Wednesday, August 07, 2013 - A Crack in QE

A Crack in QE

by Sinclair Noe

DOW – 48 = 15,470
SPX – 6 = 1690
NAS – 11 = 3654
10 YR YLD - .04 = 2.60%
OIL – 1.12 = 104.18
GOLD + 4.70 = 1288.30
SILV + .11 = 19.69

Remember back in late May when Ben Bernanke hinted that the Fed might not continue Quantitative Easing forever; there might actually be a time when the Fed stopped pouring $85 billion into mortgage backed securities and Treasuries. The stock market took a hit on the whim of a whisper of a hint that the punchbowl might be removed. Bernanke did some backtracking, and the markets rebounded to hit record highs on the Dow and the S&P, and we all enjoyed milk and cookies.

This week, we've seen several Fed officials talking about QE again, and again the markets are pulling back; down for three days. On Monday, it was Dallas Fed Bank President Richard Fisher; yesterday it was Charles Evans, president of the Chicago Fed Bank, and Dennis Lockhart, President of the Atlanta Fed Bank.

Today, Federal Reserve Bank of Cleveland President Sandra Pianalto said that the central bank would be prepared to scale back asset purchases if the labor market remains on the stronger path followed since last fall. Pianalto said that there have been "clearer signs of a more sustained recovery" in the labor market in the last few months. "In light of this progress, and if the labor market remains on the stronger path that it has followed since last fall, then I would be prepared to scale back the monthly pace of asset purchases." She did not provide any timetable for Fed action.

Taper talk, markets down. It is becoming so predictable that it even has it's own little name, a “taper tantrum”.

Over the past two months, the 10-year Treasury yield has climbed from around 1.75% to 2.75%. Consequently, mortgage rates have jumped nearly 100 basis points as well. Investors are rightfully concerned and asking how this will impact the economy and their portfolios.

And it certainly appears the Fed is playing the markets like a violin. The ongoing tapering talk is deliberate and designed to accomplish two things: one, establish a new trading range for rates and observe the markets and economic reaction to the rise in rates, and two, begin getting investors numb to the talk of tapering and rising rates so that when it does finally occur, the reaction will be muted.

The reaction is indeed muted. President Obama is going around talking about how we need to do things to improve the economy and regulate to avoid another crisis because there will be no more bailouts. But wait a minute. Remember back in 2008 when the Federal Reserve and the Treasury got together to cough up $80 billion in cash and $65 billion in loan guarantees to keep insurance giant AIG alive. What an outrage!

So, here we are, the Fed has gone through QE 1 at a cost of about $700 billion, QE2 at a cost of about $1.2 trillion, and QE 3 at a cost of $85 billion per month and counting. If you want to see where the stock market is headed, just look at the Fed's balance sheet, which is also hitting record highs; just don't call it a bailout.

Well, even the Fed understands that massive bailouts can't continue forever, even if you don't call it a bailout. Problem is, the stock market is hooked on QE, just like a junkie looking for a fix. And so we have Federal Reserve officials making the rounds, calmly reminding Wall Street that they need to step away from the crack pipe.

By the way, the President’s plan was to get Fannie Mae and Freddie Mac on the hook for mortgages, without government backing up everything. He talked about a bunch of rules and guidelines that need to be established that are actually critical to getting credit flowing to creditworthy borrowers that are shut out of the system by confusion and nervousness among lenders about how these rules will turn out.

Take "put-backs," for example. When banks originate a mortgage loan, they then typically sell it to a secondary buyer, which these days means Fannie or Freddie. But if something is wrong with the documentation, the appraisal, or the underwriting procedure of the loan, the current holder of the security can insist the bank take it back in a forced repurchase.

These put-backs have become a lot more common in recent years, as we've learned that the banks had a habit of putting bad things in the documentation. One problem is that there's a real lack of clarity as to what constitutes a "put-back-able" offense, and that's led nervous lenders to lend only to those with the pristine credit scores. Getting the regulators to fix this should be quick work. Loan are going to be more standardized, and if you can check all the boxes, it should be easier.

We know the world economic pattern we have been used to in years past–world population grows, resource usage grows (including energy resources), and debt increases. The economy grows fast enough that paying an interest rate a little higher than the inflation rate “works” for both lenders and borrowers. Borrowers are able to handle the required interest rate, because their wages are rising fast enough to buy homes and cars at prevailing interest rates. Unemployment is not too much of a problem because jobs grow with population and resource usage. Governments do fairly well, too, because they can tax the growing wages of the population sufficiently to get enough taxes to pay the benefits they have promised to constituents.

This model “works” fairly well, as long as the economy is growing fast enough–population continues to grow and resource extraction continues to grow as planned. In a finite world, we know that this model cannot work forever. At some point, we can expect to start reaching limits.

What do these limits look like?  I would argue that in the case of resource extraction, these limits look like increasingly high cost of extraction. We need to extract resources from increasingly deep locations, in increasingly out-of-the way places, using increasingly more energy intensive techniques. For a while, improved technology is sufficient to keep costs down, but eventually the cost of extraction begins to rise. 

When the cost of extraction begins to rise, it is as if we are pouring more manpower and more resources of many types (steel, fracking fluid, jet fuel, electricity, diesel fuel) into a deep pit, never to be used again. When we put more resources in, we get the same amount of resource out, or even less than in the past. If we want to continue to increase the amount we extract, we have to further increase the quantity of resources used in extraction. Obviously, if we put more manpower and other resources into this pit, we have less for other purposes.

A recent example of resources hitting limits is oil. World oil prices started increasing about 2004. If the sales price of oil rises, to what extent will this increase adversely affect the economic growth oil importing economies? While the cost of oil extraction is expected to continue to rise, can the sales price of oil really increase to match this higher extraction cost? If oil price can’t rise because of affordability issues (low salary growth, low growth in debt, or cutbacks in government transfer payments), then there is likely to be a crisis of a different kind.

Agencies such as the International Energy Agency use projected GDP growth in estimating future demand for energy products, including oil. Growth in oil usage would also be expected to mirror GDP growth, but at a slightly lower rate of increase than growth of energy use in general. This is the case because oil is the most expensive of the major energy products. Consequently, there is a strong incentive to switch to cheaper energy products or to increase efficiency. 

So, as we look at the Federal Reserve, and which way they are blowing on the issue of QE, keep in mind oil prices.

This is the 68^th anniversary of the nuclear age. August 6, 1945 the US dropped the bomb on Hiroshima. The news came in the form of a little more than 1,000 word press release. The first few sentences of the statement set the tone: “Sixteen hours ago an American airplane dropped one bomb on Hiroshima, an important Japanese Army base. That bomb had more power than 20,000 tons of TNT.…The Japanese began the war from the air at Pearl Harbor. They have been repaid many fold…. It is an atomic bomb. It is a harnessing of the basic power of the universe.”

One thing the press release did not talk about was the long lasting consequences of radiation.

In 2011, Japan was hit by an earthquake and tsunami which resulted in massive damage, including a nuclear energy plant. Now, Japan's nuclear watchdog says the crippled Fukushima nuclear plant is facing a new emergency caused by a build-up of radioactive groundwater. The Nuclear Regulatory Authority warns that a barrier built to contain the water has already been breached. This means the amount of contaminated water seeping into the Pacific Ocean could accelerate rapidly. It's not a surprise; there have been multiple water leaks at the plant. Its operator, Tokyo Electric Power Company (Tepco), has been criticised heavily for its lack of transparency over the leaks.

Tepco admitted for the first time last month that radioactive groundwater had breached an underground barrier and been leaking into the sea, but said it was taking steps to prevent it. However, the head of a Nuclear Regulatory Authority task force, says the countermeasures were only a temporary solution, and the situation is now considered an “emergency”.

JPMorgan Chase announced today that it is being investigated by civil and criminal divisions of the Department of Justice over offerings of mortgage-backed securities. The civil division gave the company a notice in May that it had preliminarily concluded that the firm violated federal securities laws in offerings of subprime and Alt-A residential mortgage securities during 2005 to 2007. The company made the disclosures in a quarterly filing with the Securities and Exchange Commission. The criminal side is apparently new, and long overdue. Interesting that they get a notice of the investigation.

Meanwhile, we told you about how Goldman Sachs has a subsidiary which warehouses aluminum in Detroit. And Goldman has been hoarding the aluminum, creating supply imbalances to drive up prices, and then trading on the information. The lawsuits are starting to fly. Last week, Goldman and the LME were named as defendants in a Detroit lawsuit. Today, a new lawsuit filed by Florida-based aluminium user Master Screens and an individual plaintiff, expands the geography and number of companies being sued: Glencore Xstrata and JPMorgan Chase are also named. The Florida lawsuit alleges "manipulation of the aluminium market through supply price fixing," among other practices, and is seeking class action status.