In todays article, I will be going over the concept of Quantitive Easing (QE), and its affect on asset prices and interest rates.
Quantitative Easing
Quantitative easing (QE) is the concept of central banks, like the federal reserve, buying assets such as mortgage backed securities (MBS) and bonds. Every entity — both bank and non bank has a “balance sheet” — which is simply a tool to measure assets (things you own) and liabilities (things you owe). When central banks buy assets, they are increasing the asset side of their balance sheet. Treasury bonds on the Fed’s balance sheet, bought through QE, are liabilities of the Treasury. Treasury issues debt in the form of treasury bonds, which are debt contracts promising to pay the buyer back the principle amount (the amount the treasury is asking for) plus an interest rate (a payment on top if the principle). Mortgage backed securities are similar to treasury bonds, in that they are debt contracts of consumer mortgages bundled in large packages. Also, liabilities of the consumers who own the mortgages, and assets of the institution that holds the debt contract. When QE is conducted, employees at the Fed’s open market desks will go into the market and buy these assets. The Fed has a set $ amount of assets it will buy each month.
Currently the Fed is buying $120 billion of treasuries and MBS a month… I will let that sink in. It doesn’t take a genius to understand thats absurd. Why would the Fed be buying 120 billion dollars worth of assets a month if the economy is sound? The answer is because we are in the midst of a severe rescission. QE’s purpose is to lower interest rates and pump asset prices. How does it do that? QE artificially lowers interest rates by easing the bond market (IE treasuries) which are tied to consumer borrowing rates (in a simple example). Remember bond prices are inverse to interest rates, meaning the more demand for the bond, the lower the interest rate will go and higher the par value. If you want to buy a house, chances are that loan is tied to the interest rate of a treasury bond. So the lower the interest rate is, the more likely you will attempt to buy the home. You can afford an interest rate of 2-3% but cannot afford a 6-7% interest rate. When interest rates are suppressed money is ‘cheap’, meaning consumers, companies, and the federal gov can take out more debt to buy assets. In turn, this creates massive demand for assets like stocks, bonds, real estate, cars, you name it.
Let me give you an example, if you were a institution and had the opportunity to take out a loan at 1% (often by issuing corp debt, aka corporate bonds) wouldn’t you do it? You would use that money to buy back your stock, which in turn, increases the scarcity of your stock (price goes up). Simple and effective tool at pumping your stock price. Most consumers known inherently, that assets will be more expensive in the future vs today. So, they take the money out today to buy the asset that will be more expensive in the future. Consider you taking out a loan today for that house, because you know it will be more expensive tomorrow. Or the federal government, who can issue bonds to fund whatever spending project they want. Same concept, the Gov is incentivized to take advantage of the ‘cheap money’, and spend it now. All of this spending and cheap debt is funded through QE. Since most interest rates are tied to some form of treasury bond, the more the Fed buys of them, the lower the interest rate goes. Again the cheaper the money, the more people will take out to invest. This is highly problematic, but we will get to that.
*Below is the feds balance sheet in comparison to the S&P500
As you can see the S&P500 has corresponded almost directly to the feds balance sheet growing. This is a direct result of the Fed manipulating interest rates lower and lower. This is why every stock is at all time highs, housing prices have gone up 25%, etc. Effectively, QE is just a way to inflate assets. Its important to note QE is highly inflationary for asset prices, not really consumer goods and services. The money being used in QE never touches the ‘real economy’, as the dollars the central bank uses are different from the dollars in your wells fargo account. These dollars are used only among bank entities and finical institutions. Another example how how QE creates more demand for assets, as the entity takes out ‘cheap money’ to buy these assets.
Now why does any of this matter? Well, QE is a dangerous game, it creates artificial demand that would not be present if the central bank didn't exist. Consumers are essentially being forced into — and insetivilsed — to take out money at all costs to buy these assets. That asset may be a stock, bond, home, etc. QE turns markets into drug addicts. Without that constant hit of fresh dollars hitting the market, as the Feds balance sheet grows higher and higher, and interest rates get bid lower and lower, the stock, bond, and real estate markets begins to withdraw. This is why the bouts of QE have gotten larger and larger after every launch of QE. The Fed is a drug dealer dosing out higher and higher amounts of drugs to the stock market, because the stock market’s tolerance keeps building. Its simple diminishing returns.
You can see how this is problematic… Real interest rates are determined by the free market’s perception of risk/reward. In times when the economy is not running as well, creditors will perceive the loan to be more risky. In healthier times, interest rates will naturally be lower, as the creditor has more confidence in the economy. Simulating artificial interest rates 24/7 365 is massively distortionary, and miscalculates the true cost of obtaining capital. If there is an entity who will always be there to soothe interest rates, which soothes and increases asset prices, why would there be any reason to make that debt truly useful and productive. 90% of public companies only take out debt to buy back their stock, pumping their stock in the process, but nothing productive or anything that adds to the company in whole.
This mass distortion is not productive for society, it does not create true value. Want proof? Why is the US trade deficit at all time highs? Why is the country taking out more and more unproductive debt every year? 29 trillion in debt, 3 trillion taken out this past year. Does Tesla really deserve to be a trillion dollar company? Have they sold more cars than any of the other car producers? No, people enjoy buying the stock with money they leveraged, and the federal government takes out cheap debt to pay Tesla in the form of carbon credits. I will reiterate, THIS IS ARTIFICIAL DEMAND and would not happen if there were true free market interest rates. Its no wonder there are so many zombie companies who haven’t done anything, but they can make their stock more attractive by taking out cheap debt, so its no wonder they are still alive. QE forces people to stuff money wherever they can, it doesn’t matter the actual earnings of the company, they need to stuff that money somewhere before somebody else goes and buys that asset from underneath them.
But who cares, I don't even own stocks, bonds, or any of that. Well…. 60% of Americans do, and just about every person with a 401k or retirement plan does as well. So a dip in asset prices is catastrophic to the economy. See the chart below.
This chart represents the total market cap of the stock market relative too GDP. As of today the stock market accounts for 218% of GDP.
Are you drawing any conclusions yet? Do you see what cheap artificial interests rates do to the economy? It creates massive bubbles. A ten year treasury pays 1.5% interest rate right now. Inflation is running at 5.4% (CPI inflation which is not accurate at all, but thats another story), so subtract 1.5%-5%… And bam you get a whopping -3.5% return on that investment! Oh wait, bonds account for +$100 trillion dollars worth of the world’s money. HOW? Its a negative yield! Well the Fed will go and buy every single bond out there, and then force pension funds to buy the rest. Without the Fed would bonds really be at +$100 trillion? Well what about stocks? Look at that chart of the S&P relative to the Feds balance sheet. Would the S&P really be that high if not for the massive amount of bonds purchased by the Fed, thus lowering interest rates, allowing for cheap debt? Or would real estate really be up 25% this past year, if not for the cheap mortgage people could leverage to buy the home they wanted? Hey, black rock the asset manager (akin to JP Morgan or Morgan Stanley) can take out loans directly from the Fed for less than 1% and buy homes. Google black rock buying homes right now.
Everybody in the economy is being forced further out the risk curve by the Fed. If intrest rates are artificially low, then consumers can no longer store their wealth in a bank account, as it yields sub 2%. They are forced to seek investments that will protect and grow their purchasing power. Bonds and savings accounts used to be the standard store of value, then returns became non tenable. Now people are forced to find an asset that can hold its value, while also producing growth. Everybody knows you cannot build a future by saving in cash, and that you gotta "InVesT". Its not supposed to be that way, but since the Fed can minuplate asset markets, and diminish peoples ability to store value, then it makes perfect sense. All of this creates pressure and forces people to find risker and risker assets, since the riskier the asset, the greater return. But, that doesn't mean your getting greater quality, you are taking an inherit risk betting on that company to perform well, when you could have been storing value in a safe real yielding bank account. Not possible anymore...
Final thought, like I said QE is inflationary in asset prices, not as much consumer prices. The dollars are almost always contained to asset markets. It makes massive distortion in the responsible allocation of capital, creating massive asset bubbles. Yet, QE allows for the federal government to take out debt for almost nothing. That debt will then be spent in the real economy, which creates inflation in consumer prices. I will go into the creation of dollars in another article to help you further understand inflation. For now remember the cheaper the debt the more reckless the entity will be with that debt. Incentives to be productive and fruitful no longer exists in a world where interest rates are bid to 0 no matter the state of the economy. Debt is only good when used productively. Think about how much debt the US gov has taken out because of artificial interest rates. The US can never pay off that debt, but they will continue to take out that debt because they can and its cheap.