Why The Federal Reserve Should Have Shied Away From QE3

By Larry McDonald

Slam dunk, done deal, in the bag…

The most recent Federal Open Market Committee (FOMC) meeting minutes pumped up the QE3 fan club’s expectations of a new buying program. At the same time, hawks have new ammunition for criticism of Chairman Bernanke.

In laymans terms, doves want to expand the Fed’s balance sheet, hawks want to shrink it.

The average Wall St. is right around a 60% chance for QE3, here are some of the forecasts:

100% RBC
90% RBC
80% JP Morgan
60% Goldman
40% Nomura
20% BMO
0% Morgan Stanley

I am surprised they moved forward with more QE this month.

Special thanks for Radius Financial for inviting me to deliver the keynote speech at the World Alternative Investment Summit. On September 20th, I’ll be speaking about the Fed’s colossal QE exit, the Fiscal Cliff and the next Risk Off trade coming out of Spain, let me explain.

I think there’s a growing concern, an expanding divisive angst inside the Fed, causing the use of experimental drugs to be shelved for now. There are secular changes making the risk – reward of more QE a bad bet.

In my next book, I bring the reader inside most dangerous bubble of all – the Bond Bubble. Since 2007, over $1 trillion has moved into bond funds, creating one of the most crowded trades of all time. Nearly $400 billion has fled from stocks over that period. The explosion of the National Debt from $5 trillion to $15 trillion over the last decade will crush savers when the side effects come crashing in. Lehman Brothers’ failure and the financial crisis caused the Federal Reserve’s balance sheet to grow by almost $3 trillion since 2008. They tell investors there is an “exit strategy,” but there isn’t.

The most important time in financial history is approaching.

I think there’s disturbing question of some Governors behind closed doors. “Are we Central Bankers becoming Central Planners in this new era of colossal balance sheet risk?”

In recent years, it takes a particular personality type to emerge as the highest financial controller in a modern economy, but too few have real financial market or commercial experience. So few central bankers around the world have ever run a business, or taken risk in a professional environment. Society’s nerves are soothed with academic jargon and theories, but have they ever been truly tested? With so much on the line, and with risks as large as a $3 trillion “exit strategy,” why is this so?

If one looks at the sovereign debt problems of so many countries, including the USA, the leaders are faced with two signs. One says, “this way to inflation”, the other “to sovereign debt default.”

They’ve choosen inflation.

The hard decisions have been pushed down the road for the seemingly less painful, less noticeable route. When former Fed chairman Alan Greenspan dropped interest rates to 1%, he traded the Dotcom Bust for the Housing Boom and Bust. And now Ben Bernanke is printing $3.3 billion per day ($2.3 million every minute) to stave off the inevitable debt crisis, the impacts of which could be cataclysmic for investors. As interest rates have plunged from 15% in 1982 to 1.65% today, a giant elastic band has been stretched to the point of snapping, which the collapse of Lehman Brothers has only antagonized.

Some worry Central Bankers have overplayed their hand by providing the sick patient with a deadly cocktail of experimental drugs, which will surely create terrible side-effects. I think Investors on Main Street must prepare for such risk.

Has the Fed’s Balance Sheet Put Us All at Risk?

$1.57 Trillion US Treasury notes & bonds
$81.4 Billion US Treasury inflation protected securities
$91.2 Billion Federal Agency Securities
$855.7 Billion Agency Mortgage Backed Securities

$2.6 Trillion Total Risk

Simple math, a 200 basis point (2% = 1.65% to 3.65%) increase in interest rates in the US would drive recently purchased treasuries on the Fed’s balance sheet down about 17 bond points, 100 to 83. That’s a colossal mark to market loss of $416 billion.

The United States is racing towards the congressionally mandated debt ceiling, we have a December date, but a dirty secret lurks in another corner. Every 1% move in the weighted average cost of capital, interest rates on US debt will end up costing $142 billion annually in interest payments alone.

Double trouble, so a 2% rise in interest rates delivers a $400 billion mark to market loss to taxpayers and $284 billion in extra annual interest costs.

Oh no… There’s More

If you include all intergovernmental holdings like the Medicare and Social Security Trust Funds, the total number of bonds owned by Uncle Sam jumps to $6.3 trillion.

Only a decade ago, total US government holdings were only $2.5 trillion. Hmm, $6.5 trillion today vs. $2.5 trillion in 2002, something smells like a printing press.

Think of the possible US pension funds losses, they own $842 billion, insurance companies and mutual funds long all these treasuries. A $143 billion loss on top of an under funded pile of pensions, is the last thing we need, but that’s the pain with a 2% move higher in interest rates.

More deadly, a move back to 5% short rates will increase annual US interest expense by almost $700 billion. According to the 2011 Congressional Budget Office, 2011 US government tax revenues were $2.3 trillion. Are we headed for a dark place where interest on our debt eats up 30% of our tax revenues?

At the FOMC meeting this Thursday, our leaders have these numbers staring them right in the face. They’ll throw a lot of pretty and impressive academically contrived jargon and analysis to make us all feel better. Tell most what they want to hear.

I think, behind the scenes, the rebel faction of hawks within the Fed is making a move against the Chairman. The last thing Mr. Bernanke and the President need is a load a dirty laundry aired just before the election. If the right move isn’t made, our stains and vulnerability will be magnified in the public’s eyes, with all the extra media spot light.

My partner ACG Analytics has noted, none of the recent dissenters to policy accommodation, the hawks, will be an FOMC voting member in 2013.

Most of the hawks reside in reserve bank governor seats, not on the board. The four Federal Reserve Banks represented on the 2013 FOMC membership will be Chicago, Boston, St. Louis, and Kansas City. It’s looking like an even more dovish Fed in 2013.

What does a fleeting hawk have to loose by letting the world know about their discomfort in putting the US taxpayers at even greater risk. A legacy is worth so much more, I’d go out swinging.

I don’t see more trecherous balance sheet expansion coming Thursday in the form of QE3. Changes in its communications, surgically aimed at presenting a more accommodative stance is the most likely scenario.

I think the FOMC will make some changes in the existing formula for providing forward guidance for the Fed funds rate target. Above all, their new weapon in the expected timing of removal of accommodation will be used. The FOMC has already extended Operation Twist and is more likely to look to change the timing of guidance, than QE3.

In looking at the Fed minutes, many members judged that additional monetary accommodation would likely be warranted “fairly soon” unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.

As my partner ACG Analytics notes, “fairly soon” is sufficiently ambiguous to leave the FOMC with plenty of wiggle room for 2012. Several members noted the benefits of accumulating further information that could help clarify the contours of the outlook for economic activity and inflation as well as the need for further policy action.

In a recent appearance as guest host on CNBC’s Squawkbox, St. Louis Fed President Bullard also dampened spirits. Bullard noted that the FOMC minutes were a bit stale as because some economic data since the meeting has been better, e.g. retail sales, housing market. Bullard also noted that market participants have the idea of some dramatic action – but the economic data does not warrant that. Bullard went further, stating that it would be unusual for the Fed to take a big action based on the data.

I think policymakers will see another QE round as inappropriate at the current juncture as the Operation Twist is still providing some support for the economy.

Likewise, Chairman Bernanke and other FOMC members will turn up the political pressure for the rest of 2012, focusing attention on Congressional actions to address the fiscal situation.

What we’re seeing in the markets is a very consistent phenomena, like a giant balloon being pushed under water, as the deflationary powers systemic risk are reduced in Europe, especially Spain, global inflation potential comes roaring back. Looking at gold, we saw this in the 2nd half of 2009 (30% move), 1st half of 2012 (14% move) and over the last 60 days, a 13.5% move higher from the lows.

There’s clearly an inverse relationship between commodity prices and systemic risk.

Gold has moved up 13.5% Move from May’s Lows

My friend and client Lee Robinson of Altana Inflation Trends Fund, reminded me yesterday, five years ago, $1 million bought nearly 1,500 ounces of gold or 14,000 barrels of oil. Today, the same million buys just over 600 ounces of gold and some 9,000 barrels of oil – a serious loss of purchasing power in terms of real assets.

The Ever Present Moral Hazard in Central Planning of Central Banking

Hedge fund legend, Moore Capital’s Louis Bacon told the FT this weekend. “Before this all other QE was to further the monetary policy when the interest rate lever had been exhausted. Here (in Europe / Spain, Draghi’s new OMT program, Outright Monetary Transactions) it’s financing a government deficit because the market wont.”

Creeping Political Impact on Global Central Banks

A Moral Hazard Moment, reminds me of Bear Stearns and Lehman

In the Spring of 2008, just as the Bear Stearns Bailout and the Federal Reserve’s creation of the primary dealer credit facility, did little to induce Lehman into serious risk and debt reduction. Today, I cast a sad eye at Spain and Europe.

I find it disappointing and almost comical. Mario Draghi, since July 24th, less than 60 days has reduced Spain’s borrowing costs, as represented by their 10 year bond yields, by 187 basis points. This is a mammoth move in such a short period of time, 7.56% to 5.69%. What did Spain and Italy say in return? “No thanks Mario, we don’t need the money.”

Spain’s Prime Minister Mariano Rajoy’s Bloomberg Headlines Last Night

He hasn’t pressured the ECB to buy bonds
ECB shouldn’t dictate how Spain should cut deficit
Spain must study conditions of ECB aid before decisions
He doesn’t want policy by policy decisions
He’ll request aid if he judges it best for Spain

One of the explicit terms of Mario Draghi’s new OMT program is he hill be dictating terms, not Spain.

Risk and Reward

President Barack Obama’s re-election team has been asserting that 4.5 million of the 8.5 million jobs lost in the financial crisis, have been created during his term. Of course, this number is from the depths of the post Lehman pain. CNN reported there’s only been a net increase of just 300,000 non-farm payroll jobs since the President took office.

Employment improvement from recession lows?

Reagan +30%
Obama +18%
Bush I +8%

Even under the rosiest review, some beg the question. Is 4.5 million jobs really worth an extra $2 trillion of Fed balance sheet risk?

Is it Cyclical or is it Secular?

The most disturbing thing of all about a possible QE3 from the Fed, is the governors seem to be taking action in the face of mounting evidence of strong secular headwinds opposing their QE actions and risk taking.

Federal extended unemployment benefits are in effect through all of 2012.

Finally, the number of weeks of extended unemployment benefits is gradually being reduced to 73 weeks (1.25 years) in states with high unemployment and 63 weeks in the other states. In our country’s history, we’ve never seen such a giant safety net, but some ask, is it becoming a hammock? We are 4 years post Lehman, weren’t these extreme measures for extreme times?

Likewise, as workers face possible higher taxes they are leaving the workforce, a record 370k more people dropped out last month. Right now, incentives are not heavy on job seeking. To make matters worse, employers and small business owners are staring at the fiscal cliff’s colossal uncertainty, they’re holding back hiring decisions as well.

An ugly number, the percentage of young people 17-25 in the workforce, dropped to the lowest level since 1955.

According to my friends at Hamilton Place Strategies, even if the US averages zero new jobs created a month until the election in November, as long as 140k people are leaving the workforce each month, the unemployment rate still drops to 7.9% from its current 8.1%.

David Einhorn’s Jelly Donut

In 2011, according to the San Francisco Business Times, bank deposits hit a record $10 trillion. Not only has a record amount of money moved into bonds the last 5 years, it’s been flying into banks. And this is not counting the trillions of money market funds at brokerage firms.

In June 2007, the 10 year US Treasury was yielding 5%, today it’s at 1.65%. A retired friend of mine from Florida called me yesterday, he was beside himself. His credit union is paying only 0.4% annual interest on his saving account, even though inflation averaged 2.8% over the last year. Even worse, he was getting almost 3% more interest in the bank back back in 07.

Simple math tells me 3% of $10 trillion is $300 billion of lost purchasing power for baby boomers, again not counting lower interest on money market funds and bonds. My whole life, I’ve been told about our aging population, the heralded baby boomers. As hedge fund manager David Einhorn recently warned investors, “every single day for the next 19 years, more than 10,000 baby boomers will turn 65. Those who started saving for retirement 15 years ago are suddenly finding themselves with insufficient savings to do so.”

Bottom line, the Fed is getting diminishing returns on more QE, with additional balance sheet risk.

Technology, the New Job Killer

Over the years technology has always replaced some workers. Economists have warned, in error, machines were gaining the upper hand. Eighty years ago, John Maynard Keynes warned us of a “new disease” that he termed “technological unemployment,” the inability of the economy to create new jobs faster than jobs were lost to automation.

In their recent book, the “Race Against the Machine”, authors Mr. Brynjolfsson and Mr. McAfee make the point that pace of automation has picked up in recent years because of a combination of technologies including robotics, voice recognition, numerically controlled machines, computerized inventory control and online commerce.

Some joke Best Buy is Amazon.com’s new show room, if so they have technology to blame. In April, Best Buy announced it was closing 50 stores, shedding 2400 jobs.

As the iPad replaces millions of PCs, yesterday Hewlett-Packard, the world’s largest personal-computer maker, expanded the total job cuts under its reorganization plan announced in May to 29,000, which is more than it had originally disclosed.

Since the end of the recession in June 2009, corporate spending on equipment and software has increased by 26%, while payrolls have been flat.

There’s no question the Fed is facing secular changes today like never before, just pick up the phone and call Amtrak, order a ticket, and collect it a kiosk. In this trade, the only human being you have any contact with is the porter on the train collecting tickets, for now.

Once again, the Fed is facing secular changes, empowering a faction of reserve bank governors very uneasy about more QE. Is the risk of QE3 really worth the reward?

The Fed Needs Dry Powder


The massive deflationary threats of a possible depression are still with us. On the back burner for now, as we’ve seen too many times, they can be back on the front page in a blink of an eye. As I’ve said all year, the greatest threat comes from Spain. A country, two years after Ireland completed its stress test on their banks, still has not completed its own. The banks need $100 to $200 billion, the states like Catalonia need $50 to $75 billion and the country itself has missed 4 out of the last 5 GDP and tax revenue targets. It’s a bailout just waiting to happen, no matter what the Spanish government says.

Just last month, for the first time since 2010, Ireland re-entered the bond market and sold €4.19 billion of a new 5 year bond maturing in October 2017 and an existing bond maturing in October 2020. The 2017 bond carried a yield of 5.9% and the 2020 bond a yield of 6.1%.

How ironic, Ireland coming back to the capital markets as Spain is heading for the exits. Somebody took the pain, while somebody else has put it off.

My partner ACG Analytics notes, Ireland’s re-entry into the bond markets and on-going compliance with the conditionality laid out in EU/IMF memorandum of understanding, means that is the only eurozone Member State which is explicitly eligible for bond purchases through OMTs, Draghi’s new QE, at this point in time.

The Fiscal Cliff

By now, most investors know the up hill battle we all face coming out of Washington as we head toward year end. Issues like the Bush Tax Cuts including taxes on dividends, Sequestration, Tax Extenders, the AMT Patch, Payroll Tax Holiday, Unemployment Insurance, Doc Fix impacting Medicare, New Taxes from Affordable Care Act, and the Debt Ceiling all add up to a trillion dollars of risk.

They’re literally kicking the can up hill and it keeps rolling back at their feet.

Today, Moody’s Investors Service said it may join Standard & Poor’s in downgrading the U.S.’s credit rating unless Congress reduces the percentage of debt-to-gross- domestic product during budget negotiations next year.

The budget deficit will reach $1.1 trillion this year, according to the Congressional Budget Office, CBO.

CBO’s Budgetary Outlook and Analysis focused on CBO’s forecast of real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013
CBO’s report also made clear that stopping the fiscal cliff will leave Congress and the Administration with difficult choices in 2013.

CBO completed projections for an alternative fiscal scenario in which all expiring tax provisions are extended indefinitely (except the payroll tax reduction in effect in calendar years 2011 and 2012); that the AMT is indexed for inflation after 2011; that Medicare’s payment rates for physicians’ services are held constant at their current level; and that the automatic spending reductions required by the Budget Control Act, which are set to take effect in January 2013, do not occur (although the law’s original caps on discretionary appropriations are assumed to remain in place).

Under this alternative scenario, the deficit would total $1.0 trillion in 2013, almost $400 billion (or 2.5 percent of GDP) more than the deficit projected to occur under current law.

For the Fed to take action with QE3, with all the systemic risk in the wings, would be a mistake. I think Mr. Bernanke is hearing these words in a loud tone from a growing number of Fed Governors.

Fed’s Ownership of Longer Dated Treasuries to Impact Liquidity When Investors Run for the Exits?

Is the Fed the entire market? Some worry there are not enough bonds out in circulation for the Fed to buy without eliminating liquidity in the bond market.
Down the road, pension funds, mutual funds, the little guy an Main St. may be severely impacted.

I say no QE3 for now, they’ll keep the powder dry, it looks like they’re very close to table max.

I’ve often told investors, the reason US treasuries are so well bid, event with all the irresponsibility coming out of Washington, is the US treasury market is the deepest and most liquid in the world. Above all, this should be preserved.

Liquidity is the ultimate king.

Speaking Engagements

HOT NEW TOPIC: What to Watch For? The 17 Lehman Systemic Risk Indicators

I’m just back from events in Iceland. Special thanks to the Arab Bankers Association for inviting me to speak in New York in June as well.

Interested in booking a speaking engagement? Click here for more information.

Important EU Crisis Key Dates to Watch For
Courtesy of ACG Analytics

11th Greece 6 Month T-Bill Auction=
12th European Commission proposals for ECB as single eurozone banking regulator=
12th Dutch Elections=
12th 9:00am GMT German Constitutional Court to rule on constitutionality of ESM=
12th European Commission proposals for ECB as single eurozone banking regulator=
12th Italy T-Bills Auction=
13th Italy Bond Auction=
13th/14th Informal ECOFIN & Eurogroup
14th Written submission delivered to European Court of Justice on Irish ESM case
20th ECB Governing Council
21st €6.5 billion Spanish maturity
28th September: Bank of Spain July Deposit Figures
Late September: Complete stress tests for all Spanish banks
Early October: Banks develop recapitalization plans and Plan to restructure or liquidate banks in a second group


4th ECB Governing Council
8th Bank of Italy Releases August Deposit Figures
8th & 9th Eurogroup & ECOFIN
18th ECB Governing Council
18th EU Summit
19th/29th/31st €9.1, €5.3 & €15 billion Spanish maturities
21st Election in Spain’s Basque Region
24th European Court of Justice oral hearing on Irish ESM case
31st Bank of Spain August Deposit Figures
October/December Banks with capital shortages to apportion losses to shareholders, preferred shareholders and holders of subordinated debt.


8th ECB Governing Council
8th Bank of Italy Releases September Deposit Figures
22nd ECB Governing Council
23rd 3.7 billion Spanish maturity
30th Bank of Spain September Deposit Figures

Leave a Reply