“QE Unplugged” by Eric Coffin

As I expected, the US
Fed pulled the trigger and announced an initial “taper” of the Quantitative
Easing (QE) program. Starting this monthly purchases of T Bills and Mortgage
Backed Securities will be reduced by $10 billion.  

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 10 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 10 times the rate of primary reserve increases.
If bank reserves were increased by a trillion dollars the money supply would
increase by 10 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 it’s 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 do
have 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. 

It’s 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 it’s 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.