Quantitative Easing (QE3) Is Imminent--Short Treasuries

[This piece was published in Sumzero on July 7, 2012. It was selected as a featured piece by SumZero]

Federal Reserve will resume expansionary policies in the form of bond purchases due to combined domestic pressure: deflationary macro readings (unemployment, money supply/velocity, CPI), and external pressure: European sovereign restructurings and Chinese slowdown (two largest trading partners). US Treasuries will sell-off in wake of inflationary implications of QE3; 3-month target for USGG30YR, currently at 2.66%, is 3.45%. BOE's signal to ease through QE in wake of European impasse, and rate cuts from ECB and PBOC, should be seen as precursors to Fed action. Further, there is room to maneuver into large scale asset purchases with: Yields near post-war lows, persistent structurally high unemployment, commodities sell-off, peak state/local debt and pending respective reduced outlays, <1 money multiplier readings, stable CPI readings, strong dollar, lower Fed balance sheet as % of GDP vs other major central banks (see charts attached).

Monetary Easing and Contraction

 "The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability." --quote from Fed release, 6/20/2012. In a recent WSJ opinion piece ("Monetary Policy and the Next Crisis"), economist John Taylor mentions the leeming effect among central bankers: they tend to follow each other's interest rates down. In this case, it includes outright asset purchases. In the coming months, the effect of a contraction in a $17.5 trillion dollar economy will be felt not just across the English Channel but across the Atlantic, the unemployment rate's downward trend will stagnate and reverse (see ecivilian unemployment rate chart). The most important statistic the Fed follows will then signal it to action. Gridlock in congress, its recent expansion, and its political unpopularity will likely preclude fiscal stimulus. Monetary action is the probable course of policy action, following the BOE.

Source: DoubleLine Capital

Source: DoubleLine Capital

Balance Sheet Comparison

A comparative chart of balance sheet size as % of GDP shows the Fed behind other major central banks (ECB, BOE, BOJ). Following the $77B QE committed from the BOE, US is set to be well behind. Market stress gives the Fed ample room to expand its balance sheet through another round of QE with respect to other central banks. 

Competitive Debasing

QE 1 and QE 2, announced Mar 2009 (1.15tn expansion) and Nov 2010 respectively, were followed by significant declines in the dollar. As the dollar strengthens with respect to the Euro, the Fed may pursue QE to cheapen exports and thus increase US competitiveness in light of foreign central bank currency debasing. Engineering a dollar collapse may be the implicit directive under the Bernanke regime. Extending the duration of the balance sheet may be insufficient with respect to more aggressive trading partners' policies.

Source: Thomson Reuters/Financial Times

Inflation

Fed is aware that QE is inflationary. They will survey the following key metrics before they embark on another round of QE: Unemployment (wage inflation), CPI, money supply/velocity, credit creation, dollar spot. Unemployment is weighted the most. If we dig deeper into Department of Labor's non-farm unemployment number and peruse steadily declining real compensation per hour and plateauing output per person (productivity), outlook is negative (see RCPHBS, OPHPBS in charts). Demand side concerns: a decline in real compensation while absolute employment numbers increase, Supply side concerns: stagnation in output per person has precipitate every recession since records began. Stagnation in this reading combined with downtrend in real compensation can only lead to reduction in payroll.

Economists who equate unconventional bond purchases by central banks with inflation do not consider the whole picture. Inflation is not a mechanism whereby dovish policy yields immediate increases in prices; there is a process, wherein lies many possibilities of bottlenecks and failures. One of which is controlled by labor and its inflation sub-component -- wage inflation. Despite temporary increases in asset prices (e.g. commodities) if jobs are not being created as a result of an asset purchase, target rate reduction or fiscal expansion, then price increases will be unsustained and non-reinforcing. Goods and commodities, need to be purchased by entities, including consumers, and these entities require an income to continue generation of demand which in turn sustains a level of price. How can that price be sustained if income is not generated? No amount of credit creation can generate a boom in prices if wages do not support it.

Source: Thomson Reuters/Financial Times

CPI readings are tame with its largest component, housing, flagging (see case-shiller chart). A few months ago, contagion seemed less probable. Now, with countries requiring ECB and IMF emergency injections (in the case of Spanish Banks -- an injection was insufficient; requiring a direct $123B injection) approaching half a dozen from just Greece, market deterioration is a concern. A restructuring in Europe will produce effects in demand directly to the US and indirectly through decreased demand in Asia (China's largest trading partner is the EU). When market participants weigh cash flows in a decision to purchase a house through a mortgage, this external variable will weigh heavily. Europe's drop in demand will push tepid demand for housing in the major cities of the US into outright downward trending prints.

The current cycle of a temporary increase in Treasury prices is coming to an end in light of a proper reading of current metrics. When prices fall and constituents demand action, the most politically suitable course is more QE.