Fedís QE Fattens Financial Markets, but the Economy Still Starves

by The Curmudgeon

At the conclusion of its 2 day meeting next week, the Fed is likely to reassure the markets that it won't slow down it's buying of $85B per month of U.S. debt securities in the near future.The U.S. central bank has noticed the market turbulence since Chairman Ben Bernanke's May 22nd comment that it might begin tapering its quantitative easing (AKA debt monetization) program even if the unemployment rate hasn't dipped below 6.5%.

 

That would pose a major threat to the mortgage market, which the Fed wants to juice to keep the housing recovery going.According to the Mortgage Bankers Association, the average rate on a 30 year mortgage rose to 4.15% last week.That's a 14 month high and up sharply from 3.59% in early May.Freddie Mac's survey pegged that rate at 3.98% this week, compared to 3.35% last month.And refinancing applications were down 36% from the first week in May, according to the Mortgage Bankers Association.

 

Rising mortgage rates are a consequence of the swift rise in Treasury yields, as the bond market sold off in anticipation of Fed "tapering," based on Bernanke's May 22nd remarks.

 

Another Fed concern is that inflation expectations are decreasing. The Fed has a 2% inflation goal and doesn't want consumer prices to veer too much above or too much below that number over time. Some inflation measures have dropped below that level recently, but Fed officials haven't been too worried because expectations of future inflation were stable.But those expectations are falling fast.

 

The yield spread between TIPS and same maturity Treasury notes provides a good measure of inflation expectations.The difference between comparable maturity Treasury and TIPs yields reflects the inflation compensation over that given timeframe.For more information see this article.

 

The TIPs spread or "breakeven" rate (vs Treasuries) has been falling, indicating a lower inflation outlook.The current 10 Year TIPS/Treasury Breakeven Rate is at 2.04%, compared to 2.51% on April 1, 2013.The recent decline in this gauge is shown in the chart below:

 


The Fed became worried about inflation expectations softening too much in 2010 when that indicator was near 2.2%. They responded by launching a second round of QE and balance sheet expansion.As the TIPS breakeven rate is now lower than 2.2% and declining, the Fed is not likely to cut back on bond purchases at this time.

 

When faced with frantic speculation over its motives, weakening markets, and diminished inflation expectations, the Fed may be tempted to say things to calm everyone down.We expect Helicopter Ben to continue putting the "pedal to the meddle."

 

Yet we have strongly argued that the Fed's QE programs and zero interest rate policy havenít worked and are incredibly reckless.It has NOT stimulated the real economy, but has instead created many overvalued financial markets (which some call "bubbles").

We can see how ineffective the Fed's policies have been by noting the bulge in Bank Reserves (commercial banks deposits at the Fed, where banks earn 0.25% interest) at the expense of commercial and industrial loans.Reserves were up 25% (or $200B) in the 1st Quarter of 2013 and have been growing exponentially for several years.As the chart below indicates, bank reserves have grown from practically zero in early 2009 to over $2 trillion now!

Graph of Reserve Balances with Federal Reserve Banks

 

Adjusted Reserves have recently grown even faster, having spiked by 80% or $510B from the end of 2012 till May 29th (latest posting).This eye popping expansion of seasonally Adjusted Reserves can be seen in the chart below:

 

The key point is that instead of lending the cash they've obtained from the Fed's QE programs, banks continue to deposit the money back at the Fed instead of making loans. The banks' ongoing reluctance to lend (along with plunging money velocity as we've shown in two previous Curmudgeon posts) totally stymies the Fed's efforts to boost real economic activity.Instead, it has resulted in overvalued financial markets (especially U.S. stocks and junk bonds), which have become almost totally disconnected from the real economy.

 

Michael Pento of Pento Portfolio Strategies LLC, told the Curmudgeon that the Bernanke-led Fed has created "the biggest bubble in the history of U.S. economics."In our next article, we'll cover the scenarios Mr. Pento has sketched out when (and if) the Fed and the Bank of Japan (BoJ) reach their inflation targets.It is not pretty!

 

Till next time.....................................

 

The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.