US cannot continue the endless sugar rush
Last Thursday, in its latest bid to kick-start the US economy, the Federal Reserve went “open-ended”. America’s central bank is to launch a third round of “quantitative easing”, Fed Chairman Ben Bernanke announced, while extending the length of its pledge to keep interest rates at rock-bottom. On cue, global equities surged, as confidence grew that the world’s leading central banks have “finally taken decisive action” to buttress both the US and European economies.
Bernanke’s move, of course, followed news in early September that the European Central Bank is to engage in “unlimited” buying of the sovereign bonds of “peripheral” eurozone members. This encouraged the belief that monetary union is less likely to crumble, which cheered-up global equity markets just before last weekend. Many traders are celebrating this weekend too, following Bernanke’s words on Thursday, which caused the S&P500 to extend a rise that has now pushed the index to its highest level since 2007. European shares also reached highs not seen for over a year.
Specifically, Bernanke said that rather than buying US Treasuries, this round of QE will focus on mortgage-backed securities (MBS) – financial instruments linked to bundles of loans previously extended to home-buyers. The Fed, we were told, will purchase up to $40bn (£25bn) of MBS each month until American unemployment looks a lot better. “If the outlook for the labor market does not improve substantially,” the statement said, “the committee will continue its purchase of agency mortgage-backed securities … until such improvement is achieved”. In addition, the Fed’s main interest rate will remain “near-zero” until mid- 2015, beyond the previous late-2014 pledge.
In headline terms, QE3 looks small compared to the “big bazooka” which Bernanke wielded in the immediate aftermath of the Lehman collapse. Between November 2008 and March 2009, the Fed bought no less than $1,750bn of US Treasuries and bank liabilities. That represents a monthly purchase rate almost nine times that of the program Bernanke just launched.
If you add this latest MBS-focused package to existing Treasury-buying schemes, though, then the Fed’s on-going monthly purchases will be more like $80bn – twice the headline amount. Remember, also, that the US central bank has just committed itself to explicitly targeting not prices, but unemployment. In August, only 96,000 US jobs were created in net terms and joblessness remained at 8.1pc. With Bernanke referring to 6pc unemployment as “the long-run average”, and the Fed committed to QE3 until the labour market “substantially” improves, this latest bout of money-printing could extend into 2014, which is when the Fed predicts unemployment will fall to “normal levels”. So even at the relatively low monthly purchase rate just unveiled, which could of course rise, last Thursday may have signaled the launch of a $1,500bn funny money missile, around the same size as that the Fed fired in its initial post-Lehman response.
QE3 could be around the same size as QE1, then, albeit over a much longer period. That’s what got the markets so excited. In fact, QE3 could even extend beyond 2014. After all, Bernanke also said, for the first time, that QE and ultra low interest rates “will remain appropriate for a considerable period after the economy strengthens”. So we could see a prolonged “ultra-easy” policy, going way into the future. To sit alongside the eurozone’s “unlimited” bond-buying, America has offered up endless QE.
Some Fed critics note that QE3 is to happen at a time when major equity markets are at multi-year highs and monetary policy is already incredibly loose. Some commentators also “detect” a political bias, given that this equity sugar rush could help President Obama’s chances of re-election in November. Such observations, while entirely true – obvious to the point of banality, in fact – don’t get to the heart of the matter.
For the heart of the matter is that with US house prices down 25pc since their 2007 peak, between and quarter and a third of American residential mortgages are “under water”. Millions of US home-loans have gone bad. By purchasing bucket-loads of MBS, then, the Fed is basically buying up yet more of the toxic waste which the banks, as a result of their previous deeply irresponsible investments, still have smoldering on their balance sheets. Rather than writing down such losses and taking the hit, the money-men now know that the Fed, on top of the $1,250bn of MBS it has already bought, will suck-up even more of the banking sector’s mess.
Politicians are desperate for Wall Street’s campaign donations, of course. By refusing to lend, banks across the Western world have anyway got the political classes over a barrel. America’s QE3, and its Western European variants, represent the latest round in an extended game of blackmail which our elected leaders seem happy to let the banks win. Then again, money-printing helps myopic politics too, meaning they can worry less about budget deficits and spending constraints, seeing as previous bouts of QE have dampened sovereign yields.
If “insanity” is doing the same thing again and again and expecting a different result, then it’s difficult to describe Bernanke’s latest initiative as anything other than insane. By focusing on MBS purchases, the Fed’s is trying to re-inflate America’s real estate bubble, in the hope that rising prices will encourage home-owners to spend more by re-mortgaging and getting even deeper into debt. America has done this before, repeatedly, and its always end in tears. The difference this time, is that rather than just guaranteeing the mortgages, the US government will now own them too, doing even more damage to its precarious credit-rating.
For all the market euphoria, QE3 will do far more harm than good. By undermining the dollar and fuelling future inflation, it will discourage household spending by further debasing wages and pensions. By putting upward pressure on the cost of living, QE3 will eat further into real disposable incomes, forcing American consumer to retrench even more.
Oil prices are up almost 30pc since mid-June, even though the global economic outlook has worsened, as speculation has grown about American and European QE. That’s because money-printing encourages shrewd investors to seek out tangible assets – not just gold, but commodities too – and that trend is now spreading into the mainstream.
The Fed already has $1,600bn of Treasuries on its balance sheet, compared to a $1,100bn budget deficit. With foreigners, not least foreign governments, now owning more than half of America’s debt stock, Washington is wide open to justifiable charges of debt monetization. That’s why QE could eventually spark a trade war or, more immediately, a lot more explicit reluctance in Beijing and elsewhere to keep lending the US money.
Bernanke wasn’t facing a banking collapse or the prospect of “imminent deflation”. Last Thursday wasn’t a “Lehman-moment”. To please his political masters and their friends in high-finance, the Fed Chairman administered another big dose of QE anyway. So money-printing has evolved from a drastic remedial action to a life-style choice … which strikes me as an addiction.
Yes, financial markets feel warm and fuzzy after this QE3 announcement. The S&P500 is sharply up. Take note, though, that after months of quiescence, the bond markets are stirring. The yield on the US 30-year bond rose sharply after Bernanke spoke, breaching 3pc in its biggest weekly increase for 3 years.
Long-term bonds are super-sensitive to fear about inflation and currency debasement. So, beyond the relief rally hype, investors are now asking serious questions. Such questions can only get louder as this QE binge goes on.