On Friday, the Department of Labor reported that March non-farm payrolls increased by 120,000, falling well short of consensus expectations in excess of 200,000. For our part, we continue to expect a deterioration in observable economic variables, with weakness that emerges gradually and then accelerates toward mid-year. On the payroll front, our present expectation is that April job creation will deteriorate toward zero or negative levels.
Immediately after the payroll number was released, CNBC shot out a news story titled "Disappointing Jobs Report Revives Talk of Fed Easing." Of course it does, because this remains a market dependent on sugar. And with little doubt the Fed will eventually deliver it - perhaps following a market plunge of 25% or more - but with little doubt nonetheless, because like the indulgent parent of a spoiled toddler, the FOMC can't stand to see Wall Street throw a tantrum without reaching for a lollipop.
If the Fed indeed steps in with an additional round of QE, a few distinctions may be helpful. First, regardless of Fed actions, and even in the past few years, the market has invariably suffered significant losses following the emergence of the "overvalued, overbought, overbullish, rising-yields" syndrome that we presently observe. In contrast, the main window where it has not paid to "fight the Fed," so to speak, has been the period coming off of oversold lows. That's primarily the window where financials, cyclicals, materials, and garbage stocks with highly leveraged balance sheets have outperformed. Regardless of the fact that QE has had no durable economic benefits (more on that below), and does little but to repeatedly lay fresh wallpaper over the rotting edifice that is the global banking system, the main effect of QE has been to provide temporary support for the most speculative corners of the financial market after they have been pummeled.
Strategically, then, we concede that there is some latitude to ease back on defensiveness between the point where QE induces an early improvement in market internals and an upturn in various trend-following indicators (coming off of a previously oversold condition), and the point where an "overvalued, overbought, overbullish, rising-yields" syndrome is established. But once that syndrome is established, it is unwise to ignore it, and a defensive stance becomes essential (as we saw separately in 2010 and 2011, not to mention at most major market tops over history). Meanwhile, it is unwise to believe that additional rounds of QE will do much to help the economy in any event, as its primary effect is merely to drive investors into speculative investments by starving them of safer yields.
There is a very well-defined theoretical and empirical relationship between the monetary base and targets like short-term interest rates and monetary velocity (see Sixteen Cents: Pushing the Unstable Limits of Monetary Policy), but investors should note that the response of the stock market and other financial assets to quantitative easing is far more based on superstition than on structure. We can observe, for example, that drowning the financial markets in zero-interest assets has tended to lower the yields (and therefore raise the prices) of higher-risk, longer-duration assets, but that response is dependent on a certain form of myopia. Specifically, investors either have to assume that they can safely speculate until some particular date arrives on the calendar and they can all take their profits simultaneously, or they have to ignore the tendency for low prospective long-term returns to go hand in hand with quite negative prospective intermediate-term returns. For that reason, any "QE indicator" we might develop (as several people have requested) would likely be spurious and not very robust going forward, even though one might be back-fitted to the data. A better approach, as noted above, is to take a signal from market action and trend-following measures, but emphatically to also impose several alternate exit criteria - including for example a deterioration of those measures, or the establishment of an overvalued, overbought, overbullish, rising-yields syndrome. I remain convinced that investors who simply have blind faith that QE is reliably bullish in and of itself, or can be trusted to limit losses, will have their heads handed to them.
How QE "works"
Keep in mind that the U.S. banking system has trillions of dollars sitting in idle deposits with the Fed already. Quantitative easing simply does not relieve any constraint that is binding on the economy. Rather, QE is a method by which the Fed hoards longer-duration, higher-yielding securities like U.S. Treasury bonds and replaces them with cash that bears zero interest. At every moment in time, somebody has to hold that paper. The only way for the holder to seek a higher return is to trade it for a more speculative asset, in which case whoever sells the speculative asset then has to hold the cash. The process stops when all speculative assets are finally priced so richly and precariously that the people holding the cash have no further incentive to chase the speculative assets, and are simply willing to hold idle, zero-interest cash balances.
Why does the Fed want this? Simple. Chairman Bernanke believes that by creating a bubble in speculative assets, people will "feel" wealthier and keep consuming - regardless of the fact that real incomes are stagnant and debt burdens are already intolerable, and despite the fact that there is extremely weak evidence for any such "wealth effect" in the historical record. Undoubtedly, it would be difficult for Bernanke to refrain from these reckless policies when everyone is crying "do something!" But the willingness to tolerate short-term criticism in the interest of long-term benefit is part of what separates leadership from cowardice.
Given the bubbling concerns among various FOMC members about inflation risk, the next round of QE is likely to be "sterilized." Essentially, the Fed would buy Treasury bonds from banks, and would pay for them with newly created cash, but the Fed would then borrow those funds back from banks, holding them as idle deposits with the Federal Reserve. By definition, the additional "liquidity" created by a sterilized round of QE would not be available for new lending (as if there aren't enough idle reserves in the banking system already). So again, the main goal is to increase the outstanding stock of zero- and low-interest assets in the economy, in order to lower the yields and increase the prices of more speculative investments.
Now, if you think carefully about this, you'll recognize that the U.S. government is still running a deficit of more than 8% of GDP, so the Treasury will have to issue more than a trillion dollars of new debt in the coming year anyway. Given that banks already hold trillions of dollars in idle balances, the Treasury could have the identical effect of an additional round of QE simply by issuing a larger portion of the new debt as very short-term T-bills, which also yield next to nothing. So why bother doing this as "quantitative easing" when the Treasury could just change the maturity profile of the new debt all by itself?
Well, for one, the Treasury securities are issued on the open market. The Fed typically pre-announces which issues it will buy, allowing the banks that act as primary dealers to essentially front-run: buying the newly issued debt from the Treasury in expectation of getting a higher price from the Fed. So doing all of this as QE has the benefit of handing the banks a nice trading profit. Second, the Fed has an awful lot of Treasury debt on its balance sheet, which is leveraged about 50-to-1 against its own capital. By purchasing Treasury securities and creating zero-interest cash (or low-interest reserves), the Fed essentially earns a spread that can cover any shortfall it might experience if it is ever forced to unwind its position and sell any of those securities at a loss. It's true that if the Fed earns any surplus interest, it has to go back to the Treasury, but the surplus rendered back to the Treasury is only what remains after a night on the town in the Fed's balance sheet.
Continue reading.
Immediately after the payroll number was released, CNBC shot out a news story titled "Disappointing Jobs Report Revives Talk of Fed Easing." Of course it does, because this remains a market dependent on sugar. And with little doubt the Fed will eventually deliver it - perhaps following a market plunge of 25% or more - but with little doubt nonetheless, because like the indulgent parent of a spoiled toddler, the FOMC can't stand to see Wall Street throw a tantrum without reaching for a lollipop.
If the Fed indeed steps in with an additional round of QE, a few distinctions may be helpful. First, regardless of Fed actions, and even in the past few years, the market has invariably suffered significant losses following the emergence of the "overvalued, overbought, overbullish, rising-yields" syndrome that we presently observe. In contrast, the main window where it has not paid to "fight the Fed," so to speak, has been the period coming off of oversold lows. That's primarily the window where financials, cyclicals, materials, and garbage stocks with highly leveraged balance sheets have outperformed. Regardless of the fact that QE has had no durable economic benefits (more on that below), and does little but to repeatedly lay fresh wallpaper over the rotting edifice that is the global banking system, the main effect of QE has been to provide temporary support for the most speculative corners of the financial market after they have been pummeled.
Strategically, then, we concede that there is some latitude to ease back on defensiveness between the point where QE induces an early improvement in market internals and an upturn in various trend-following indicators (coming off of a previously oversold condition), and the point where an "overvalued, overbought, overbullish, rising-yields" syndrome is established. But once that syndrome is established, it is unwise to ignore it, and a defensive stance becomes essential (as we saw separately in 2010 and 2011, not to mention at most major market tops over history). Meanwhile, it is unwise to believe that additional rounds of QE will do much to help the economy in any event, as its primary effect is merely to drive investors into speculative investments by starving them of safer yields.
There is a very well-defined theoretical and empirical relationship between the monetary base and targets like short-term interest rates and monetary velocity (see Sixteen Cents: Pushing the Unstable Limits of Monetary Policy), but investors should note that the response of the stock market and other financial assets to quantitative easing is far more based on superstition than on structure. We can observe, for example, that drowning the financial markets in zero-interest assets has tended to lower the yields (and therefore raise the prices) of higher-risk, longer-duration assets, but that response is dependent on a certain form of myopia. Specifically, investors either have to assume that they can safely speculate until some particular date arrives on the calendar and they can all take their profits simultaneously, or they have to ignore the tendency for low prospective long-term returns to go hand in hand with quite negative prospective intermediate-term returns. For that reason, any "QE indicator" we might develop (as several people have requested) would likely be spurious and not very robust going forward, even though one might be back-fitted to the data. A better approach, as noted above, is to take a signal from market action and trend-following measures, but emphatically to also impose several alternate exit criteria - including for example a deterioration of those measures, or the establishment of an overvalued, overbought, overbullish, rising-yields syndrome. I remain convinced that investors who simply have blind faith that QE is reliably bullish in and of itself, or can be trusted to limit losses, will have their heads handed to them.
How QE "works"
Keep in mind that the U.S. banking system has trillions of dollars sitting in idle deposits with the Fed already. Quantitative easing simply does not relieve any constraint that is binding on the economy. Rather, QE is a method by which the Fed hoards longer-duration, higher-yielding securities like U.S. Treasury bonds and replaces them with cash that bears zero interest. At every moment in time, somebody has to hold that paper. The only way for the holder to seek a higher return is to trade it for a more speculative asset, in which case whoever sells the speculative asset then has to hold the cash. The process stops when all speculative assets are finally priced so richly and precariously that the people holding the cash have no further incentive to chase the speculative assets, and are simply willing to hold idle, zero-interest cash balances.
Why does the Fed want this? Simple. Chairman Bernanke believes that by creating a bubble in speculative assets, people will "feel" wealthier and keep consuming - regardless of the fact that real incomes are stagnant and debt burdens are already intolerable, and despite the fact that there is extremely weak evidence for any such "wealth effect" in the historical record. Undoubtedly, it would be difficult for Bernanke to refrain from these reckless policies when everyone is crying "do something!" But the willingness to tolerate short-term criticism in the interest of long-term benefit is part of what separates leadership from cowardice.
Given the bubbling concerns among various FOMC members about inflation risk, the next round of QE is likely to be "sterilized." Essentially, the Fed would buy Treasury bonds from banks, and would pay for them with newly created cash, but the Fed would then borrow those funds back from banks, holding them as idle deposits with the Federal Reserve. By definition, the additional "liquidity" created by a sterilized round of QE would not be available for new lending (as if there aren't enough idle reserves in the banking system already). So again, the main goal is to increase the outstanding stock of zero- and low-interest assets in the economy, in order to lower the yields and increase the prices of more speculative investments.
Now, if you think carefully about this, you'll recognize that the U.S. government is still running a deficit of more than 8% of GDP, so the Treasury will have to issue more than a trillion dollars of new debt in the coming year anyway. Given that banks already hold trillions of dollars in idle balances, the Treasury could have the identical effect of an additional round of QE simply by issuing a larger portion of the new debt as very short-term T-bills, which also yield next to nothing. So why bother doing this as "quantitative easing" when the Treasury could just change the maturity profile of the new debt all by itself?
Well, for one, the Treasury securities are issued on the open market. The Fed typically pre-announces which issues it will buy, allowing the banks that act as primary dealers to essentially front-run: buying the newly issued debt from the Treasury in expectation of getting a higher price from the Fed. So doing all of this as QE has the benefit of handing the banks a nice trading profit. Second, the Fed has an awful lot of Treasury debt on its balance sheet, which is leveraged about 50-to-1 against its own capital. By purchasing Treasury securities and creating zero-interest cash (or low-interest reserves), the Fed essentially earns a spread that can cover any shortfall it might experience if it is ever forced to unwind its position and sell any of those securities at a loss. It's true that if the Fed earns any surplus interest, it has to go back to the Treasury, but the surplus rendered back to the Treasury is only what remains after a night on the town in the Fed's balance sheet.
Continue reading.
