Earlier this week the Federal Reserve
ignited a firestorm in the global markets by admitting that the U.S. economy
is facing downside risks. Although it continues to sugar coat the unpleasant
reality, never has such a stunningly obvious statement resulted is so much
turmoil.
Once again we are seeing the knee-jerk
market reaction to seek refuge in the perceived safety of the U.S. dollar and
U.S. Treasuries. However I expect investors will soon discover that such
assets are firmly in the eye of the storm. As the tempest moves on, those
enjoying the dollar's current stability may soon find themselves battered by
a category five monster.
Market disappointment was compounded
when the Fed failed to follow up its dire outlook with a new round of
quantitative easing (QE). Instead, through a policy entitled "Operation
Twist" the Fed promised to sell $400 billion of short-term Treasuries
and use the proceeds to buy an equivalent amount of long-term Treasuries. The
markets evidently perceived this "balance sheet neutral" policy as
too timid.
From my perspective, the Twist really
amounts to another Fed "Hail Mary" pass that will fall short of the
end zone. But, by putting the squeeze on banks and further restricting credit
availability to small business the move will likely do more harm than good.
The policy rests on the false premise
moving already historically low interest rates even lower will stimulate the
economy into recovery. But low interest rates are part of the problem, not
part of the solution.
Even by the government's debased
standards, trailing headline inflation is already hovering above 4%, and, at
current rates, 30-year Treasuries are negative by 100 basis points. This
distortion is inflicting untold damage on the economy. Pushing rates further
into negative territory seems only to invite more problems in the future.
With the Twist, the Ben Bernanke wing of
the increasingly divided Fed is offering debtors the short-term gain of low
long rates in exchange for its own long-term pain of limited balance sheet
flexibility and diminished power to deal with surging inflation. By selling
on the short end (thereby pushing up short term yields) and buying on the
long end (thereby pushing down long-term yields), the Fed will flatten the
yield curve. But to attain these insignificant benefits, the plan exposes the
Fed, and the economy, to great risks.
First the "benefits": Mortgage
rates are already at generational lows and have recently lagged the declines
seen in long dated Treasuries. Is it reasonable to believe that mortgage
rates will go much lower as a result of this policy? Even if they do, what
would be the net economic benefit of a new refinancing wave? Do we really
want to encourage consumers once again to use their homes as ATM machines?
Even if they do, any short-term boost in consumer spending would be
transitory and counter-productive to a genuine recovery. The last thing we
want to encourage is more spending, particularly on the imported products
that would likely be purchased by those who refinanced.
What's more, the program will actually
increase borrowing costs for small businesses. By increasing the cost of
short-term borrowing and lowering returns on long-term loans, it will severely
pressure the profitability of the beleaguered financial sector. In other
words the borrower's gain is the lender's pain. In such conditions, should we
expect banks to provide more credit to small business? In fact, the move will
be a devastating blow to bank balance sheets and further enfeeble a financial
sector on life support. Business credit will instead be diverted to dead end
consumer spending, resulting in less business activity to grow the economy
and create jobs.
Now the costs: The Fed severely
underestimates the danger of loading up its own balance sheet with long dated
securities. Not only does the move expose the Fed to severe losses when
interest rates inevitably rise, but it drastically reduces its ability to
withdraw liquidity to fight inflation. Short-term securities provided
flexibility as they could be sold into a falling market with little price
risk, or if need be, held to maturity. Such options do not exist with bonds
maturing in 6-30 years. So when inflation continues to rise, as I'm sure it
will, the Fed will be powerless to slow it without crushing the bond market
and causing yields to soar.
In any event, the markets did not want
the Twist program, they wanted additional liquidity
injections in the form of QE III. In this respect, the market is like a
heroin junkie. It needs ever-greater doses of money to continue moving
higher. When it gets its fix, it will rally.
But a growing popular mistrust of
stimulus is currently pressuring the Fed to forestall the launch of QE III.
But a few more whiffs of financial turbulence could cause the Fed to fold.
When the market rally ensues the Fed will claim victory. But the celebration
will be hollow. The nominal gain in stock prices will likely be eclipsed by
dollar declines and a more rapid gain in gold, oil, or other commodity
prices. The result for investors will be higher nominal portfolio values but
lower real purchasing power and a reduced standard of living.
But many of those who oppose QE3 do so
because they believe the economy doesn't need more stimulus
not because the stimulus itself is causing the economic weakness. As a result
when the economy deteriorates, support for QE III could grow. In the end QE3
will likely be far more popular than another bank bailout (possibly to be
called TARP II), which may be on the table if the Fed fails to rescue the
banks it may be pushing over the edge with the Twist.
But our zombie economy does not need to
be perpetuated by more QE. It must be allowed to die so that a living,
breathing, self-sustaining economy can replace it. By feeding our addiction
now the Fed is impeding the recovery. QE may goose the markets and provide a
short-term boost to spending, but it will also increase debt and grow the
government. This process exacerbates the structural imbalances underlying the
U.S. economy, making what may be the inevitable crash that much more
spectacular.
- Peter Schiff, CEO of Euro Pacific Capital
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