Thursday, February 23, 2012

How Central Banks Worldwide are Supporting Stock and Commodity Markets

In my opinion the markets are being driven higher, to a large degree by quantitative easing. This is going to be a bit lengthy, hold on (tried to make brief but it's a bit of a difficult subject).

The original exploration of monetary policy, according to Nobel prize winning economist Robert Lucas in his 1995 Nobel Prize Lecture, was David Hume's "On Money" in the late 18th century. Hume asked, "what would happen if the money supply doubled overnight?" (Hume proposed an angel would come in at night and put 10 pounds equally into everyone's pocket). Well, Hume states, clearly this is impossible!

It is only possible to increase the money supply by distributing new money through certain agents first, in Hume's time this would have been Spain, the "conquistadors" taking gold from the new world, bringing it back to Spain, hiring tailors, buying grain, housing -- the price increase from the new gold would flow first to sectors that serviced the conquistadors, then onward until prices go up overall approximately by the amount of the new gold. (tailors take the gold from the conquistadors, buy more food and housing in the second time period, food producers use that gold in the third time period to buy other items, on and on, prices going up each time period until equilibrium)

So it's important to trace the flow of money when new money is "introduced" or "printed." Prices will go up in the time order that the money flows through acquisition of assets, according to Hume.

The US Federal Reserve is currently doing $600Bn of Operation Twist, which was preceded by $2.7Tr of QE1 and QE2. The ECB did Euro800Bn of QE primarily to buy southern EU governmental debt, the Central Bank of Switzerland did approx SF100Bn buying back Swiss Francs in September, Bank of Japan, Bank of England, Central Bank of China, even the Central Banks of Brazil and Chile and Norway (I don't know why Norway needs to do QE, as the Norwegian economy appears very strong) -- and many others -- did major easing programs.

The central banks will (although there is a slight variation in the first round in 2008 and 2009 for the Fed and BofEngland, used mainly reserves from member banks) create the money with a keystroke to buy the assets - government bonds, some cases MBS, currency from a list of major banks, Fed has I believe 29 major banks.

The major banks will buy, in the first round (I believe) with the newly printed money more highly rated fixed income assets, (providing the un-intuitive effect of interest rates declining during economic crises), but (I think) will in the second time period lend out margin loans (repurchase agreements) to funds, for the purchase of buying stocks, bonds and commodities.

Repurchase lending is considered very safe for the banks, in fact, repurchase lending bounced back extremely quickly during the crisis in October 2008 (only one week of uncertainty in funding according to Annaly Capital, an investor in agency MBS, then all the funding Annaly could need by the fourth week of October 08 (Annaly is leveraged between 7 to 10 to one, debt to equity, buys MBS with repurchase or margin loans from banks).

One can see that the total assets under management for the total fund management industry have now gone significantly higher than the peak in August of 2008. This does not mean that 100% of the new money comes from margin loans from major banks -- but certainly a lot of it is -- I'm actually looking for the data here, overall repurchase loans (hard to find).

Concluding, adding up the different QE programs I believe in the $4-5Trillion range, this drives down interest rates in first time period and then boosts stocks and commodities in the second time period (gas prices, food prices to follow soon - is following now), as banks undertake repurchase lending on a large scale.

I read through the reasoning for the QE by the Federal Reserve economists, not sure if it is the "correct" road but certainly it is the playbook they are going to now. (source papers are Paul Krugman's "It's Baaack" (2002) and papers by Eggertson, and other papers on the "Zero bound" -- the Central banks will fight deflation at all costs since they view deflation as devastating for the economy: quantitative easing is the main weapon against deflation when interest rates are low.

Oddly, however, in these papers to my reading the economists do not trace the newly printed money from the banks to other assets on a time period by time period basis, but appear to assume inflation increases in all sectors all at once (clearly impossible unless there is Hume's Angel, alive today although dead two centuries ago :) The models the economists use do not make use of time sequences for price appreciation (this is to say the models have a lot of complex math in them, but it is assuming one move to a final end state, turing a blind eye to intermediate states).

One more point: the central banks are terrified of sovereign defaults leading to major bank collapses, so QE supports the banks by getting these problem debts off the books and also supports the price of these problem assets.

So the final conclusion, is that one really need to watch the Federal Reserve and the worldwide Central Banks to determine the direction of the market. So far things look ok until June 2012, (Operation Twist good until then) but if the Central Banks stop easing, watch out. Overall in my opinion, it's a weird market currently, in so far that the Fed and other Central Banks haven't done large scale QE in 60 years, with the small exception of Japan in 2001, but actually if you read before WW2, the Fed and Central Bank in Europe were extraordinarily active in supporting banks, governmental debt during periods of wars and crisis -- it's incredible sort of a lost history. (I'll save this for another post).

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