QE unplugged

Equity markets rallied strongly then flattened as traders locked in profits and awaited earnings and fresh economic readings. Mom and Pop were piling into Wall St but no one who actually works there thought things look very cheap.

The gold market took a quick dive on the taper announcement and then regained its feet. It’s now trading above where it was then the taper was announced.  After all the hand wringing why hasn’t the reaction been larger?

Traders with strong convictions about gold see it heading lower so they are out of the market, if not short.   I don’t think there are a lot of new players in the market on the sell side.

It’s possible new sellers will appear each time QE is reduced but reactions should get smaller as traders accept QE is ending and price it in. On top of that you have a huge short position in  gold that has to unwind sometime.

Every major brokerage house in North America is calling for lower gold prices. Even traditional gold bulls are hedging their bets and saying gold should have a final down leg to $1100. That level of unanimity is exactly what a contrarian wants to see.  It’s very reminiscent of 2009 when HRA called a bottom on the big board in part because everyone though the market had to go lower.

Most brokers were wrong about gold prices year after year through most of this bull market.  I don’t see a reason to believe they are suddenly more prescient.

Even gold bug commentary I’ve seen either warns about the end of QE or comes up with reasons why QE won’t be ended.  Suddenly QE is the only reason the gold price moves.

Few seem to have noticed that QE3 did nothing for the gold price. Take a look at the chart below comparing the gold price with the size of the US Fed’s balance sheet—a proxy for the cumulative amount of QE—since late 2009.  There was some positive correlation during QE1 and QE2 but it’s been strongly NEGATIVE since the start of QE3.

QE isn’t “money printing” and does not affect the money supply in the manner most people expect. The confusion isn’t surprising. Even the Fed is unsure about the impact of its program.  There have been recent studies by Fed economists that question the transmission mechanism and basic effectiveness of QE.

The Fed studies concluded that QE’s most important aspect is as a signaling tool.  In other words, QE may be “working” because the Fed’s actions convince market participants that the Fed really, really means it when they promise to keep interest rates low.

The Fed creates money to complete QE transactions but it’s really an asset swap.  In a QE transaction the Fed will purchase financial assets from a bank and pay for them with money (that is where the printing comes in).  It doesn’t change the overall total of financial assets in the system but does change their composition.  Banks have a higher cash total in their reserves and a smaller amount of Treasuries or approved mortgage debt.

So why isn’t there more money, and inflation, being created?  Everyone who took Economics 101 remembers the “money multiplier”.  Banks in a fractional reserve system would lend money to the extent allowed by their primary reserve requirements.

If a bank was required to hold 10% of its capital as reserves in cash or deposits with the Fed (as it is in the US) the bank could create ten times as many loans (which are assets to a bank) as its reserves on deposit.  Creating those loans would generate new money on deposit in the banking system.  It’s the private banking system that really grows the money supply.

In the simple macroeconomic models we all learned, bank lending and hence the money supply would increase in lockstep at ten times the rate of primary reserve increases.  If bank reserves were increased by a trillion dollars the money supply would increase by ten trillion.  That calculation underlies warnings about hyperinflation you hear from hard money advocates.

Pretty much EVERYONE uses the money multiplier argument to either rail against or praise QE. That includes Wall St, which is decidedly not full of hard money advocates.  The problem is that this time honored measure doesn’t work.

If you look at the long term chart of US M2 money supply (currency in circulation, chequing/savings accounts and money market funds—basically) above you can see that its risen by about $3.4 trillion since the financial crisis.  Not chump change.

The change in the Fed’s balance sheet since the start of the financial crisis (before the start of that chart on the previous page) is about $3 trillion.  Using this very simplified but generally accurate comparison we get a “money multiplier” of about 1.1!

Even that lower multiplier assumes the Fed is the only actor in the economy.  Some of the money supply growth is organic based on a slowly recovering economy. More importantly, it means there is no reason to expect a big inflation push because of QE alone or a big price collapse when the Fed backs out of it. 

The potential money supply growth that worries traders really comes from bank lending. Banks do not have reserve constraints right now.  In theory US banks could lend out trillions without having to even give a thought to their reserve ratio.  Of course, they dohave liquidity and solvency constraints, as many found out the hard way in 2008-2009.  Bank are being very cautious and only starting to relax lending standards.

It’s not just about banks either.  Even if banks were willing to lend to anyone they still need to find customers to borrow.  Without credit demand there won’t be loan growth even if bankers are feeling reckless.

The lower chart on the next page shows year over year changes in US household credit demand, going back to 1970.  Credit growth was never below 4% and averaged about 8% until 2007, and then it fell off a cliff.

Credit contracted from 2007 until H2 2013 as consumers retrenched.  There was no net demand for new credit until a few months ago.

Credit demand is now positive again.  This is borne out by consumer spending numbers.  Spending has exceeded wage gains during several recent months and the savings rate is declining again.

Whether this is a “good” thing or not isn’t the point.  If credit creation is the mother of money supply growth then we may start seeing money supply expansion now, even though the Fed is starting to taper.

The chart below shows inflation rates for major economies going back to the start of 2007.  Inflation went to low (or negative) values in most major economies during the financial crisis.  There was a recovery to a lower high then rates fell back again starting in 2011.  This includes the US where the Fed was supposedly printing money like mad.  If that was intended to inject inflation into the system it’s been a complete fail.

I’m cheering for inflation.  I think moderate CPI (not just S&P, wine and modern art) price growth would be a good thing.  There is no reason to fear it in developed countries.    Inflation driven by money supply growth and/or higher capacity utilization will be the result of a higher growth track and higher confidence levels.  I think there is a shot at that this year.  Not great growth rates but better ones at least.

I’m not expecting much when it comes to inflation but it could at least begin to trend up rather than down.  I certainly hope it does.  There isn’t much room to maneuver on the downside and other areas, particularly the EU, could still see outright deflation if we screw this up.

So what does this mean for major markets and gold? The biggest fear in both of those markets is that “tightening” by the Fed will drive up yields and compete with both gold and equities.

Yields have moved up since early last year but the Fed’s done a good job of talking down market so far.  Even with the start of tapering announced 10 year yields have held below 3%.   I’m sure they will go higher this year but not to real danger levels.  I expect we see 10 year yields at something like 3.5-4%, enough to be a headwind for the markets but not enough to derail them. The Fed isn’t likely to be actually selling bonds until late this year at the earliest. Yes, the Fed has a lot of debt to unload but we need to keep the amount in perspective.  The US debt market does about $800 billion in daily volume and bid to cover ratios for recent US debt auctions have been good.  I don’t see the Fed blowing this market up.

Its orthodox belief among hard money advocates that there will be a debt collapse.  Is it possible?  Sure.  Is it likely? No.  It would be better if the US (and everyone else) got debt levels down but a country that can issue 10 year paper in its home currency that yields 3% does not have a shaky debt market.

Mortgage debt is a little trickier but only by degree.  The Fed is a bigger part of this market but there is no need to just sell indiscriminately.  Reversing mortgage debt purchases can be stretched out too.

Yellen will spend a lot of time convincing the market there will be no near term rate increase.  As long as they don’t screw up the messaging there shouldn’t be a debacle here.  So far its working though I think we can thank a skittish market for that rather than superior communication skills of Fed governors.

If the US growth accelerates a bit bond yields should naturally lift anyway.  Higher yields due to higher confidence are a good thing, especially if it is accompanied by a mild upturn in inflation.

The bottom line is that I don’t expect a contraction in money supply or exploding bond yields because of QE being rolled back.  Either of those would be damaging to the gold market and equities.  The money supply might even expand faster this year if the mood of consumers and banks continues to improve.

Higher capacity utilization is needed to give companies the confidence to increase prices.  That, and wage gains, is the most direct route to CPI numbers that are increasing rather than decreasing every month.  Real interest rates are what matter. A small increase in inflation accompanying an increase in bond yields won’t generate any panic.

Inflation last year decreased in large part due to lower energy prices.  That increased the real yield on Treasuries which may have helped on the demand side even as traders worried about QE.  Most energy analysts believe the US can get to oil self-sufficiency if the production growth of the past few years continues.   This may lead to lower prices that keep inflation subdued though it’s the core rate—which excludes energy and food prices—that I expect to see getting a bit stronger.

Even if you’re convinced unwinding QE will lead to disaster it will be some time before the Fed is selling bonds. The Fed is reinvesting interest paid on its current holdings which is adding another $25 billion a month to the purchases, more or less.

It’s unlikely the Fed will be actually selling debt before 2015 and I’m sure they will watch bond yields like a hawk.  I doubt the Fed will be a seller unless yields are stable.  Yellen may be more cautious than Bernanke but remember there are several new voting members on the Fed committee.   Most are hawks that will resist extending QE.

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