QE & The Power of Language, 9-14-2012 Edition

Previously I’ve written about the way bond math and in particular bond spreads have the power of language. They tell you things you wouldn’t otherwise know.  And today is an example of them being particularly talkative.  I don’t usually write about current events, but in this case it serves to illustrate an important point.

Unless you live under a rock, you probably know there was a big Federal Reserve announcement yesterday.  The Fed announced another round of quantitative easing (QE), which has to be one of my least favorite economic doublespeak terms.  QE is the process by which the Fed directly increases the money supply.  They take new dollars, created (literally, printed) by the treasury, and use them to buy bonds.  This is nothing new – the Fed has done two previous rounds of QE since the financial crisis.  That’s why you may see this one referred to as QE3 for shorthand.

QE is a classic central bank economic manipulation.  In essence it’s the central bank’s way of telling firms to get off their asses and start increasing production (and thus employment, which is the Fed’s nominal mandate).  You may wonder what bonds have to do with production and employment, but there’s a very direct connection.  The bonds the fed is buying are some of the least risky financial assets in the world since they’re insured by the US government.  Once the Fed buys them, they effectivly won’t exist any more – they’ll be out of circulation.  Meaning no one else can be invested in them.  And if you can’t be invested in risk-off stuff, the only options are to horde your cash or buy risk-on.  That’s where the secondary effect of money supply expansion sets in.  The more money there is, the more inflation there is.  Inflation is in effect a tax on hording.  Now don’t get too excited about how much inflation we’re going to see.  My guess is in the 4-5% range (just a guess).  But it will be enough to make sitting on cash unacceptable.  There are two reasons that inflation will be smaller than the money supply expansion:

  1. Economic expansion will increase the demand for money to go along with the supply.
  2. The rest of the first world is still in love with dollar-backed assets.  Again, more demand.  In other words, this moves us further along the course of the dollar being the world currency.

But we are going to see some inflation.  So if risk-off is unavailable, and hording is now heavily taxed, what’s left is risk-on.  Growth stocks, real estate, commodity production etc.  That’s the point of QE – to force investment into parts of the economy that actually do something.  At least that’s how it’s supposed to work.

Much to Uncle Ben’s consternation, QE1 and 2 didn’t do the expected.  Yes, the Fed bought bonds, and bond prices went up.  The 30 year T-bond hit record low yields.  But the expected shift in assets to risk-on didn’t occur.  Instead money shifted to things that weren’t T-bonds but kind of looked like them if you squinted.  Other low risk bonds.  Then other medium risk bonds.  Then dividend stocks, which act sort of like an interest-only bond.  Basically, the market bet that yes, there was now more money.  But things are still in the shitter, so we’re going to move to the safest places available and preserve capital.  The stock market went up, but lead by the most boring imaginable stocks.  Which is why unemployment still sucks and people on the street still have that haunted recession look years after the recession ended.  Which brings us to this week’s Fed meeting.

We have only limited visibility as to what went on behind closed doors, but we know what policy the Fed announced: QE3.  They would buy $40B (yes, billion) of mortgage backed securities (read: T-bonds) every month indefinitely until employment improved.  In other words, each month the dollar supply is going to increase by about 2% and the outstanding supply of AAA debt is going to fall by a few 10ths of a percent depending on exactly what you count.  The market did exactly what it had done after QE1 and 2: bonds went up, and stocks went up led by the boring high yield stuff.

The immediate effect of this was inevitable.  Several thousand Wall Street guys enjoyed a paper profit (almost no one but the speculative alternatives portfolio lost yesterday).  That profit was converted to expected bonus.  The bonus was converted to the more meaningful units of Porsches, beach houses and yachts.   The numbers were favorable.  Everyone went to their favorite Manhattan watering hole to have a beer or five and celebrate.  But somewhere around beer two, a funny thing happened.  A bunch of guys in grey suits realized that they were positioned completely wrong.  $40B a month is kind of a lot of money.  And if the printing is never going to end unless the economy improves, eventually there HAS to be inflation.  And if there’s inflation then T-bonds and high yield stocks are about to get pummeled.  The revelers had just spent all day buying T-bonds and high yield stocks.  That felt a little wrong.  But not so wrong you couldn’t drink three more beers and discuss the relative merits of Porsches vs. Maseratis.  Which brings us to this morning.

At about 7:00 EST a bunch of guys with hangovers in different but indistinguishable grey suits tackled their problem: how to get out of bonds (and bond-like things) and into something that would do well in a growth/inflation environment.  Clearly what they needed was a growth stock – a new industry that would profit from the coming forced boom.  And apparently the vast majority of them settled on one answer: Facebook.  Don’t laugh.  Over the past 2 hours the street bid up the price of FB by about $3B (over 6%).  In other words almost a 10th of Uncle Ben’s largess for this month showed up in one stock in the course of a couple hours.  The patterns is market wide, however: T-bonds and dividend stocks offered.  Exciting, sexy stocks bid though the roof.  Since the speculative alternatives portfolio is currently short dividend stocks and long the broader market, I got showered in money.  As of this writing it’s still raining.

I hate making macro calls, but I’m going to make one now.  At about 10:00 EST this morning we moved from the bitchy, begrudging bull market everyone loved to hate to a real risk-on bull market driving new (and perhaps short sighted) investment and growth.  The macro rigging can’t be denied and if you stand against it you will lose money.

Now you might ask how I know all this (or think I know in the case of the macro call).  I wasn’t actually in any Manhattan bars last night – I was two thousand miles away.  I didn’t see the light go on in any heads during beer two.  But I know it happened.  And the way I know it happened is that the bonds talked to me.  Well, Facebook stock had a little to say this morning too, but it’s just a humorous side light.  The big deal is that long term AAA bonds are down even though Uncle Ben promised to bid them forever.  Stocks that look like bonds are down even though the stock market is up.  Sexy stocks are flying high.  Junk bonds (which are about half way between boring and sexy) are break even.  The most controversial form of new “industry” is flying the highest.  All those ratios and spreads tell you what’s happening, and it doesn’t take too much imagination to figure out why.

Welcome to the new bull market.

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