Friday, May 13, 2011

QE3 - Scenario 1

Today, Quantitative Easing (QE) is the hot topic on everybody's mind. The question goes something like this: Will the Federal Reserve (Fed) end QE2 in June or will they continue with a third iteration, QE3? Admit it, that's exactly what was on your mind... The first scenario goes something like this:

Outcome 1: 
The Fed ceases QE2, on schedule, at the end of June 2011.

Situational Analysis 1: 
Currently the Fed is responsible for monetizing a large portion of the US debt and has become the largest holder of treasuries followed by China and Japan (as of May 2011). If the Fed stops purchasing treasuries the yield will have to rise to entice investors into purchasing treasuries. That would cause a rise in interest rates across the board and make borrowing more expensive for consumers, as well as the US government, which is in the process of issuing record debt (a lot of treasuries to sell). The increase in interest rates would be a significant drag on the economy, likely pushing the US back into recession (over the course of several months). At that point, additional fiscal or monetary stimulus (aka money printing) would certainly be called for, especially during an election cycle. If this wasn't bad enough, the 'assets' on the Fed's books are interest rate sensitive, meaning, if rates go up then the Fed's assets bleed losses. Now, the Fed is something like a black hole where losses and malinvestment seem to disappear. In any event, rising rates would kill the Fed's 'assets', giving additional incentive to keep rates low...not to mention the Fed isn't hedged against rising rates, but that's another $200 trillion dollar discussion, literally.

To further complicate matters, the recent disaster in Japan and inflation concerns in China are likely to reduce their appetite for treasuries, putting a greater burden on the Fed to monetize the debt. Which of course, Bernanke said he would never do and yet here we are. Oh, and housing prices will never come down, that didn't work out too well...recall that this guy is still in charge.

So, how can this scenario possibly work out? If the US economy is on solid footing and can produce organic growth the cessation of QE2 would not harm the economy. In fact, it would be harmful to continue the program under this assumption. One must believe the economy is sound and does not require stimulus. There also must be an appetite for treasuries, even though yields are at record lows and treasuries are at record issuance. Essentially, supply, demand, and reality must be thrown out the window.

Overall, ceasing QE2 will reveal severe weakness in the US economy, dashing GDP expectations, and raising serious questions about how the US will service its debt. The emperor will be exposed, naked for the world to see. Game, set, match. No one wants to be be holding the bag when the economy collapses, and for this reason, the Fed will continue the charade as long as possible. The trade-off of course is a much larger collapse when the game finally ends...

Overall, 'Scenario 1' is unlikely to be the hand that the Fed plays, there is little to no advantage in doing so, unless a short term collapse is needed to provide covering fire in the face of inflation. This sounds somewhat conspiracy theory, but in fact, its more along the lines of game theory and strategy. Stayed tuned for Scenario 2...

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