Reversing the Speculative Effect of QE Overnight

The latest from John Hussman

Author's Avatar
Dec 21, 2015
Article's Main Image

In recent quarters, I’ve been adamant that the immediate first step of the Federal Reserve in normalizing monetary policy should have been to reduce the size of its balance sheet. The Fed’s failure to prioritize that first step, in the apparent desire to maintain an aggrandized role in the U.S. financial markets, has significantly increased the risk of a collapse from the speculative extremes the Fed has created in recent years. Given the increasing risk aversion evident in market internals, we doubt that even a reversal of last week’s rate hike would materially reduce that prospect.

To see why, it’s important to understand how the Federal Reserve’s tools – open market purchases, interest on reserves and reverse repurchases – actually work in affecting the economy and the behavior of speculative investors.

Let’s begin with open market operations. Traditionally, the Fed has used open market purchases of Treasury securities in order to affect short-term interest rates. The Fed’s transactions don’t really accomplish this by directly pressuring market prices higher and lower. Instead, the Fed has traditionally determined the level of short-term interest rates by determining the quantity of zero-interest money that must be held across the economy as a whole.

Specifically, when the Fed goes out and buys a Treasury bond from the public, it pays for that bond in the form of currency and bank reserves (known as “base money” or “monetary base”). The bond becomes an asset on the Fed’s balance sheet, and the base money is a liability of the Fed. As a reminder that currency is a liability of the Fed, look at one of the pieces of paper in your wallet that reads “Federal Reserve Note.” The same is true for bank reserves. Bank reserves are deposits that banks have with the Federal Reserve. They are assets to the banks and liabilities to the Fed.

In short, when the Fed makes open market purchases of government bonds, it takes those bonds on as assets, and creates new liabilities in the form of currency and bank reserves.

Once created, someone in the economy has to hold the existing quantity base money, at every moment in time, until it’s retired by the Federal Reserve. Someone with cash can certainly use it to buy stock, but the same cash then goes into the hands of the seller. So base money is always “cash on the sidelines” in the sense that someone gets stuck with it, like a hot potato changing hands. But it’s impossible for that cash to go “into” or “out of” the stock market. It merely goes through it.

Traditionally, currency and bank reserves have been zero-interest money. Of course, the more zero-interest money there is sloshing about in the economy, the more people who are uncomfortably holding those hot potatoes and the more yield-seeking you’ll tend to see in securities that offer the hope for higher returns. The first stop, because it’s the closest to safe, liquid cash, is Treasury bills. Increase the amount of zero-interest money in the economy, and you’ll increase the number of investors who are willing to pay up for Treasury bills, so Treasury bill yields will fall. The “reach for yield” stops when the last “marginal” holder to get the hot potato is indifferent between ultra-liquid cash and near-liquid Treasury bills.

The chart below shows the relationship between the monetary base and Treasury bill yields in monthly data since 1929. The higher the quantity of zero-interest monetary base, as a fraction of GDP, the lower Treasury bill yields have fallen. It’s a rather pretty relationship, and it’s our version of what economists call the “liquidity preference curve.”

continue http://hussmanfunds.com/wmc/wmc151221.htm