A Deeper Look Into Why QE Is Bad

Posted at 11:24 PM (CST) by & filed under Trader Dan Norcini.

Hello,

I would love if one of you gentleman could mention the following BusinessInsider article on QE on JSMineset.com and refute their sophisticated argument on why QE does not increase the money supply and is not bad. It is articles like these in the mainstream media that your readers should be able to respond to, so I (and I am sure many others) would much appreciate your expert insight into the author’s argument.

Thank you for all the great work you do,
CIGA Sim

CIGA Sim,

Obviously Chinese concerns over the Fed’s QE program are unfounded then according to this “logic”. Same goes for Brazil and its resentment at the soaring Real as the Dollar drops in value on the world foreign exchange markets. In other words, all the Central Banks of the East and the emerging markets have gotten it all wrong. There is no reason whatsoever for the Dollar to be falling. It is just ignorant foreign exchange market participants who need a good education and should have read this article first.

Here is the problem with his argument – it fails to consider the impact of QE on international capital flows. Capital will flow OUT of a country employing QE because its goal is to lower interest rates in an attempt to generate loan activity. Investment capital ALWAYS seeks a higher rate of return and will flow to nations with more vibrant economies with higher bond yields and more opportunities to secure capital gains. This flow has the effect of destroying demand for the currency undergoing QE and raising demand for the currency of other nations where higher rates of return can be secured.

As the domestic currency of the nation falls in value due to the slowdown in demand, the cost of many goods in that nation begin to rise for two reasons:

First – investors move to protect the value of their wealth and shelter it against the fall in the currency in which their holdings are denominated. That is what is currently happening with the commodity markets. Those things which will tend to retain their value are sought out and purchased.

Second – weakness in the currency leads to a rise in the price of all imported goods as it now requires additional units of that currency to secure the same amount of foreign goods.

These two items are where the inflationary effect of QE arises.

One other issue that this article fails to consider is the role of speculators. Any analysis of QE impact that does not take into account the speculator is deficient. This role is closely related to the fact that investors will look to protect their assets from a decline in the currency but it goes a step further. Speculators will look to profit from the weakness in the QE currency by using it to fund a “carry trade”. This involves borrowing that currency, because of the extremely low interest rates, and then leveraging that borrowed money into trades that allow for maximum gains. For example, if one can borrow $1 billion at 0.5% and then invest that into a trade that yields 2.0%, they have just secured a gain of 1.5%.

QE feeds the carry trade frenzy by guaranteeing that the funding currency will not rise in value, which if it did, would offset any potential gain made by the trade. It does this because the money borrowed is then sold or exchanged in order to allow the borrower to make the purchase of other assets which are denominated in a different currency. For example – those speculators who wish to buy Brazilian equities as part of their carry trade must first borrow the newly created dollars, then take those dollar and exchange or SELL them for reals which can then be used to buy the Brazilian equities. This tends to keep additional pressure on the funding currency because the additional supply being created eats through the demand. One has only to look back at the Japanese Yen chart from a few years ago to see how the carry trade can lower the value of a currency.

The carry trade then works to jam higher the price of those assets which are the recipients of leveraged buying which tends to feed into the inflationary impact of points one and two mentioned above.

Perversely enough, the effect of these rising prices on tangible assets, particularly food and energy, can have the effect of actually stalling economic growth since consumers in those nations are forced to deal with the effect of the weakening currency as they must now pay higher prices for the essentials of life and have less income left over for discretionary spending.

Hopefully, this will help you to understand why this course of action is so fraught with danger. I get the distinct impression from reading the article that all of the commotion in the markets is nothing but a mere tempest in a tea pot and all of us are worried for no reason whatsoever. Meanwhile, while we needn’t worry, the Dollar has dropped 12% in value since the summer of this year. The only thing that has kept it from collapsing further is that the Euro is not any better. Any wonder why gold is staying so strong?

Trader Dan

A Deep Dive Into The Mechanics Of A QE Transaction
The Pragmatic Capitalist | Nov. 9, 2010, 2:41 PM

Some people want you to believe that the Fed just injected the economy and stock market full of money that will now result in an economic boom and much higher prices in most assets.  That’s simply not true.  Here’s the actual mechanics behind QE.

Before we begin, it’s important that investors understand exactly what “cash” is.  “Cash” is simply a very liquid liability of the U.S. government.   You can call it “cash”, Federal Reserve notes, whatever.  But it is a liability of the U.S. government.  Just like a 13 week treasury bill.  What is the major distinction between “cash” and bills?  Just the duration and amount of interest the two pay.  Think of one like a checking account and the other like a savings account.

This is a crucial point that I think a lot of us are having trouble wrapping our heads around. In school we are taught that “cash” is its own unique asset class. But that’s not really true. “Cash” as it sits in your bank account is really just a very very liquid government liability. What is the difference between your checking and savings account? Do you classify them both as “cash”? Do you consider your savings accounts a slightly less liquid interest bearing form of the same thing a checking account is?

What is a treasury note account? It is a savings account with the government. So now you have to ask yourself why you think cash is so much different than a treasury note?  What is the difference between your ETrade cash earning 0.1% and that t note earning 0.2%? NOTHING except the interest rate and the duration.  You can’t use your 13 week bill to pay your taxes tomorrow, but that doesn’t mean it isn’t a slightly less liquid form of the exact same thing that we all refer to as “cash”.  They are both govt liabilities and assets of yours.

When you own a t note you really just traded your “cash” for a slightly less liquid form of the same exact thing.  If the Fed buys those t notes from you they give you back your cash minus the interest rate. That’s all there is to it. No change in the money supply. No change in anything except the rate of interest you were earning.  If the government removes t notes then all they’re doing is altering the term structure of their liabilities.   They’re not changing the AMOUNT of liabilities.

The other day, Ben Bernanke explained that he is not adding any new cash to the system via QE:

“Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed.”

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