Debtor's Prison

Greetings fellow inmates:

The kind folks at Government Sachs published a note on 07.08.09 on the various quantitative easing (QE) programs at the major central banks, which we have uploaded here. The document is a very worthwhile and short read and we highly recommend it as it has plentiful information on the various programs. As usual, we provide a summary for you as well as commentary on some notable points.

In general, the note discusses the intricacies of QE exit strategies. It begins by commenting on the recent market expectations that QE will begin to be phased out due to improving economic conditions. The authors state that these expectations are premature. As we have said several times before, we completely agree with this statement. The fact of the matter is that all these programs have undertaken long-term actions that are not easily reversed. Moreover, the financial conditions that propitiated QE in the first place remain very much alive, despite the seemingly desperate desire by some to ignore them. Specifically, the note pinpoints the need for a revival in credit creation, a sustained contraction in the output gap and an awakening of inflation concerns as necessary conditions before we can seriously discuss QE termination. More on this below.

The chart below shows the balance sheets of each of the five major central banks and how they have ballooned in the past year. The UK and the US have led the pack with balance sheets that are currently 250% what they were pre-crisis levels. The Swiss National Bank is not that far behind. As you know, these wanton expansions have been the result of the slew of liquidity facilities provided to banks as well as direct asset purchases. It is important to remember that in large part, these BS expansions have amounted to a silent bailout to the different banking systems.

The following chart details the issuance of sovereign debt versus central banks purchases of the same, in other words, debt monetization. This is a very troublesome graph, as debt monetization is extremely dangerous. As we have said many times before, the problem with an excessive debt overhang is not to issue more debt. As sovereign debt gets issued to effectively replace private toxic debt and absorbed into the balance sheets of central banks, this clogs the system further at the very base of the monetary system. It is precisely this effect that we expect will lead to a broad fiat currency crisis in 2-3 years’ time as all the reserve currencies except the Euro are undertaking debt monetization. Though the Euro area has remained very negative on sovereign debt purchases, it is still very uncertain whether they will undertake it, especially if the economy takes another turn for the worse, as we expect it will.

Prerequisites for QE exit

1. Stabilization of credit creation: The note states that financial conditions have improved somewhat as some of the debt problems have been dealt with. While we cannot deny that funding has improved for certain sectors, we disagree that debt problems have been dealt with significantly. There is still an enormous amount of off-balance sheet debt that still festers and whose losses have not been reported. Changes to accounting regulations have allowed banks to forestall loss reporting though they cannot change the nature of the underlying debt. This is one of the aspects of the crisis that baffles us since these problems seemed to have disappeared from the public sphere in spite of their being very much alive. The note does mention how all the excess reserves that central banks have provided have been parked in the interbank market, meaning that monetary easing has been pushing on a string so far. This is a significant statement: in spite of the unprecedented and gargantuan actions undertaken by all these central banks, they have failed to achieve their aim. This will only extend the duration of all these QE programs.

2. Sustained contraction in output gaps: GS expects output gaps to be much wider in this recession than in previous ones. They also estimate that the gaps will not be eliminated until 2014-2020, meaning that economies will not reach their longer-term potential growth rate until 2010-2014. While conventional monetary policy would wait until the elimination of the output gap to initiate tightening, the increased inflationary pressures created by QE would lead central banks to move ahead of the curve and begin tightening when a sustained contraction has begun, allegedly.

3. A switch from deflationary to inflationary concerns: As long as the main concern remains centered on deflation, QE will remain in place. This switch to inflationary concerns will come about mainly through the bond term structure, in other words, higher long-term yields. We certainly expect this to be the case. In contrast with the note however, we believe that the widening of yields will prove faster and stronger than the authors believe. This will be part of the extremely destructive end-game for this global QE experiment. In addition, we believe that the constraints placed on central bankers from the composition of their balance sheets, will restrict a full exit from QE even once inflationary concerns have taken hold.

Challenges for QE exit

1. Asset prices: Now that QE has moved to direct purchases of long-term assets, any balance sheet contraction will have to be mindful of its effect of the prices of these assets. The excess reserves have directly financed these purchases, so any reduction in liquidity (reserves) will require a sale of the assets. The authors express some concern any sales will have on long-term yields, a concern we share. They believe that the first route to unwinding QE will be to let liquidity facilities expire (no roll-over) and limit themselves to short-term asset sales, with long-term asset sales to be used as a last resort. This is the natural process one would expect would take place. However, the size of the long-term purchases, especially by Uncle Benny, is large enough that the balance sheet will remain very expansive without any sales. We’ve said many times how these sales will likely exacerbate rising long-term yields. If the authors are correct and asset sales are to be avoided, then we will have QE in place for many years to come, perhaps an equally unpalatable scenario. This is the root of extremely fine line central bankers will have to walk in any contemplation of QE exits. If they have shown us anything, is that they are not adept at walking fine lines.

2. Managing market expectations: The authors mention the importance of establishing a credible system of managing market expectations on the part of central banks so that term rates can be controlled in an orderly manner. Naturally, policy rate expectations will be influenced by the exit approach taken by each central bank. An important point they bring up is that policy rate hikes will follow QE. This is an often overlooked fact that leads us to believe that expectations of rate hikes are also currently premature. In order to preserve easy financial conditions, the authors believe that central banks could commit to low interest rate policies for a considerable amount of time. This will of course limit the flexibility of central banks and a potential reduction in central bank credibility, as shattered as it already is.

3. Consistency with fiscal policy: An important driver to the size and composition of the different QE programs has been the expansionary fiscal policies all these regions have undertaken to combat the crisis. The aggressive issuance of government debt has created the need for debt monetization as demand, especially from foreign nations, has not kept up with supply. The deterioration in the fiscal balances has created an impediment on monetary freedom and independence as it creates a fiscal premium for long-term yields. As long as these conditions remain in place, QE will remain constrained. We expect this will be the case for years to come, as the variety of debt that will remain impaired will increase, necessitating additional support in the form of sovereign debt substitution.

Ultimately, there is much to take away from this note. Foremost is the fact that any expectations for early QE terminations are completely premature and unwarranted. Even GS expects no QE exit before 2011 in the US and Japan, while the UK might exit as early as 2010. As the authors say, it will be a long and winding path for QE exit strategies. We do believe that the difficulties on exiting, in particular the speed and magnitude of inflationary pressures and higher long-term yields, will prove much more difficult to manage than the authors believe.

May your capital be safe and your investments prosperous,

MAAA