The government's "ingenious" solution to end the Great Recession
was to recreate the same wealth effect that engendered the credit crisis to
begin with: The definition of the wealth effect is an increase in spending
that comes from an increase in the perception of wealth generated
from equities and real estate.
Our Treasury and Federal Reserve figured the best way to accomplish this was
to rescue the banking system by; taking interest rates to zero percent, buying
banks' troubled assets, and recapitalizing the financial system. Most importantly,
our government loaded banks with excess reserves. This process, known as quantitative
easing (QE), pushed lower long-term interest rates through the buying of Treasury
Notes, Bonds and Agency MBS.
It is imperative to understand the QE process in order to fully understand
why the tapering of asset purchases will lead to a collapse in asset prices
and a severe recession.
The QE scheme forces banks to sell much higher-yielding assets (Treasuries
and MBS) to the Fed, and in return the banks receive something know as Fed
Credit, which pays just one quarter of one percent. For example, the Five-year
Note currently yields 1.75 percent and the Seven-year Note offers a yield of
2.30 percent. The Fed is currently buying $30 billion worth of such Treasuries
per month and $25 billion of higher-yielding MBS.
In fact, the Fed has purchased a total of $3.5 trillion worth of MBS and Treasuries
since 2009 in a direct attempt to boost equity and real estate prices. QE escalated
in intensity as the years progressed. The year 2013 began with the Fed promising
to purchase over a trillion dollars' worth of bank debt--without any indication
of when the QE scheme would end...if ever.
Therefore, financial institutions did exactly what rational would dictate.
These banks bought bonds, stocks and real estate assets with the Fed's credit
because not only were the yields higher, but they also understood there would
be a huge buyer behind them-one that was indifferent to price and had an unlimited
balance sheet. Since these assets offered a yield that was much greater than
the 25 basis points provided by the Fed and were nearly guaranteed to increase
in price, it was nearly a riskless transaction for banks to make. This QE process
also sent money supply growth rates back up towards 10% per annum, as opposed
to the contractionary rates experienced in 2009 and 2010.
Of course, most on Wall Street fail to understand or refuse to acknowledge
that ending QE will cause asset prices to undergo a necessary, but nevertheless
healthy correction. However, looking at the evidence since the tapering of
asset purchases began, it is clear that the Fed's wealth effect has ended.
The Fed announced in December of last year its plan to reduce asset purchases
beginning in January of this year. Its base-case scenario would be to reduce
QE by $10 billion per each Fed meeting. Since the start of this year, asset
prices have stopped rising. According to the Case-Shiller National Home Price
Index, home values have actually dropped 0.33% during the last 3 months of
the survey. In addition, the Dow Jones Industrial Average and the NASDAQ have
both dropped in price over the past four months. Only the S&P 500 has managed
to eke out a very small gain so far this year-and one third of the year is
over.
Real estate and equity values have already lost their momentum, as the Fed
is removing its massive support for these assets. In a further sign of real
estate weakness, the Commerce Department recently announced that New Home Sales
fell three months in a row and plummeted 14.5 percent in March from the prior
month's pace. But Wall Street will try to convince investors that the spring
allergy season-also known as the pollen vortex--is unusually bad this year.
Therefore, nobody wanted to go outside and purchase a new home, even after
all the snow melted.
The bottom line is as the central bank stops buying assets from private banks,
these institutions won't have the need or the incentive to replace them, and
the direct result will be a contraction in the money supply.
But nearly every market strategist believes the Fed's taper will have an innocuous
effect on markets. They believe this because of their conviction that new bank
lending will supplant the money creation currently being done for the purpose
of buying new assets. But what would cause banks to suddenly start lending
to the public?
The government has overwhelmed banks with new regulations and announced on
April 8th that it will force banks to add $68 billion to their capital, which
will negatively affecting balance sheet growth. The public sector is still
greatly in need of deleveraging because Household Debt to GDP ratio is still
over 80%, opposed to the 40% it was in 1971. Real disposable income is not
increasing, which has left the consumer with little ability to take on more
debt. There just isn't any reason to believe that consumers will suddenly ramp-up
their borrowing.
It wasn't any coincidence that the size of the Fed's balance sheet and the
S&P 500 were both up 30% last year. But very soon the amount of QE will
be close to, if not exactly at zero. And without banks supporting asset prices
by consistently creating new money at the behest of the Fed, stocks and home
prices have nowhere to go but down.
I anticipate the reduction of the wealth effect to intensify as the taper
progresses. Since the economic "recovery" was predicated on the rebuilding
of asset bubbles, a long delayed and brutal recession will start to unfold
later this year.
The real question investors need to answer is to determine how long Janet
Yellen will wait before admitting the economy is completely addicted to QE,
and that there is no escape from the Fed's constant manipulation of money supply
growth and asset prices.
Having raised significant funds ahead of this huge selloff in order to profit
from the launch of the Fed's next massive round of debt monetization should
prove to be one of the most important investment strategies of a lifetime.
This is exactly the reason why Pento Portfolio Strategies has been in 75% cash
since January.
