Thoughts from the Frontline

The End of QE2?

By John Mauldin

March 18, 2011

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New York Times Bestseller
The End of QE2?
Producer Prices Up 35-40% in the Last Six Months
What Happens When We Come to the End of QE2?
London, Malta, Milan, Zurich, Salt Lake, and New York

What happens when the Fed is finished with QE2? I have been letting that filter into my thinking lately as I look at the economic landscape and the data we have seen the past few weeks. Correlation is not causation, as I often say, but all we can do is look back at what happened last time and speculate about the future. A very dangerous occupation, but your fearless analyst will plunge on ahead into the jungle of a very hazy future. You come with me at your own risk!

New York Times Bestseller

Quickly, a big Mauldin thanks to those who already bought my book, Endgame, as it made the New York Times bestseller list yesterday, earlier than I thought it would. That would be my 4th, and that and my kids are about my only small claims to fame. I have ruthlessly promoted the book to you, and so this week I resist my inner promotional demon and simply provide a link to http://www.amazon.com/Endgame-Debt-SuperCycle-Changes-Everything/dp/1118004574/ref=sr_1_1?ie=UTF8&s=books&qid=1298937384&sr=8-1 where you can read the reviews and buy the book if you have not, or get it in your local stores. At the end of the letter, I note that I will be at a book launch party in London Monday evening, and would love to have you stop by. Details below. And now to this week’s letter.

The End of QE2?

The Fed committed to buying $600 billion of Treasuries between the beginning of QE2 in November and the end of June. June is 3 months away. What will happen when that buying goes away? The hope when QE2 kicked off was that it would be enough to get the economy rolling, so that further stimulus would not be deemed necessary. We’ll survey how that is working out, with a…

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Richard Eckert

March 23, 2011, 5:05 p.m.

I will take a brief stab at the question on the link between QE2 and food and commodity prices.  And, by extension, to the unrest in North Africa and the Middle East.  Yes, supply and demand dynamics clearly have a role here.  But the same shortages due to drought, fire and underplanting were present all of last year.  Ditto rising demand from burgeoning middle classes in China and India.  Actually these have been present for some time.  The really sharp increases in CPI and PPI (all items) did not appear, however, until the commencement of QE2 (see charts above).  Actually, these measures began to swell with Mr. Bernanke’s mere whisper of QE2 in August.

I believe that what has happened is that commodity producers around the globe are beginning to lose faith in the dollar.  So they are demanding more of them in return for wheat, cotton, soybeans, industrial metals, etc.  This is a de facto devaluation of the dollar.  Because the dollar is still the world’s reserve currency, international transactions are settled in dollars.  Countries like Egypt, Tunisia, Yemen suddenly had to pay a lot more for their food.  And what is that old English axiom about being “four missed meals away from anarchy”?  Don’t get me wrong, the powderkeg was already packed in those countries and the fuse inserted.  But skyrocketing food prices and empty bellies lit the match.

Richard Eckert

March 21, 2011, 12:18 p.m.

I am entitling this “Thinking the Unthinkable”.

Although the annual Strategic Investment Conference is over a month away and I do not purport to possess nearly the credentials of those speaking at the conference, I would like to try to answer the two questions to be asked of them.

What happens when QE2 goes away?  I feel David Rosenberg summed up the answer to that question quite nicely.  And there’s every reason to believe this stimulus-addicted economy when once again sputter in the absence of such stimulus and the equity markets halt their seemingly inexorable march northward.  Among them are:

1) When the tide of surplus liquidity goes out, asset prices decline.  Not only does the cost of financing those assets increase, but because the yields on Treasuries and privately issued investment grade securities rise, the return requirements for risky assets increase as well.  And prices vary inversely with expected returns.  Householdsâ?? stake in those risky assets declines with their values.  Unable to borrow against the artificially inflated value of their assets, or to otherwise liquidate them, turn them into cashâ??or psychically measure what they can spend against what they are worthâ??householdsâ??  will have to curtail their spending.  Especially since many have not received a real wage increase in a decade or moreâ??at least those in the private sector.

2) Debt service requirements increaseâ??and in a vicious, self-feeding cycle with each round of policy accommodation.  The additional debt taken on during each of these rounds makes even the smallest hike in rates more onerous than in the previous cycle, crowding out even more spending and investment with each go around.

For instance, with just over $50 trillion in debt outstanding in the U.S. at the end of 2010, a 1% increase in rates across the board lifts debt service requirements by $500 billion.  That amounts to nearly 3.5% of last yearâ??s nominal GDP and would have wiped out the reported increase in that (2010) statistic in its entirety.  By way of contrast a 1% increase in rates in 2000 would have boosted debt service requirements by only $263 billion, a little less than half of the reported increase in nominal GDP.

3) Because the debt and excess liquidity was used for consumption rather than to accumulate capital goods capable of generating the income necessary to pay it offâ??or if it was invested, it was invested in speculative assets like stocks and home (or if actually invested in capital assets and permanent hires, it was invested abroad)â??it just reinforced the secular decline in manufacturing and manufacturing jobs in the U.S.  And not just manufacturing!  You wonâ??t believe how much engineering, legal, and back office accounting work has been outsourced now.  Itâ??s not just low-paid customer service or tech support jobs any more.  Anyway, ever fewer manufacturing (and other high value-added) jobs to return to combined with the dependence of an economy driven by surplus liquidity on extremely pro-cyclical jobs in the real estate, construction and finance industries tends to prolong periods of high unemployment.

4)  Higher un- and underemployment and higher interest rates encourage savingâ??at the expense of consumptionâ??which aapears to be an anathema to Mssrs. Bernanke and Greenspan.  Under their reign, the U.S. economy has become extremelyâ??and unhealthilyâ??dependent on personal consumption.  As a component of GDP, it has expanded from 62% in 1980 to over 70% today.  Any pullback on the part of consumers has a disproportionately negative effect on reported GDP.

5) Deleveraging resumes, bringing powerful deflationary forces to bear.

And under what conditions will the Fed launch QE3?  The only conditions that need be extant are that Mr. Bernanke a) has a pulse and/or b) can fog a mirror.  He is well aware of 1-5 above.  He understands full well what happens when he allows the pedal to come off the metal in the stimulus-fueled economy he is driving.  Also motivating him are the following:

1)  All of the eggs are in the Obama basket.  You asked “What about the future?”  Mr. Bernanke appears to care about only 2 dates in the future.  Nov. 6, 2012 and Jan. 31, 2014.  The first is the next presidential election and the second his last day as Fed chairmand if he cannot get President Obama re-elected.  Bernanke cannot risk a recession before the next presidential election.  No other president is going to re-appoint him.  And Obama can only re-appoint Bernanke if he is re-elected.  So, it wonâ??t matter how high into the ionosphere gas, other energy, food, industrial commodities rocket.  He will keep printing nonetheless.  Providing some cover will be Europeâ??s sovereign debt crisis and the BLS’ hedonically-adjusted, geometrically-weighted core CPI statistic. 

2)  “When the printing press is the only tool your toolkit, the whole world looks like a ream of 80# uncoated printing paper”.

3) Mr. Bernankeâ??s apparent obsession with deflation.  Or more precisely, as the title of his 2002 speech suggests, an obsession with â??Making Sure It Doesnâ??t Happen Hereâ?.  Also, a self-proclaimed expert on the Great Depression, Mr. Bernankeâ??among othersâ??has drawn what he feels is the obvious conclusion that stimulus was withdrawn too early and the absence of that stimulus extended and deepened the Depression.  I am certain he will do everything in his power so as not to be accused of withdrawing stimulus too early.

5)  Mr. Bernanke and Mr. Greenspan have gone so far down the path of â??easy moneyâ?, and they have been so committed to accommodative policy, that there is no turning back.  And no exit strategy.  When one thinks back on it, there never has been.  Not since Mr. Greenspan was appointed Fed chairman in 1987.  I can only conclude Mr. Bernanke is just going to print our way to self-sustaining, private business sector-led expansion or die trying.

6)  He is also committed to protecting the capital markets and, above all else, the big banks and broker/dealers, which I believe are still on Fed life support.  One of the reasons the banks can carry so many worthless assets at some non-zero number is that non-performing assets (NPAs) do not represent a liquidity risk when the cost of carrying them is also zeroâ??or some number near that.  Some would argue—and, indeed, have already done so—that hat is what ZIRP is all about.  Introducing a cost of carry, even if it is just 1-2 percentage points higher than it is now, will badly expose banks and other spread lenders.

The question of QE3, 4, 5…etc. is not “if”, but “when”.

Jack Ekin

March 20, 2011, 2:48 p.m.

A significant silver lining to QE3—the help to those underwater with debt (also a probable motivation of the FED).  Unfortunately, it will be at the expense of savers and those on fixed incomes, the least able to afford it.

terry cooper

March 20, 2011, 8:21 a.m.

John,

Well done. And let me simply say Jim Rogers once said “If you want to get rich…figure out what the FED is doing and do the opposite!” Better yet, Jim Rickards has a very interesting thought on this “End of QE2”. He states the the FED has so much skin in bonds these days ($3T) that they can simply rollover existing bonds to the tune of $750B annually. No need to up the bond total after June… just farm the perpetual debt machine already in place. No balance sheet additions but certainly it will continue to dilute the currency…Just as IMF special drawing rights will. Inflation on steroids will be here soon enough. Use the time remaining wisely. Check out Rickards here: http://kingworldnews.com/kingworldnews/Broadcast/Entries/2011/3/12_Jim_Rickards.html

Wayne Hochmuth

March 19, 2011, 10:08 p.m.

John, a very astute and compelling analysis on whether the Fed will move to QE III. However, I think it overlooks one important factor in the Fed’s calculus; if they don’t proceed to III, bond rates wil rise significantly, and the Treasury can’t afford higher rates as it refinances $billions in maturing securities each month, while also funding the monster deficit. It MUST push rate increases into the future. Yes, bond rates must rise at some point, but the Fed can’t afford to let that happen in the summer of 2011.

We’ll see some form of Fed balance sheet expansion when QE II runs dry!

Rodger Malcolm Mitchell

March 19, 2011, 5:41 p.m.

Congratulations on putting a book on the best seller list, despite not understanding Monetary Sovereignty (the basis of all modern economics), and not recognizing the fundamental differences between Monetarily Sovereign nations and monetarily non-sovereign nations.

Keep up the good work.

Rodger Malcolm Mitchell

Jim Beetem

March 19, 2011, 4:52 p.m.

Hi John,

With regard to your comments on inflation, it is not clear to me how QE2 could be causing the increase in food and raw material commodity prices (crude might be an exception, since I’m not sure I understand the relationship between the US$ and crude prices and the impact of the Libyan and Bahrain situations).  Most the run up in prices of corn/wheat/soybeans/cotton seem to be caused by product shortages brought on by drought and fires.  Increases in consumption by the growing middle classes in India and China are a factor—but MOST of the inflation is most likely caused by cost-push rather than demand-pull factors.

If QE2 is causing a problem, will those problems go away when it ends?

On a side note, I hope tht you will be ablr to return to your usual insightful writing now that your book is on its way to success.  I have missed you usual quality over the last 6 months.

Jim

pat phillips

March 19, 2011, 3:35 p.m.

QE 3 ?

They will just rollover the debt of the previous QE programs and buy more treasuries and mbs etc.

Is that considered more QE ?

Robin Day

March 19, 2011, 1:52 p.m.

I recall that about $1.5 trillion in treasuries come due over the next year. If there is no demand to roll these over, the gov’t will have to print the money to redeem them. If so, is it reasonable to assume a significant portion of this money will go into the US economy, making a QE 3 redundant?

Paul Speer

March 19, 2011, 1:42 p.m.

John,

Looking at the commercial real estate market—in which I am, petard wise, hoist—we are not at the bottom.  First, the market at the strip center (10,000-90,000 sq.ft.) overbuilt, especially if you have not a larger multi-store retail anchor.  These were built and sold based on a household credit card marketplace.  Consumers are still rectifying their own balance sheets and have opted for the Wal Marts of the world—cheap imported goods bought in huge bulk and sold at small margin.  Second, state and local governments still burden commercial property with heavy and increasing real estate taxes.  Stores don’t vote; residences do.  Third, financing and refinancing is a bitch.  Long term financing is generally not available.  lenders want long term rates with five year balloons.  Worse, the increase in market cap rates from six to nine percent as reduced the market value of commercial properties by one third, and the long term mortgage amounts similarly.  There is no longer any correspondence between borrowing rates and Cap Rates..  Upper class retail (Fifth Avenue, mag-Mile and Rodeo Drive) may be booming.  It is the remainder of the commercial sector that is sucking wind.

It all goes back to the paydown of the consumer debt as middle class balance sheets are rationalized.. The consumer has become rational   If nominal wages are not in tandem with the cost of living, Inflation will force these consumers to slide down the razor blade of life once more, and take the commercial real estate market with them.

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