Tuesday, August 10, 2010

QE 2.0? We Can Hope That Fed Waits

Its Noon time in New York City and every market participant is waiting on the Fed announcement that should come out sometime after 2pm.

Market expectations are for the Fed to start an asset buying program. I think if this is announced it will be a total disaster not only for the Fed but for all markets around the world.

The rational is that the US Economy is going into deflation. This is true but its not a total disaster. So far its been an orderly deflation. Every time the Fed/Govt/Treasury overreact, it becomes a disaster and then prices spiral out of control. Again, deflation is a problem. Its hitting the US Economy right in the grill at the moment, but it’s yet to be proven that these deflationary conditions have twisted itself into a self-reinforcing and perpetuating vicious cycle. A little bit of deflation is not bad after the asset bubble we have encountered. This economy needs to deleverage and a little bit of deflation is needed. The bottom line is this. Bernanke is a classical academic who believes that asset prices have to be always rising, they can't be allowed to drop. This is ludicrous thinking and policy. One does not need a little or a lot of deflation because Bernanke and his 40 thieves believe its a huge enough potential danger, and they will do whatever to avoid it, even if this pain needs to be felt for the economy to move on for further future expansion. Instead we get extend and pretend. We get more stimulus, more useless QE.

So how did we get here? When the Fed started the first version of QE last year, many considered that the Fed needed a bigger boat. That the stimulus and asset buying the Fed was doing was not going to spur aggregate demand. Many of the monetarists wanted more juice to goose inflation, as of course in the words of Chief Neo-Classical Charlatan Milton Friedman "Inflation is a monetary phenomena."  Give the Fed some credit. The Fed more than doubled its balance sheet, in order to carry out QE Version 1.


From less than a trillion dollars to over $2.2T in 60 days! Forget about the balance sheet expansion, Bernanke more than doubled the entire money supply in less than 2 years. The big problem here of course is that what gets put into the economy needs to come out. So far all that is happening is more stimulus, more QE, more expansionary policies, but no aggregate demand nor loan growth. Loan growth is having a problem because there is no loan demand and banks don't want to lend. The banks are better off rebuilding their balance sheets by parking their money at the Fed gaining 25 basis points and riding the risk less yield curve. The banks are hoarding the liquidity provided by the Fed. In fact, financial institutions are financing the Treasury's stealth monetization program via open market purchases of treasuries at auction. So real asset prices are falling while treasury prices are rising. The monetarists are all freaking out over the current state of affairs and the Fed is dominated by these monetarists. Thus we have Bullard's paper last week. They want the QE2 to leave the shores. Another massive monetary expansion, to both prop up asset prices, and prevent a supposed deflationary death spiral. The scary part is the Fed has lots of room to print and not afraid to do so. My guess is that when we are all said and done, the Fed balance sheet will be bloated to at least $4.5T.

For what ever reason for today anyway,  I think the Fed will pass on the idea of an asset buying program. They need to keep bullets in their holster. The balance sheet is going markedly up, but not today I am hoping.

The Fed would be stupid to buy treasuries when they have already rallied by a huge amount. Why not wait till treasury yields go higher? My big fear is that the Fed announces a program today, this will put a floor in treasury prices even at these levels. The market will drop but not as much as if they don't do nothing. The market will slowly figure out over the next few weeks that the Fed thinks the economy is a lot worse than imagined and that deflation is a huge spiraling disaster. Both of these themes will self perpetuate. They wanted to stop deflation but just lit the fuse to do so.

China is the big factor hear. There economy is slowing down. Export figures last night doesn't give confidence for global growth as growth imbalances are preposterously on the Chinese side. The Chinese may or may not revalue their currency. its doesn't matter. With elections coming up in November, protectionist policies will creep up and we may see the makings of a trade war with China. The October 1987 on Monday the 19th, was preceded by Treasury Sec. Baker's comments about the dollar that very weekend. This time, Treasury Sec. Geithner has already hinted at such when speaking about the Chinese Reminbi.

The Chinese have a massive housing/construction bubble. Its really a credit bubble disguised as a super global growth story. The spark I am thinking will be when the Chinese economy slows down taking down the construction industry. China is long a ton of treasuries and will need to create liquidity to pay for the deflated bubble, and they will sell the most liquid asset available - US Treasuries. This will likely cause long term rates to soar. Why would the Fed buy up Treasuries now when they can buy them up later from the Chinese? They can keep our interest rates low and also help out the Chinese in the process. What it comes down to is, that the Fed is the lender and buyer of last resort. They bought up trillions of crappy MBS from the TBTF banks, this kept mortgage rates low, housing in check and the banks alive. The Banks in turn took the money and invested it in treasuries, keeping long term rates low. Its a giant ponzy scheme wrapped in a circle jerk, but its all we have at the moment. The Treasury/Fed can't afford the debt markets to go into the tank, this will be a national defense issue. That's why its very important that the Fed sits tight today. They need to keep their powder dry. If the Fed does what the market wants at this moment, we are all in trouble.

Eventually this will lead to some sort of USD revolt. Hyperinflation is just not a monetary issue, its an issue with regards to what investors think about a countries currency. The Fed is so worried about deflation they will have unwittingly stoke the fire for hyper inflation. Who knows when? All I can say is that if QE1 failed, then QE2 is the answer. When QE2 fails, QE3 will be the answer. Its a never ending story that will end in tears. St. Louis Fed official Bullard is on record stating that Japan was not successful because there was not enough QE, so the Fed is not going to take no for an answer until everyone is dead. I have stated in the past that all the Fed knows how to do is to print and they will do so until the country is sunk. The Fed is irrationally worried about deflation because its Wall Street that keeps pulling the strings. They are 100% committed to fighting falling asset prices and their only weapon is monetary expansion. They won't stop until they have broken the backs of deflation which will in turn break this economy into pieces.

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