TradePlacer.com Blog - bonds tag

Quantifying Quantitative Easing

Thu, 04 Nov 2010 20:06:00 GMT

Many investors are struggling to understand the ramifications of the recently announced QE2 plan. Quantitative easing, or more simply known as money printing, is a dilution transaction similar to issuing more shares for a stock. The dilution has two primary affects: a decrease in the value of the initial shares and a redistribution of wealth from the original owners to the new owners.

The most significant difference between stock dilution and currency dilution is of course that publicly traded companies tend to use the funds raised through dilution to add value by investing those funds - whereas governments don't add value by diluting a currency.

In this case, $900 billion will be diluted to purchase US treasuries so the primary benefactor of the quantitative easing will be the US federal government and the financial institutions selling that debt. However, capital flows can rarely be controlled and the newly created money will find its way into other markets and asset classes.

Interestingly, the $100 billion per month figure that has been mentioned as the target rate for QE is almost exactly what is needed to rollover maturing treasuries coming due - so it could be argued that the plan is to effectively finance the US Federal debt which would eventually lead to a complete monetization of the treasury market. Supporting this argument is the recent projection made by ZeroHedge that the Federal Reserve will own more treasuries than China by the end of November.

In an attempt to measure these affects, we can compare the size of the quantitative easing plan to the size of several markets.

	Outstanding	$900B as Percent of Market	Diluted value of $900B entering market
US GDP	$14,500.00	6%	$0.94
US Federal Debt	$14,500.00	6%	$0.94
M2	$8,750.00	10%	$0.91
M1	$1,800.00	50%	$0.67
Currency	$900.00	100%	$0.50
Treasuries	$11,030.00	8%	$0.92
Municipal	$2,670.00	34%	$0.75
MBS	$8,860.00	10%	$0.91
ABS	$2,600.00	35%	$0.74
Money Market	$3,900.00	23%	$0.81
Corp Bonds	$6,720.00	13%	$0.88
Silver	$24.30	3703%	$0.03
Gold	$2,475.00	36%	$0.73

If the QE2 funds went into the currency market, its value would fall in half. However, $900 billion is roughly 6 percent of US Federal Debt. Inflation is defined by the growth in the money supply. If using M2, the QE2 plan would dilute the money supply by 10 percent. $900 billion represents 36% of the world’s gold supply, so an equivalent move upward in price could be seen if the money finds its way into the gold market. QE2 is 37 times the size of the world’s estimated silver supply so a flow of capital into the silver market could be explosive.

A dollar on November 1st is now worth 92 cents if measured in treasuries or 91 cents if measured with the money supply. It can be seen that inflation as measured by the growth in money supply is projected to increase by 10 to 20 percent on an annualized basis.

The result will be a double digit real negative interest rate and a carry trade opportunity to sell treasuries and other US dollar secured paper at a cost of near 0 percent while accumulating real assets such as precious metals and other resources that cannot be diluted.

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Past the Point of No Return

Thu, 26 Aug 2010 21:33:07 GMT

People often say that the US dollar is no longer backed because it is no longer backed by gold or silver. The truth is that the US dollar is a promissory note backed by the ability and willingness of American taxpayers to pay the value of the dollar.

The currency value of the US dollar is the perceived value of the US government’s ability to collect taxes and repay its debts. This being the case, let’s review the fundamentals of the US economy and dollar.

GOVERNMENT DEBT:
DEBT TYPE	DEBT AMOUNT
Federal Government Sector debt - a record high in 2010.	$13.4 Trillion
State & Local Government Sector debt - a record high.	$3.1 Trillion
Un-funded Social Security contingent liabilities estimated looking forward	$17.5 Trillion
Un-funded Medicare/Medicaid contingent liabilities	$89.3 Trillion
Total Government Liabilities	$123.3 Trillion

Source: http://www.ncpa.org/pub/ba662

The above summary calculates the current unfunded federal, state and local government liabilities to be 123.3 Trillion. I have seen several other estimates running as high as 200 Trillion; however this article will continue to use that figure. If we take that $123 trillion in government liabilities and divide it by the 111 million households in the US we find that the average household liability to the government for its promises is $1,108,108. In other words the average household would need to pay $1 million each in additional taxes in order to pay for the unfunded liabilities. Government budgets are not currently balanced and are unlikely to become balanced as tax revenue declines during the recession. However, assuming government budgets were balanced let’s consider the following chart:

Average Household Government Liabilities:	$1,108,108
Average Household Income Before Taxes:	$67,163
Average Household Federal Tax:	$22,929
Average Household State and Local Tax:	$6,783
Average Household Income After Taxes:	$37,451
Income As a Percentage of Government Liabilities:	3.4%

Sources: US Census Bureau, The Heritage Foundation, CNN Money

Total household income in the US is roughly 3.4% of total government liabilities already in place without future unbalanced budgets. In other words, if everyone living in the US spent their entire income after taxes - without food, clothing, or shelter - they could pay the interest only on that obligation as long as the interest rate was less than 3.4%. This is a good argument for keeping interest rates low indefinitely. Since people generally need food, shelter and clothing, let’s look at household budgets to see how much more they can afford to pay the government:

Given that the US savings rate of disposable income is hovering around 0%, it is clear that the average household already spends everything it earns buy its food, clothing, and shelter. One problem is that while the government has indebted itself beyond the brink of physics, another problem is the average American household has done the same. According to the Grandfather Economic Reports, the household sector has an additional $12.8 trillion in its own debt - and the interest rate on that debt is much higher than the government’s treasury interest rates.

It is often argued that the government can raise tax rates and increase its revenue. Sounds like a great idea, but it once again defies physics. Even assuming that households pay 100% of their income in taxes without any loss in GDP, the unfunded liabilities couldn’t be paid. In addition, the higher tax rates go, the lower tax revenues go and vice versa. If the government reality wanted to increase its revenue it would have to lower tax rates. As tax rates increase, taxpayers increasing turn to Fight, Flight or Fraud to avoid paying more taxes. This trend can be seen clearly below:

In the past, debts were manageable and households saved so the US dollar had perceived value. Some of this perceived value still exists. However, today it is clear that the US government will be unable to fulfill its obligations. While people may perceive or believe in the US dollar and government, the truth is that both are insolvent. It is only a matter of time before perception catches up to reality. If the government diluted $123 trillion in obligations against the current M3 monetary supply of roughly $14 trillion in an orderly fashion, the dollar would fall in value to about 11 cents in today’s dollars.

While the US is insolvent, it is not bankrupt. Bankruptcy is the realization of insolvency. As long as investors are willing and able to purchase and hold government bonds the liabilities can be refinanced. It is only when these promises can’t be delivered upon that participants will be forced to realize default and it may be possible to push this off for years.

The US is not the only country with unsustainable unfunded liabilities. Both the US and Greece have unfunded liabilities exceeding 800% of GDP, The European Union’s unfunded liabilities are 432% of GDP.

Source: Jagadeesh Gokhale, "Measuring the Unfunded Obligations of European Countries," National Center for Policy Analysis, Study No. 319, January 22, 2009 and Eurostat

The US along with most other industrialized nations are undeniably past the point of no return on the path towards a historical renaissance. There is no way out, but to go forward. While many free market proponents are pushing for smaller government, balanced budgets, increased savings, and criticize the Federal Reserve for its inflationary policies, it makes much more sense to support the nation’s current trajectory because it is much easier to go forward than back and it is too late to change inevitable outcomes. The more intervention and liabilities taken on by the government, the faster the realization will become. Despite fairy tale stories by the media and politicians, the laws of mathematics dictate that the dollar and the US economy will default either through the default of obligations or default of the currency itself through inflation.

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What's the Fed's next move

Wed, 23 Jun 2010 01:34:00 GMT

With the stock market up over 50% last year, talk of a V shaped recovery, green shoots, and other aberrations, most analysts expected the economy to resume growing as if 2008 was some sort of unpredictable outlier. With interest rates at 0, and massive government spending programs, the biggest concern for mainstream media was that the economy might grow too fast.

However, it seems evident that even the Federal Reserve doesn't believe in the green shoots theory anymore. Despite government intervention, economic indicators are rolling over, money supply measured by M3 is declining, and financial stress is increasing. Europe is now in an economic crises that could easily spread, and oil is filling the Gulf of Mexico. Risks of a shock to the financial system are everywhere.

Some analysts have been arguing that interest rates must rise to compensate bond holders, however the European crisis has been a gift to the dollar and treasuries so interest rates have remained low. A spike in interest rates appears unlikely in the near term.

If the current trajectory continues, there could be another sharp correction in equity markets globally but US assets may perform the best in comparison, especially treasuries. This could trigger another bout of financial asset deflation and panic. But what can the Fed do now that interest rates are at 0? Will Robert Prechter finally be right after so many years?

Unlikely.

The Fed will never be out of bullets as long as there is a fiat currency - for better or worse. The Fed would probably resume quantitative easing programs on an astronomic scale. And it might even work for a while.