Pondering the End of QE2 - By Doug Noland

<blockquote>'...Dallas Fed President Richard Fisher suggested that it might make sense to unwind QE2 as the first step toward tightening monetary policy. As appealing as this may sound, such a policy reversal is at this point completely unrealistic. It concerns me that our leading central bankers don’t appreciate how their unprecedented – and ongoing - market interventions have painted themselves into a corner.'</blockquote>


Pondering the End of QE2

By Doug Noland
February 18, 2011
Source

We’re now close to the half way point for QE2. The June wrap-up date should begin to move from the back of the markets’ mind to the forefront. This week from the Financial Times’ Michael Mackenzie: “It is no secret that China’s appetite for Treasuries has been waning. Official figures now bear out Beijing’s stated desire to diversify away from US government debt. The market impact is likely to be muted for now, given the Federal Reserve’s bond-buying under its ‘quantitative easing’ program. But what happens when QE2 ends in June?”

It is central to Credit Bubble analysis that policies that artificially inflate price levels are inevitably problematic. To be sure, policy stimulus engendered specifically to create excess marketplace liquidity inflates market prices while manipulating market perceptions. The Bernanke Fed wanted stock prices higher and they’ve succeeded. Along the way, policymaking has fomented Bubble Dynamics - reinvigorating risk-taking and leveraged speculation. Speculative excess and inflationary forces have been unleashed upon the world.

Global policymakers have succeeded in re-inflating global securities markets – in the process they also incited rampant food and commodities price inflation. More broad-based inflationary pressures are mounting, although global policymakers in unison are slow to move away from extraordinarily loose policies. There is increased talk of how the world’s central bankers – especially those in Asia – are falling further “behind the curve.” Systemic fragilities are escalating along with the potential for belated monetary tightening and “hard landings”

The Fed clearly has no inclination to reverse course anytime soon. Our central bank has basically signaled that its blinders have been positioned to see little else beyond our unemployment rate. It’s also apparent that structural issues and the current strain of global inflationary dynamics ensure that U.S. employment gains lag inflationary pressures. It’s the wrong economic indicator for which to base monetary policy.

The Fed has convinced the markets that our central bank would feel more comfortable with a higher inflation rate. And, at some point down the road, policy could change course to manage the inflation level to some optimum point. Our central bank – along with the markets – has grown comfortable with “quantitative easing,” over-confident in its capacity to control the unfolding financial boom, and complacent about what comes next.

This week, Dallas Fed President Richard Fisher suggested that it might make sense to unwind QE2 as the first step toward tightening monetary policy. As appealing as this may sound, such a policy reversal is at this point completely unrealistic. It concerns me that our leading central bankers don’t appreciate how their unprecedented – and ongoing - market interventions have painted themselves into a corner.

In this week’s release of the latest budget, the Administration (again) raised its estimate for the 2011 fiscal deficit to $1.6 TN – the largest ever and approaching 11% of GDP. With no end in sight to the massive supply of new Treasury debt, it is simply infeasible for our central bank to add further to the supply overhang. For a couple years now, the anticipation of Fed buying has done wonders for our debt markets. In a bit of wishful thinking, Mr. Fisher stated that “Markets for Treasuries are very deep and very liquid -- that gives you a lot of maneuvering room.”

I suspect that the Treasury market won’t always qualify as “very deep and very liquid.” And I wouldn’t be all too surprised if this day of reckoning is closer at hand than market participants anticipate. For the most part, the marketplace has remained deep and liquid throughout one of history’s most protracted bull markets in debt instruments (as yields demonstrated a down-ward bias/prices an inflationary bias). It remained deep and liquid as foreign central banks accumulated Trillions of our debt obligations. And the perception of liquidity has been maintained as the Fed has ballooned its holdings of Treasury and agency obligations. On all fronts, a case can be made we’ve passed – or are quickly approaching - important inflections points.

As always, bull markets enjoy the perception of endless liquidity, while bear markets shatter such (excess liquidity-induced) myths. For some time now, the Treasury/agency market has defied the truism that bull market excesses dictate the pain and duration of the bear. Yet, the makings for a big bear market having been falling into place.

Our deficits are completely out of control, and the Federal Reserve has added to its list of historic blunders by accommodating Washington spending profligacy. Quantitative easing distorted the pricing of government debt and the markets perceptions of risk, thus promoting unprecedented government borrowing and spending. Without QE1 and QE2, higher Treasury borrowing cost would have some time ago commenced the necessary “austerity” measures. Instead, the Fed has aggressively manipulated borrowings costs and the Treasury has accumulated debt recklessly.

It hasn’t mattered much in the market that the Chinese and other central banks have backed away from accumulating Treasurys. Few take notice that the dominant international buying now takes place through the financial hubs in the UK and the Caribbean (hedge funds and other leveraged players?). Perhaps, as the FT suggested, it might matter in June when the Fed wraps up its (latest phase of) monetary experiment.

There are reasons for the marketplace to become increasingly nervous with the confluence of massive supply, the lack of a reliable central bank (Fed, China, etc.) backstop bid, potentially “weak-handed” leveraged players becoming the marginal source of market liquidity, and a potential derivatives tinderbox. With inflationary pressures mounting in a world dominated by derivatives and sophisticated hedging programs, one has the makings for one volatile bearish concoction. And with the unprecedented trajectory of federal debt accumulation, we’re now at the point that market yields don’t have to surprise much on the upside for some really serious problems to unfold.

I think the sophisticated players have believed there were still a couple of years before the U.S. debt problem turned unstable. I think they may have to rethink. I have in the past pointed out that in early November 2009 Greece could borrow for two years at about 2% - and markets could pretend the Greek debt situation was manageable. The fact that markets were content to postpone the disciplining process ensured that when it did finally arrive it was serious.