Courtesy of Lee Adler of the Wall Street Examiner
Ilene of Phil’s Stock World interviewed me by email last night with some questions about the Fed’s QE New.
Here are the highlights of the exchange.
Ilene: This is bullish for stocks, but not so good for the economy in general?
Lee: Yes. It’s bullish and it’s not. The commodities rally will eventually choke the economy, and the Fed will be in a double bind. Checkmate. But until then, up…
Ilene: What’s the difference between the new program and the old one?
Lee: The original purpose of the existing Mortgage Backed Securities (MBS) purchase program was to replace the MBS being paid off from the Fed’s balance sheet. This goes on all the time at the rate of $10 billion to $40 billion per month, depending on whether mortgage rates are low and falling, stable, or rising. MBS are paid down monthly as mortgages are refinanced and paid off or the underlying real estate is sold. The rate of paydowns increases as rates fall, and decreases as rates rise. The existing MBS purchase program replaces those mortgages that are coming off the Fed’s balance sheet to keep the balance sheet from shrinking (For reference)
Ilene: So the Primary Dealers mediate the transactions?
Lee: Primary Dealers do not mostly “mediate” transactions. They are not the Primary “Brokers.” The are the “Primary Dealers.” They are typically the other side of the trade with the Fed, although in some cases they may be acting for customers. The Fed’s purchases result in a credit to a Primary Dealer’s account at the Fed, while the Fed’s sales result in a debit to that account. That’s how Fed purchases inject reserves into the system. The conduit is the Primary Dealer accounts. They then use that cash to trade their own accounts or lend to customers, pushing the markets higher when the Fed is buying on balance.
Ilene: I am confused. The Fed said it would buy $40 billion a month in MBS but that it would add $85 billion in long term securities to its balance sheet
Lee: The Fed said $85 billion, and I take them at their word. I was thinking how it could add up to their target. $40 billion plus the $37 billion this month under the old program is $77 billion. I assume that the other $8 billion will come from tilted Twist, as the Fed buys more than it sells or redeems in the Maturity Extension Program for Treasuries (Operation Twist). They have bought more than they sold to the dealers for the past 2 months and I think not a soul other than me has mentioned it. They have tilted toward more outright purchases from the Primary Dealers than sales and redemptions.
If rates start rising, the Fed will not be able to reach the $85 billion target, because MBS paydowns will drop back to $10 billion a month, the natural background rate from house sales. MBS paydowns recede when rates rise because there are fewer mortgage refinances. Fewer MBS are therefore paid down. That means the Fed will only buy $10 billion a month to replace the paydowns. It would specifically need to do larger outright purchases of MBS, GSE, or Treasury paper to keep the flow of cash to the Primary Dealers at $85 billion per month.
On further reflection, perhaps the Fed meant that the $85 billion added to the Fed’s long term holdings would be the $40 billion from the new program, and the $45 billion a month from Twist, not from the MBS replacements. The Fed did not specify how that would work, and the language was murky since the Fed’s SOMA (System Open Market Account) won’t actually grow by $85 billion. The number that matters most will be the monthly net purchases from the Primary Dealers, which will probably be between $50 and $80 billion per month. That will need to be tracked from what the NY Fed publishes about the transactions.
Ilene: How will this hurt the market and the economy?
Lee: First of all. As this cash hits dealer accounts, they will divert some of it to speculative activities that they deem have the best chance of profiting. They also provide margin for their big hedge fund customers who do the same. We saw this in the last two rounds of QE. Commodities- energy, food, materials, and precious metals all soared. This is likely to happen again. We already saw the front running as traders became convinced that more QE was coming. I expect the commodities to continue to soar. Furthermore, if traders believe that the program is inflationary, they will sell bonds even faster if the Fed announces larger purchases, and this could devolve into a vicious spiral.
Commodity Prices Move With QE – Click to enlarge
Meanwhile commodity prices should go through the roof as a result of the $50-85 billion month in purchases, which are a direct injection of cash into Primary Dealer accounts. As they trade for their own accounts and create margin for the hedge funds who are their biggest customers, some of the cash will be put to work in the commodities markets as large traders and investors seek money substitutes as big hedges for the trashing of currency. As commodity prices rise, the economy will choke. I think that the Fed just swallowed the dildo.
Ilene: Ouch. Can I quote you?
Lee: Yes
Thanks to Ilene at Phil's Stock World.
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