By
The
Inflation Trader
:
The most striking facet of Wednesday's trading was that the
stock market actually reacted to the Fed's announcement, which was
precisely as universally expected: no change in anything but the
technical language about where the economy currently stands. It
wasn't a huge reaction, but the fact that the S&P actually
dropped 5 points on the news is mind-boggling to me because it
implies that some people were expecting big things out of the
Fed.
To be sure, the arrow of action on the Fed is clear and pointed
to ever-increasing amounts of liquidity, but this wasn't ever on
the docket for today. However, several Street economists have
predicted, plausibly I think, that when Operation Twist expires in
December (partly because the SOMA will run out of short-dated
Treasuries to sell) the Fed might keep going with the buying leg of
the Twist - effectively increasing the monthly outright purchases
of paper to $85bln (including Treasuries) from $40bln (all mortgage
paper) currently.
Operation Twist has been a useless operation from the standpoint
of monetary policy - it has neither added nor subtracted liquidity
from the system. It may have had some value from the standpoint of
asset-market-maintenance policy, by removing duration from the
market and forcing investors to accept more risk for the same
amount of reward. So it may be the case that Twist had some effect,
but mostly a bad effect since it certainly doesn't seem from market
pricing that investors have been timid about taking risk. And I
suppose it ought also be observed that "asset-market-maintenance"
isn't part of the legislative mandate of the Federal Reserve.
However, legislators can be generous when markets are being pumped
up - it's when the air goes out that they're unhappy.
Weirdly, though, I would prefer Operation Twist, which has
little impact, to what is likely to replace it (additional QE).
Policymakers globally are growing increasingly bold about
quantitative easing. In Europe Wednesday, ECB President
Draghi told German legislators
that outright bond purchases by the ECB "will not lead to
inflation. In our assessment, the greater risk to price stability
is currently falling prices in some euro-area countries. In this
sense, OMTs are not in contradiction to our mandate: in fact, they
are essential for ensuring we can continue to achieve it." (
See also this story
.)
Central bankers are getting bold, but I'm not sure I understand
why. They clearly see the connection between QE and inflation -
fending off deflation was the purpose of QE2 and Draghi is clearly
indicating the same even though core inflation in the Eurozone has
risen from 0.8% in 2010 to 1.5% now (
see chart below, source Bloomberg
). That's not exactly flashing red signals on inflation, but it is
utterly fantastic to suggest that it indicates deflation is a
greater risk.
(click to enlarge)
In the U.S., QE3 and the likely acceleration of QE3 later this
year is happening in the context of year-on-year rises in median
new home sales prices (released Wednesday) and existing home sales
prices (released last week) of over 11%, as the chart below (
source: Bloomberg
) shows. Note that the existing home sales data is much more
dependable on a month-to-month basis, because the number of
existing homes and existing home sales swamps the number of new
homes sold, but both show the same, clear trend. Home prices are
now rising nearly as fast, nationwide, as they did in the bubble
years.
(click to enlarge)
For the record, the all-time record one-year price rise in
existing home sales was 17.4% in May, 1979. Of course, in May 1979
core inflation was rising at 9.4%. In fact, with the exception of
the last phases of the bubble of the early 'Aughts, existing home
sales prices are rising at the fastest margin above core inflation
ever, as the chart below shows (
source: Bloomberg;
Enduring Investments
calculations
).
(click to enlarge)
Policymakers, and investors, seem to be numb to the threat of
additional QE for one of two reasons. Either it is because of the
belief that prior QE did not cause inflation (incorrect, as
illustrated above and by the statements of intentionality of the
policymakers themselves) or because they're buying the line that QE
is only adding to "sterile" excess reserves.
I think that this is dangerously sanguine. In fact, although it
is true that QE initially results in greater excess reserves only,
and these have only slowly trickled into transactional money, I
think there's reason to believe that adding more QE may increase
that pace of transmission. Picture a large cylindrical vat, open on
top with a small valve at the bottom. The water in the vat
represents excess reserves, and the water trickling out through the
valve is transactional money.
Many things can affect the pace at which the vat water flows
through the valve - lending opportunities tied to credit demand and
credit quality, disincentives to lend such as Interest on Excess
Reserves ((IOER)), and moral suasion in both directions. Crank IOER
to 25%, and all of the water poured into the vat remain as sterile
excess reserves and QE is just reliquifying the banking system. Put
IOER at a 10% penalty rate, and all of the water going in the top
will flow out of the bottom very quickly - and all of the other
water that's already in the vat, too.
But even if you don't adjust the valve at all, the greater
weight of water in the cylinder, as you keep adding more water,
will increase the flow out of the valve. Adding more QE is akin,
economically, to increasing the weight of water in the
cylinder.
The parallel economic concept is that a greater amount of excess
reserves increases the opportunity cost of reserves. The average
return on assets for a bank gradually declines as more of these
assets become excess reserves rather than required reserves against
lent funds. Leverage also declines, with the result (as I have
pointed out before) that return on equity suffers. The chart below
(
source: Bloomberg
) shows the return on equity for large banks (those with more than
$10bln in assets). You can see that while bank earnings have
recovered significantly from the nadir of the crisis, they also
appear to have leveled off at around 8% compared to the 15% that
was the consistent standard prior to 2007.
(click to enlarge)
The lending officers in these banks, although they're being told
to increase the quality of their loans, are being told more and
more to also increase the quantity of their loans. They cannot do
both, but as the pressure of too many reserves on the balance sheet
builds, the pressure to make more marginal loans increases as well.
This is the part of the valve that the Fed cannot control, and
where danger lies going forward. The multiplier may well respond,
eventually, to the weight of the reserves themselves.
See also
Retirement Strategies: To Hedge Or Not To Hedge,
That Is The Question
on seekingalpha.com