Dear Jerome Powell: End quantitative easing now. The Japanese attempted QE in 2001, buying government debt, mortgage debt and even stocks. It did not work. The Federal Reserve has tried four times since Lehman Brothers went bankrupt in 2008. QE doesn’t work and instead of keeping markets stable it creates instability.
The Fed oversees and regulates US banks. But mainstream banking (think Mr. Potter from “It’s a Wonderful Life”) only accounts for about 15% of all loans, maybe less. The rest is the mysterious shadow banking system based on securities lending and other credit products, including repurchase agreements – the repo market.
In repo, brokers, hedge funds and banks build short-term transactions. You offer collateral – treasury bills or sometimes less pristine instruments – with an agreement to buy them back the next day or week for a little more, and invest the proceeds in the interim. Jeffrey Snider, head of research at Alhambra Investments, calls it a “no reserve money system”. This is how global supply chains are funded, to bring us cheap products from Walmart or Amazon.
Sometimes lenders post collateral to other lenders and take out their own pension loans. And the cycle continues. It’s a bit like the hot potato, passing the warranty on to the next. Known as remortgage, these transfers were once done once or twice for each asset displayed, but are now sometimes made six to eight times, each time creating a new money supply. Note: this is modern money creation – outside the jurisdiction of the Federal Reserve – and it’s huge.
When times are good, pensions work well: agreements expire without a hitch and the collateral flows back smoothly down the chain. But eventually, questionable guarantees creep through the system. This is also fine, until the markets hit an inevitable hard time, like, say, March 2020. Nobody will take the junky stuff anymore, and everyone is scrambling for good collateral. So there’s a mad rush, a brawl really, to buy Treasurys – like musical chairs with six to eight buyers eagerly eyeing a chair.
We have seen this collateral problem in action. In March, the credit spreads between good and bad debt widened and Treasury bill prices soared as yields fell on the buying frenzy. The interest rate on one-month Treasury bills fell from 1.61% on February 18 to 0.00% on March 28. It was the rush for good guarantees.
But wait, the US government debt was $ 24 trillion in March – why weren’t there enough Treasuries to buy? Because, you guessed it, the Fed is gobbling them up, $ 80 billion a month, for quantitative easing. Mr. Snider explains that “the low interest rates were not the result of the Fed’s bond purchases, but of the market stripping of good collateral.” The Dow’s 22-day plunge into a bear market (Feb.20-March 12) was not due to feared lockdowns, but fear of a financial collapse caused by the lack of good collateral for the credit works.
But didn’t the Fed come to the rescue, through its credit facilities authorized by the Cares Act? Well not really. You can tell because the Fed has loaned virtually nothing. Instead, Cares funds were spent on payroll protection, bailouts, unemployment bonuses and $ 1,200 checks. To fund the Cares Act, the Treasury Department had to issue nearly $ 2 trillion in new debt.
Bada-boom, that was it! These new Treasurys were precisely the right collateral the credit market needed! The stock market has been on an uptrend ever since, although it wasn’t until later in April that the Treasury Department raised debt, easing the credit market. “When the government auctioned more Treasuries,” Mr. Snider told me in astonishment in his voice, “by accident, they provided exactly what the market absolutely needed.
So, should Washington spend and issue treasures willy-nilly? I’m sure the Biden administration and the Tax and Expenditure House would be happy to do so.
No no no. To solve the instability problem, the Fed must end QE – stop swallowing Treasuries, the good collateral the global economy needs to function.
Yes, stop buying treasures. The Fed is depriving the rest of the system of the oxygen it needs to thrive. And the six to eight times the Treasurys are replenished, which creates this excess money supply – well, that money has to go somewhere, which explains the inflation of Tesla, DoorDash,
Bitcoin, etc. Without QE hogging collateral, maybe the re-mortgage is only done two or three times, which means a much more stable credit market. Beware of Momentum investors.
Unfortunately, there are hurdles, the least of which is that Mr. Powell wants to be re-appointed chairman of the Fed. Ending QE would likely let interest rates return to a higher normal, which would increase the cost of running government deficits. And the bubbling stock market could deflate. So what?
Global credit is, Mr Snider tells me, a “fragile system that doesn’t need a lot of triggers to go back”. The least the Fed can do is step aside. Complete the QE now.
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