Tags: hans | parisis | fed | us | economy

Some Unease About the End of Fed’s Easing

By    |   Monday, 30 May 2011 12:05 AM

Well, the downgrading “waltz” continues. Fitch Ratings just revised Japan's outlook to “negative” from “stable.”

The head of Fitch's Asia-Pacific sovereigns team comments: “Japan’s sovereign creditworthiness is under negative pressure from rising government indebtedness. A stronger fiscal consolidation strategy is necessary to buffer the sustainability of the public finances against the adverse structural trend of population aging.”

Keep in mind Japan’s gross government debt reached 210 percent of GDP by the end of 2010, the highest ratio for any “serious” sovereign. It will be interesting to see who will be the next candidate for downgrade of the “serious” or “not so serious” sovereigns…

Now, that said, at the end of next month, the U.S. Fed will end its controversial program of “printing money” and buying of U.S. Treasurys, also known as “large scale asset purchases” or “quantitative easing” (QE) that will have added $600 billion since November 2010 to the Fed’s balance sheet. Since the QE program started in late 2008, the Fed now holds some $2.8 trillion of assets in U.S. Treasury bonds and mortgage backed securities.

From a broad perspective, there is still a lot of discord of opinions on how the end of QE will affect the economy and markets. There are those who are convinced QE has had little effect on the economy as well as on the markets and ending QE will be a non-event. Others, on the contrary, see the Fed’s action as critical to the revival in the economy and financial markets and therefore see the end of QE as potentially bearish for both.

There is no doubt the direct effects of QE on the economy seem to be limited and not at least because the money created through QE has become trapped in the banking system. Bank’s reserve holdings have risen sharply, but they have not been lent out into the “real” economy. We see the private sector continuing to “de-lever,” and because of that the impact on money growth and national income has been limited. It’s also important to take notice that the velocity of circulation and the money multiplier have fallen sharply. Of course, this situation could change in the future.

Nevertheless, the Fed’s QE has had without any doubt more effect through other channels. The first round, or QE1, was instrumental in unblocking credit markets, which have seen a substantial increase in issuance.

Companies have been able to bypass the banking system and go direct to investors that remained chasing higher yields. Remember, Wal-Mart profited from the situation and was able to sell in October 2010 $750 million worth of 3-year bonds, paying a stunning low 0.75 percent. It also sold $1.25 billion of 5-year bonds paying 1.5 percent, $1.75 billion of 10-year bonds paying 3.25 percent. I wouldn’t have bought them but obviously others did!

It’s a fact that the collapse in the M1 money multiplier apparently doesn’t matter to companies like Wal-Mart as they still can raise capital. However, the overall level of capital provided to the economy remains low even with the credit markets picking up some of the slack. The main reason being that households and small and medium sized companies are unable to take advantage of this channel and still rely on banks.

Now, a lot of investors would have expected that $600 billion (QE2) purchases of Treasury bonds by the Fed should have depressed yields. Well, actually that’s not the case with the 10 year Treasury yield that is now above the level when QE2 was announced last November.

It’s also a fact that nobody knows where the U.S. Treasury yields will be in the absence of Fed purchases. Don’t forget there was “some” evidence the U.S. economy was improving before QE2 started and that markets discounted QE2 in advance. So, why QE2 after all?

The effect of QE2 in the currency markets has been interesting with the dollar weakening somewhat over the QE2 period. Again there are a whole range of factors driving the currency markets, but there is a general perception outside the U.S. that the main aim of QE was to drive the dollar lower via lower yields forcing investors overseas. If that was the intention, we could say that the result, so far, has not been such a big success.

Of course, U.S. authorities deny, what could they really say otherwise, any intent to weaken the dollar, but it is the Fed’s portfolio effects that are causing concern to many investors. There has been an un-ambivalent increase in foreign exchange reserves at emerging market central banks during the whole QE period, as capital inflows have risen in emerging markets.

Consequently, this has caused boosting money growth in these emerging economies as those with “more or less” fixed exchange rates have struggled to contain capital inflows. That growth has fueled commodity demand, which in turn has pushed up commodity prices. Now, investors should be attentive and take into account, notwithstanding it’s not a sure thing that the end of the Fed’s Quantitative Easing (QE) at the end of June could result in a reversal of the recent capital flows, resulting in a stronger U.S. dollar and weaker commodity prices. Market movements could also become more volatile should the end of QE also trigger a reversal of carry trades funded in U.S. dollars. No, nothing is written in stone… and investors still have time to think about it.

Finally, I think QE2 is unlikely to have had a major impact on the U.S. economy as its main effect has been boosting already excessive bank reserves. In my opinion ending QE should result in higher U.S. Treasury bond yields that could cause a reversal of capital flows and therefore strengthening in the U.S. dollar, which should cause commodity prices to go lower, if that would be the case.

Risk appetite may wane if U.S. dollar-funded carry trades unwind, resulting in some volatility in equity and credit markets. These financial moves could feed back onto the economy. If that occurs, investors may question whether growth is robust enough to prevent a relapse. This would suggest a new period of greater risk aversion and rising bond yields and a stronger dollar.

Of course, we aren’t there yet. In the meantime, my positive opinion on the dollar, gold and Swiss franc haven’t changed.

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Well, the downgrading waltz continues. Fitch Ratings just revised Japan's outlook to negative from stable. The head of Fitch's Asia-Pacific sovereigns team comments: Japan s sovereign creditworthiness is under negative pressure from rising government indebtedness....
Monday, 30 May 2011 12:05 AM
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