtesy of Fed Fund futures, and the Taylor Rule, imply that not only is the economy now worse than it was before the Fed embarked on the colossal monetization ploy that is QE, but that rampant deflation courtesy of a much worse economic picture than presented by the government, will force the Fed to launch QE 2.0 imminently. The probability of a Fed Fund increase for a long, long time is zero.