Eureka! QE2 Worked?
Well … maybe.
New lending to small businesses recovered in 2010. A Thomson Reuters/PayNet survey showed such lending jumped by 17% compared to 2009. The survey also suggested small businesses are investing again.
We got a headline from Reuters today:
Dollar Up, Gold Up, Stocks Up And EUR Still Vulnerable
We’ve seen the dollar and gold move up simultaneously, at times. Similarly we’ve seen the dollar and stocks move in the same direction at times. But usually this isn’t the case as the risk appetite driver has not supported such a correlation.
The month following the release of QE2 saw somewhat of a positive correlation between these three assets; though the thin trading to finish up the year brought back the negative correlation. But we watch …
Maybe the growth differential for the United States is improving to some extent. Maybe to some degree QE2 is finding its way into the real economy in a way QE1 did not. What will be important to watch is how BOTH the financial economy and the real economy develop as 2011 gets underway. Improvement in each side of the economy might be critical for US equities, but the dollar will likely be tied more so to the condition of the real economy.
We already see that interest rate expectations have changed – a stark contrast from the wake of QE1. Is this due to an improved outlook for US growth?
US 30-yr bond and 10-year Treasury futures price (inverse of yields)
The 10-year Treasuries basically topped (yields bottomed) with the announcement of QE2. It has been a rather emphatic trend since then.
We proposed an idea back in early November – maybe Ben Bernanke and Company have chosen the right path with QE2, which could be validated or refuted based on the change in commercial bank credit .
Red line in the chart below shows actually change in C&I loans from a year earlier:
Our November 9, 2010 article is reprinted in full below:
What if Ben is right? [from November 9th 2010 report]
You know how it goes, when the market is usually sure something will happen it usually doesn’t. There are a host of reasons for this. One reason is that we always tend to make inferences or draw conclusions on what we see—which is natural—as opposed to thinking about the stuff going on we don’t see.
Classical French economist Frederic Bastiat summed up this best in an essay titled, What is Seen and What is Not Seen: [our emphasis]
In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.
The same thing, of course, is true of health and morals. Often, the sweeter the first fruit of a habit, the more bitter are its later fruits: for example, debauchery, sloth, prodigality. When a man is impressed by the effect that is seen and has not yet learned to discern the effects that are not seen, he indulges in deplorable habits, not only through natural inclination, but deliberately.
This explains man’s necessarily painful evolution. Ignorance surrounds him at his cradle; therefore, he regulates his acts according to their first consequences, the only ones that, in his infancy, he can see. It is only after a long time that he learns to take account of the others.**2 Two very different masters teach him this lesson: experience and foresight. Experience teaches efficaciously but brutally. It instructs us in all the effects of an act by making us feel them, and we cannot fail to learn eventually, from having been burned ourselves, that fire burns. I should prefer, in so far as possible, to replace this rude teacher with one more gentle: foresight. For that reason I shall investigate the consequences of several economic phenomena, contrasting those that are seen with those that are not seen.
Despite the ongoing criticisms of Fed Chairman Ben Bernanke, it is clear he is a very smart man and knows a bit about economics—more than most of us, to say the least. And surely Ben is familiar with Mr. Bastiat. And just maybe Ben has more foresight than we have given him credit [despite the barrage of criticism we have tossed from these pages].
“…for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa.”
Many have called QE1 a disaster. Many have said it didn’t matter. Some have said it saved the system. So there is some debate. But most now have said (we plead guilty) that QE2 will not matter at best, and be a disaster at worst (hyperinflation, Japan style stagnation, currency wars, emerging market bubbles, etc.). With this type of crystallized consensus, we have decided it is time to be open to the idea that indeed QE2 will work much better than now expected in tweaking US growth.
It wasn’t until we read a blurb by Alan Abelson in Barron’s this weekend did we realize that economist extraordinaire Paul Kasriel, who toils away at Northern Trust, laid out some sensible reasons why QE2 will indeed work. He did this over a month ago; here is the summary if you too missed it:
But I do not think the level of U.S Treasury security interest rates or the level of the U.S. dollar foreign-exchange rate are the correct way to think about the prospective effectiveness of QE2. Rather, to judge whether QE2 is likely to stimulate the aggregate demand for U.S. goods and services, I will be observing the changes in another aggregate – the sum of Federal Reserve Bank credit and commercial bank credit. All else the same, when the commercial banking system increases its holdings of loans and securities, the recipients of this commercial bank credit are able to increase their current spending without any other entity in the economy having to cut back on its current spending. Similarly, an increase in Federal Reserve Bank credit enables the recipients of this credit to increase their current spending without any other entity in the economy having to cut back on its current spending.
According to Kasriel, the reason QE1 was seen as a failure is because commercial bank credit decreased by a greater amount than the increase in Federal Reserve Bank credit. See the chart below [grey area represents QE1]:
Increased Fed credit offset by falling commercial bank credit:
We know banks were sucking up this credit to repair their own balance sheets first, as expected. So it wouldn’t be a stretch to believe bank balance sheets are in much better shape than before. And if you notice the blue line in the chart above, commercial bank credit IS turning up.
The point is that maybe QE2 Fed credit will be funneled through the system allowing “the recipients of this commercial bank credit are able to increase their current spending without any other entity in the economy having to cut back on its current spending,” as the theory goes.
Of course the effects of this will not be immediate, and market players will likely act on “the first consequences” of dollar debasement for a while, which in and of itself seems a crystallized rationale. If Kasriel is right, the whole dollar expectations game changes in a big way, we think. And here’s why:
1) The Fed has left open the door to reducing the amount of QE2 should growth materialize, i.e. $600 billion is not a done deal.
2) Once the US starts to grow, it will likely grow much faster than the eurozone, UK, and Japan.
This may not sound like much, but juxtaposed against dollar debasing as far as they eye can see (which seems to be a big part of the gold story) it is a gigantic shift in expectations, we think.
Gold (black) vs. EURUSD (red) Daily:
Mr. Kasriel says he will be watching Fed and Commercial bank credit very closely each week—so will we.
For now, dollar debasing is ruling the day. And as long as it appears a steady decline, Ben and Co. are likely not unhappy about that. But sooner or later that rationale will become stale. And maybe we will know the reason why—Ben was right. Stay tuned.