Spoiler alert: QE does not work as advertised.
The title of this Collection probably gave that away, but it bears repeating nonetheless. Why? Because of how much misunderstanding that surrounds this topic. Markets move wildly every time the words “Quantitative Easing” show up in the headlines, investors make forecasts decades out into the future based on the amounts of money QE pumps into the system; and traders see the ghost of more QE behind every poor data point and between the lines of every central banker’s statements.
Believe it or not, all of this has been going on for five years in the Eurozone, ten years in the States, and almost twenty years in Japan. Doesn’t an “extraordinary” monetary policy measure having such longevity hint at its inefficacy? After all, “extraordinary” means not normal. Surely using the same policy over and over again, in ever larger amounts, means that QE really isn’t what it’s hyped up to be?
What then does this say about markets and policymakers? Doing the same thing repeatedly expecting different outcomes, and all that jazz.
This Collection is our effort at dispelling the myths surrounding QE by starting from the ground up. We cover the basics of how the banking system works, the basics of how QE works, and then why it doesn’t work. All of which is a build up to an exploration of the truly fun question:
What happens to all of the things they said would happen because of QE?
The chart below has to be one of the most famous, and circulated, charts of the past decade.
Countless people have observed that both data sets dovetail nicely in an upward trajectory, and come to the conclusion that the stock market is rising because of the Fed’s massive expansion of bank reserves.
However, what they don’t know is that QE is nothing more than a right-pocket-to-left-pocket asset swap.
Putting it another way: No money was created in this transaction.
The premier form of money used in the financial system, US Treasuries, was taken out and replaced with bank reserves, a form of money that can only be used by banks and no one else in the wider economy.
Bank reserves are used by banks to settle transfers between themselves on behalf of their customers like you and me. While this is, without doubt, an extremely important economic function, it has no direct bearing on the equity markets.
This is because bank reserves very rarely make it to trading accounts that purchase stocks (like asset managers or individual traders).
Bank reserves sit on the balance sheets of banks… and stay there.
But why can’t banks purchase stocks directly?
Surely because of the correlation that has to be what is happening?
Banks will not purchase stocks (or for that matter fixed income instruments deemed to be “risky”) for the same reason any well managed corporation will not purchase stocks with their cash balances* – they are NOT in the business of speculating in equity prices!
Banks are in the business of banking, just as McDonald’s is in the business of serving fast food. McDonald’s doesn’t invest its cash balances into stocks, so why would banks?
It also isn’t a matter of “McDonald’s isn’t involved in finance and can’t understand markets”. It is however, a matter of not taking excessive and needless risk with what is ultimately, shareholder’s money. (It must be noted that Tesla is a notable exception, with the company investing in Bitcoin)
Over the years, it has been possible for some amount of the Fed’s liquidity to end up in fixed income markets, and possibly (although unlikely), even equity markets. If the Fed purchased Treasuries and/or Mortgage Backed Securities directly from asset managers instead of through the primary dealers (banks), the asset managers would have reinvested the proceeds back into the markets.
However, most of QE has been transacted through the primary dealers, which means bank reserves stuck on bank balance sheets.
No torrents of liquidity flowing into equity markets then. But if this isn’t the case, why is “QE juices stocks” such a popular narrative?
The first reason would be the obvious one, a simple misunderstanding of what QE is and is not, how the Fed transacts the programs, what bank reserves are and are not, how the financial system works in reality, etc.
The second, and much more powerful reason, is paradigm. Market participants have been trained too well, since the days of Greenspan, that when the Fed says its programs and policies support markets, that’s actually what happens.
They believe that the Fed will achieve what it says its policies are supposed to achieve, because that is how the Fed says the system works, and that is how the textbooks say the system works.
Since paradigm is the deepest and most difficult part of a complex system to change, every new episode of QE results in the same manic bidding up of all risk assets.
Correlation really doesn’t equal causation. In the case of QE and stocks, given the outsized influence a complex system’s paradigm has on its future paths, what happens when the paradigm switches from belief to disbelief?
*Corporations can and do purchase stocks when they are looking to take minority stakes in other companies, but this is a business decision, not a “let’s buy stocks to earn more yield on our cash balance” decision.
Here is another famous chart, circulated widely around financial circles ever since the modern Fed first employed QE in 2009.
The chart shows gold prices soaring along with massive increases in bank reserves, the idea being that the Fed’s massive “money printing“ has led to the debasement of the USD relative to gold.
How true is this?
The debasement narrative runs further, with gold touted as the haven against “inevitable” inflation (some go so far as to suggest hyperinflation), as well as the “ineluctable” destruction of the dollar.
Unfortunately for those who have bought into this narrative, it simply is not true, because QE does not work in the way they think it does.
For the debasement narrative to work, there has to be an increase in money supply in the economy. The narrative rests on the belief that this increase comes about from all the reserves that the Fed has printed to pay for its QE purchases.
As we now know, those reserves are stuck in the banking system. Bank reserves are not lent out, which means the reserves that were printed into existence because of QE do not enter the economy.
As such, money supply in the economy has not skyrocketed in the way people believe it has.
Supporting this is the fact that inflation has failed to materialize in any sustained, meaningful fashion, much less in a manner needed for hyperinflation.
Furthermore, money velocity in the States is at abysmally low levels, which makes one wonder: if velocity is at multi-decade lows, and money supply isn’t growing because QE does not work, what kind of broad based inflation is there to be had?
Additionally, the lack of money supply growth in the economy also means that the USD has not been debased into destruction.
This is because, 1) QE is nothing more than an asset swap where no new assets are created, and 2) the reserves that the Fed swaps for USTs (and MBS etc) are stuck on bank balance sheets and cannot be circulated in the economy.
In fact, the lack of USD debasement is clearly demonstrated by the dollar’s upward trend against a broad basket of currencies ever since QE1 in 2009.
Why then does gold keep moving higher with each iteration of QE?
Because of Paradigm. Everyone believes that QE = printing money, and acts accordingly. It doesn’t matter if the narrative is erroneous, it only matters that people believe in it*.
Add into the mix a good dose of FOMO, people mistaking correlation with causation, and the spark of QE is lit on the kindling of misunderstanding.
*There are those who think in the opposite way, that QE is evidence of policymakers’ failure, but still end up buying the precious metal anyway – as a hedge against the government.
QE has not created the desired kind of inflation that is a byproduct of robust, economy wide growth – the kind of tide that lifts all boats (or as many as possible).
Instead, it has exacerbated inequality, leading to inflation in other areas. Most notably US housing.
As you can see, house prices in the US, on the national level, are at all time highs.
In fact, they have been making new all time highs since 2016, when the index surpassed its previous high made in 2007, just before the Great Financial Crisis.
House prices fell for about 5 years, bottoming out in 2012, after which they embarked on an as yet uninterrupted move upward. Interestingly, they raced even higher in Pandemic 2020, ignoring the widespread economic pain and uncertainty sweeping through the labor market.
Why would this be?
While we may never have a definitive answer given the complexities of the systems involved, let us consider the impact of three seemingly disparate things: low rates, labor market bifurcation, and unequal access to capital.
Simply put, low rates have allowed those with capital and those with easy access to capital, i.e. those not locked out of the labor market after ’08 and March/April 2020, to live in completely different realities to those who were locked out.
Being able to remain in the labor force is not as simple as being a “good thing” because one has a job.
Being able to be employed and remain consistently employed means that one can access bank credit, in the form of credit cards, consumer loans, and mortgage lending – these are the “lucky labor few”.
This unequal access to credit can be observed in the Housing Credit Availability Index (HCAI), which, in stark contrast to US home prices, is at all time lows.
In other words, US house prices are at all time highs, even as record numbers of Americans cannot easily obtain a mortgage from a bank.
Therefore, we have inflation in places where the lucky labor few have easy access and the unlucky labor few do not, capital markets (both public and private), as well as housing.
In the statistics that include the unlucky labor few, like CPI/PCE, disinflation, and even the odd deflationary episode, is the order of the day.
As such, the bifurcation of the labor market has created much more than have and have nots. It has, and continues to create, can always haves and can never haves.
This labor force problem has been going on since the GFC, and QE has been going on since 2009.
QE has not helped the labor problem at all. The lower borrowing costs that it contributes to has not led to bringing folks back into the labor market.
Instead it has exacerbated the divide between those with access to credit and those that do not.
QE prints more dollars, this increases the supply of USD, and since higher supply = lower prices, USD will weaken. SELL SELL SELL!
Okay, simple enough linear logic that is easy to follow, but is this really what’s going on?
As confusing as it sounds, USDs are being printed, but they are not really USDs.
This is because QE increases the amount of Reserves in the American banking system, but banks do not lend Reserves.
As such Reserves do not leave the banking system, at least not in a way that allows for the level of USD depreciation that the “Sell USD because QE” crowd has in mind.
Since Reserves are stuck on bank balance sheets, they do not count as USDs that the broader American economy, much less the international economy, has access to.
In other words, QE has not changed the supply of USDs that really matters – those in circulation.
Furthermore, context is important. In the case of QE, the context is, economic conditions are pretty bad (if not why bother with QE); and when conditions are pretty bad, the USD tends to do well.
This is a chart showing the USD’s exchange value against a basket of global currencies:
As you can see, the USD has been rallying for a decade.
From the very basic, but still extremely important, standpoint of supply and demand, a rising price means that demand is relatively higher than supply.
That is, dollars are scarce.
The reason for this is, for better or worse, the USD is the world’s reserve currency. This means that international trade tends to be conducted in dollars, as this gives sellers multiple advantages, not least of which is very easy convertibility into other assets/currencies.
Hence, in times of stress where markets are freaking out, non-American companies and governments, especially in the Emerging Markets, have to rush to get their hands on as many USDs as they can.
They do so to ensure that they have enough USD liquidity to cover not only their current USD liabilities, but also their USD liabilities in the near future. The more USD-centric a company’s line of business, and the more USD-centric a country’s economy, the more they will scramble and struggle in such times.
This is why, while there will be large and volatile spikes in both directions of the USD’s value during times of crisis, the overall trend will be towards a stronger dollar.
Maybe SELL SELL SELL! is not such a good idea after all.
If QE is more closely linked to a stronger dollar rather than a weaker one, why then does the USD go through large initial sell offs while QE is happening?
The first and most important reason is, of course, Paradigm.
The USD sells off because people believe that it should be selling off. To quickly recap their rationale, they believe that QE debases the USD because the Fed is “printing money”. Hence, in their minds, more USD supply = lower USD value.
Of course, we now know that this line of thinking is false.
But it really doesn’t matter that the vast majority of people misunderstand how QE does not work, and the implications this has, or more accurately, does not have on asset prices. It only matters that the vast majority believes that QE works in the way the financial media and everyone else says it does.
And, because they are the majority, their actions decide what happens with asset prices.
Unfortunately for the USD (and its holders), this tends to mean a brutal sell off.
While the beginning of the sell off is sparked by traders/investors “pricing in” QE by selling USDs, it quickly devolves into panic selling as parties who once thought they held strong hands find the value of their USD longs dissipating extremely quickly.
It is important to note that not all of the Fed’s crisis policies fail to work as intended. The Fed has used USD swap programs with other global central banks in the past in order to provide USD liquidity internationally (USDs being the global reserve currency and all that).
These have existed in various forms over the years, expanding from a small number of countries who had access to them, like Japan early on, to a broader audience during the Great Financial Crisis of ‘08.
The arrival of Covid in 2020 then saw the Fed greatly expand the roster of international central banks who could access their USD swap lines. Which is an often overlooked fact demonstrating how dependent the world is on USD liquidity.
These USD swaps, unlike QE, actually increase the supply of USDs in the global economy. This is because when a swap line is activated, the Fed lends USDs to foreign Central Banks, who in turn lend these dollars to their local banks.
As such, international banks get access to USD loans, which alleviates their need to scramble for USDs in the repo, Eurodollar, and FX markets.
However, these swap lines are only a temporary measure, meant to push USDs out into the global financial system when the Eurodollar market seizes up. They must ultimately be paid back to the Fed when the swap reaches maturity.
Of course, they can be repeatedly rolled over until USDs are easily and widely available in the open market again, which reduces the impact of global financial parties repaying the USDs they obtained from the Fed.
That being said, Paradigm is far more important than swap lines in the USD’s QE driven sell offs, simply because the Fed has engaged in QE numerous times between 2008 and 2020. On the other hand, the global financial system only tapped into the Fed’s swap lines in a big way twice, in 2008 and 2020.
Remember that the market does not care about what is right or wrong, logical or illogical. It only cares about greed and fear!
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