The Hussman Report

The Recklessness of Quantitative Easing 
John P. Hussman, Ph.D.
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"With continuing weakness in the U.S. job market, Ben Bernanke confirmed last week what investors have been pricing into the markets for months - the Federal Reserve will launch a new program of "quantitative easing" (QE), probably as early as November. Analysts expect that the Fed could purchase $1 trillion or more of U.S. Treasury securities, flooding the financial system with additional bank reserves.

A second round of QE presumably has two operating targets. One is to directly lower long-term interest rates, possibly driving real interest rates to negative levels in hopes of stimulating loan demand and discouraging saving. The other is to directly increase the supply of lendable reserves in the banking system. The hope is that these changes will advance the ultimate objective of increasing U.S. output and employment...."

"Opacity masquerading as solvency

One of the arguments for quantitative easing is the notion that the Fed's purchase of $1.5 trillion of Fannie Mae and Freddie Mac debt somehow "pulled the U.S. economy back from the abyss" of a Depression. But a closer examination of the past 19 months suggests that a much more specific mechanism - suspension of truthful disclosure - was actually the key element. Unfortunately, the benefits of this suspension are also impermanent, because the underlying solvency problems have been left unaddressed.

In early 2009, many major U.S. banks were faced with clear capital shortfalls that effectively rendered them insolvent - their liabilities exceeded their assets. Instead of restructuring this debt, or dealing with the problem in a sustainable way, the Financial Accounting Standards Board, responding to Congressional pressure, suspended "mark to market rules" and allowed major U.S. financials to use "substantial discretion" in valuing their assets. Since it was neither possible nor credible for banks to immediately write up those assets overnight, loans from the Troubled Asset Relief Program (TARP) were critical in bridging the immediate shortfall. Over the following quarters, banks substantially wrote up their assets, and they issued a large volume of additional stock. The new issuance created a moderate but legitimate improvement in the financial position of these banks, but the asset writeups appear to be inconsistent with the growing volume of delinquent and unforeclosed homes, and the deteriorating debt-service performance of commercial mortgage-backed securities. Presently, the U.S. financial sector is essentially opacity masquerading as solvency..."

"Risk without benefit

Despite the probable lack of measureable benefits, further QE poses significant risks. It has already triggered a steep decline in the exchange value of the U.S. dollar, and threatens a destabilization of international economic activity, a loss of confidence, and the creation of a "boom-bust" cycle threatening to choke off any economic recovery that does emerge..."

"Commodity Hoarding

An additional fruit of careless, non-economic thinking on behalf of the Fed is the idea of announcing an increase in the Fed's informal inflation target, in order to reduce expectations regarding real interest rates. The theory here - undoubtedly fished out of a Cracker Jack box - is that lower real interest rates will result in greater eagerness to spend cash balances. Unfortunately, this belief is simply not supported by historical evidence. If the Fed should know anything, it should know that reductions in nominal interest rates result in a lowering of monetary velocity, while reductions in real interest rates result in a lowering of the velocity of commodities (commonly known as "hoarding").

Look across history both in the U.S. and internationally, and what you'll find is that suppressed real interest rates are not correlated with an acceleration of real economic activity, but rather with the hoarding of commodities. Importantly, when people hoard, they generally hoard items that aren't subject to depreciation, technological improvement, or other forms of obsolescence. Look at the prices of the objects that are rising in price at present - gold, silver, oil - and you will see this dynamic in action. That said, investors should not extrapolate these advances indefinitely, because all of these commodity prices have moved up in anticipation of Fed action, and now rely on massive and sustained quantitative easing. They do not represent low risk investment opportunities at present, elevated prices..."

"Market Climate

Reduce risk.

Presently, a wide range of risky assets are priced in a way that requires perfection. Corporate bond yields are barely above 3%, while our estimates for 5-7 year total returns for the S&P 500 hover around zero. Even our precious metals models, which with few exceptions have been constructive for nearly a decade, shifted to a "high risk" condition last week.

Demand for risky assets has not been driven by the prospects for unusually high returns. Rather, investors feel "forced" to take risk despite elevated valuations, largely thanks to Federal Reserve action. The Fed has provoked risk-taking by driving down competing Treasury yields to levels that give investors no apparent option but to chase risky assets. But now that valuations are elevated and prospective long-term returns are compressed, the only way for this situation to be sustained is for investors to remain willing to accept low long-term returns indefinitely."

"My impression is that much or all of the potential upside of quantitative easing is already fully reflected in stock, bond and commodities markets. Investors now rely not only on QE itself, but also on its success. This is a dangerous place to be. The Strategic Growth Fund is tightly hedged, with a staggered strike position that provides additional downside protection for our holdings. The Strategic International Equity Fund is largely but not completely hedged against local stock price fluctuations, owing to the fact that valuations and market conditions are not uniformly as negative abroad as domestically. We did reduce our exposure to foreign currency fluctuations last week on further dollar weakness. While the dollar may decline further, our view again is that much of the effect of quantitative easing on the financial markets is already priced in.

In the Strategic Total Return Fund, we sharply cut our portfolio duration on price strength last week, to about 1.5 years from just over 4 years. While the Fed will undoubtedly be purchasing Treasury securities in the coming months, it will also be bidding in the face of fairly eager offers, since Treasury securities no longer provide yields that can be considered attractive barring a deflationary collapse. We took our bird in the hand. Likewise, we clipped our precious metals position down to just 3% of assets, and our foreign currency position down to just over 1% of assets. As trader and friend Linda Raschke puts it, "when the ducks are quacking, feed them."