Hera : MB

QE2 and its Consequences (Part I)

Ron Hera — Tue, 18 Jan 2011 01:35:00 GMT

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.

Chart courtesy of Shadow Government Statistics

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).

Chart courtesy of StockCharts.com

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.

Chart courtesy of StockCharts.com

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.

Chart courtesy of StockCharts.com

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 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.

The Ultimate Bubble and the Mother of All Carry Trades

Ron Hera — Sun, 31 Jan 2010 15:14:00 GMT

Among the many opinions expressed by billionaire investor George Soros over the course of the 2010 World Economic Forum in Davos, Switzerland was his statement on January 28 in an interview with Maria Bartiromo, host of CNBC's Closing Bell, that "When interest rates are low we have conditions for asset bubbles to develop, and they are developing at the moment. The ultimate asset bubble is gold." New York spot gold closed at $1085.40 down $1.80, but the price of gold is not as much about gold as it is about the value of currencies, particularly the US dollar.

Since new currency is created through lending activity, very low or 0% US interest rates and government deficit spending are fueling a US dollar carry trade and monetary inflation in the US dollar resulting in rising asset prices and global speculation. According to Zhu Min, deputy governor of the People’s Bank of China, “[The US dollar carry trade] is a massive issue; estimates are that it is $1.5 trillion, which is much bigger than Japan’s carry trade.” The close relationship of global commodity prices, particularly the gold price, to the value of the US dollar can be seen by comparing the changing value of the US Dollar Index to an inverted US dollar spot gold price chart.

^{Chart courtesy of}^{StockCharts.com}

The inverted gold price chart follows the USDX closely and while the fluctuations are not strictly proportional the overall trends as well as the peaks and troughs generally correspond, thus the asset price bubbles noted by Mr. Soros are reflections in asset prices of both the US dollar carry trade (the effective value of the US dollar) and, ultimately, of the long-term devaluation of the US dollar, thus the value of the US dollar in real terms.

^{Chart courtesy of}^{StockCharts.com}

An “ultimate bubble” in gold could be an offspring of the mother of all carry trades, but its magnitude would depend not only on the effective value and rate of change in value of the US dollar while the carry trade is booming, but also on the actual, eventual value of the US dollar (in real terms) after the carry trade has come to an end. Although the value of the US dollar will certainly recover to some degree when the carry trade ends, it will remain significantly lower in value for other reasons.

US Dollar Devaluation

In the above mentioned interview, Mr. Soros went on to say that "Some countries, like the US and European countries have plenty of room to increase their deficits; [although] the political resistance to doing so increases the chances of a double dip [recession] in the [global] economy in 2011 and after that." Since further monetary inflation as a consequence of government deficit spending may be necessary to maintain economic stimulus measures and financial system life support, Mr. Soros anticipates further devaluation of the US dollar. Devaluation of the US dollar will have both beneficial and harmful effects on the US economy.

Devaluation of the US dollar will reduce the value of debts in real terms, reducing the overall debt to GDP ratio of the US economy, and stimulate nominal GDP growth as domestic prices and wages (at different rates) adjust to the altered value of the US dollar, while at the same time helping to create conditions where US banks can resume lending to consumers and small businesses. Unfortunately, currency devaluation also has deleterious effects, such as higher prices, a loss in the value of savings and a reduction in the real value of wages. There is also a risk of uncontrolled domestic price inflation (although prices can be held in check without raising interest rates by curtailing the flow of money and credit to consumers and small businesses).

^{Chart courtesy of}^{Karl Denninger}

In addition to reducing the US debt to GDP ratio, devaluation of the US dollar will lessen the risk of higher interest rates resulting in greater deficit spending by the US government as a consequence of increased debt service ($145.4 billion in fiscal 2009) since it will allow the US federal government’s tax receipts to grow faster than the increase in debt service resulting from higher interest rates.

Currently projected US federal government borrowing (or, alternatively, quantitative easing) will maintain downward pressure on the value of the US dollar through the year 2019. According to the US Office of Management and Budget’s (OMB) baseline projection of current policy, federal deficits will total between $7 and $9 trillion for fiscal 2010 through fiscal 2019 and the US public debt will grow from $12.3 trillion to more than $16 trillion in 2019. Other estimates indicate that US federal government debt will exceed $18 trillion in 2019, setting aside the net present value of unfunded federal liabilities based on Generally Accepted Accounting Principles (GAAP). According to David M. Walker, former Comptroller General of the United States from 1998 to 2008 and current President and CEO of the Peter G. Peterson Foundation, current federal liabilities and unfunded obligations total approximately $63 trillion. As a result, further devaluation of the US dollar is inevitable.

Disparate US Dollar Values

Curiously, the US dollar has two different and diverging values, one within the US financial system and another in the broad US economy. As a result of the US financial system rescue, which included purchases of various assets from banks at book value by the US Treasury and Federal Reserve, the US monetary base has expanded roughly 150% since the beginning of the global financial crisis in 2008, but the newly created currency has not filtered into the broad US economy where, in contrast, deflationary pressures persist.

^{Chart courtesy of}^{Federal Reserve Bank of St. Louis}

Although it is not apparent in the broad US economy, the value of the US dollar has been dramatically altered and its devaluation cannot be isolated indefinitely within the financial system independent of the broad US economy. The counterbalancing, but much smaller, contraction of the broad US money supply, as measured by the M3 monetary aggregate, also cannot continue indefinitely.

^{Chart courtesy of}^{Shadow Government Statistics}

At some point, the two disparate values of the US dollar (that found within the financial system versus that found in the broad US economy) will be reconciled and, unless current policies are reversed, the outcome will be a substantially less valuable US dollar. The consequences of the eventual reconciliation will certainly include price inflation in the US, higher US dollar prices for commodities that are subject to global demand, such as oil and gold, as well as higher nominal values for US dollar denominated assets. However, the potential unintended consequences of a falling US dollar include high domestic price inflation, a further reduction in international demand for US debt or a collapse in demand, a disruptive decline in trade, i.e., US imports, or in the worst case, rejection of the US dollar as the world reserve currency or a hyperinflationary collapse of the US dollar.

Is Gold in an Asset Price Bubble?

Diversification for the purposes of risk mitigation and wealth preservation is a rational response to unstable market conditions and is not comparable to a market mania, like the dot-com bubble. Similarly, a long-term shift in asset allocation favoring one general category of assets over another based on fundamentals, while it may result in rising prices, does not by itself describe an asset price bubble.

An asset price bubble, such as the Dutch tulip mania of the 1630s, is an irrational and economically unsustainable investment trend that holds sway over investors only temporarily and that inevitably collapses violently. Asset price bubbles end when a tipping point is reached where the awareness of and tolerance for escalating risk exceed irrational exuberance producing a panic. So long as the great majority of market participants discount risk, individual participants may rely on the irrational exuberance of others. In contrast, rational confidence does not depend on a majority of market participants behaving irrationally and is based instead on sound fundamentals.

The view that rising global commodity prices, fundamentally, are asset price bubbles in various stages of formation unreasonably discounts the risks associated with financial institutions, governments and currencies. If we are to learn anything from Iceland, the Baltic states, Dubai, and Greece it is that if irrational exuberance exists in the financial markets today it is exactly confidence that is not based on sound fundamentals in financial institutions, governments and currencies.

In the 1980 asset price bubble, gold rose from an inflation adjusted low using constant 2009 dollars of $392.57 per Troy ounce on August 31, 1976 ($104 1976 dollars) to its January 21, 1980 peak of what would have been $2,358.04 in 2009 dollars ($850 1980 dollars), a gain using constant 2009 dollars of more than 500% in 4 years. The 1980 asset price bubble in gold violently collapsed in same year, returning to 1979 levels by 1982.

^{Chart courtesy of}^{Bianco Research, L.L.C.}

On April 4, 2001, the gold price would have been $315.78 in constant 2009 dollars, the lowest value since 1970 adjusted for inflation. From that point, the gold price rose from a nominal low of $255.95 on April 4, 2001 to a nominal high of $1,212.50 on December 2, 2009 (London PM fix), a gain of roughly 375% over approximately 10 years (284% using constant 2009 dollars).

^{Chart courtesy of}^{Kitco Metals Inc.}

Over the past decade, the US dollar has declined from its 2002 high by roughly 33% compared to other major currencies and approximately 40% from is 2000 high compared to the Euro. At the same time, most of the currencies in the major indices have been debased alongside the US dollar since 2008 for the same reasons, thus the value of the US dollar in real terms is not apparent from the index alone.

^{Chart courtesy of}^{Federal Reserve Bank of St. Louis}

The alternate US Dollar Indices published by Shadow Government Statistics (SGS) suggest that the Federal Reserve’s trade weighted exchange index of major currencies, which includes the Euro zone, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden, may be an optimistic formulation.

^{Chart courtesy of}^{Shadow Government Statistics}

The decline of a national currency, particularly that of a nation with a large trade deficit, is first apparent in international trade while domestic prices do not at first fully reflect the devaluation of the currency. As a result, the prices of commodities that are subject to global demand tend to rise before the general increase in domestic prices that results from currency devaluation, thus the prices of commodities such as gold would be expected to rise faster than domestic measures such as the US Consumer Price Index (CPI).

^{Chart courtesy of}^{Federal Reserve Bank of St. Louis}

The alternate CPI measure provided by SGS may represent a more accurate method of estimating the US dollar prices of commodities that are subject to global demand. The SGS alternate data show accelerating price inflation over the past decade leading up to the global financial crisis in 2008.

^{Chart courtesy of}^{Shadow Government Statistics}

If the SGS alternate CPI data are applied to the gold price it is apparent why Shadow Government Statistics’ John Williams stated in an interview with Bloomberg reporter Pham-Duy Nguyen that if the same methodology of measuring inflation were used today as in 1980, the 1980 gold price would be equivalent to $7,150.

^{Chart courtesy of}^FGMR

While gold certainly has enjoyed tremendous gains over the past decade, including the effect on the gold price of central bank gold demand, the current gold price, following on the heels of an unprecedented global financial crisis, has little in common with the 1980 asset price bubble. The current gold price reflects a rational diversification into hard assets for the purposes of risk mitigation and wealth preservation and can be explained in terms of monetary inflation and associated loss in the value of the US dollar independent of the US dollar carry trade. The continuing devaluation of the US dollar will result in a further rise in the prices of commodities that are subject to global demand, thus the gold price will continue to rise also.

Mr. Soros is certainly correct in that low interest rates contribute to the formation of asset price bubbles, but neither the value of the US dollar or the price of gold depend only on interest rates or on the US dollar carry trade. The view that a gold price over $1000 per Troy ounce represents the “ultimate bubble” ignores the ongoing devaluation of the US dollar, discounts risks associated with the stability of financial institutions, governments and currencies, and does not reflect confidence consistent with sound fundamentals.