Why Quantitative Easing Will Raise Long-Term Rates

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


The two-year treasury yield fell to another record low on Monday, touching 0.3987%. The 10-year treasury yield was up slightly however in September, rising for the first time since March. Federal Reserve money-printing is behind both falling shorter-term rates and rising longer-term rates.

A survey by Bloomberg of more than 60 mainstream economists indicates they expect 10-year treasury yields to keep rising in 2010 and through 2011. Perhaps someone has been passing around some notes on the approximately 500 hundred year old 'quantity theory of money', which states if the amount of currency is increased without an appropriate increase in economic growth, inflation will result (and consequently interest rates will have to rise, with the biggest increase taking place on long-term bonds).  For this not to happen, the laws of simple arithmetic have to be violated. The Federal Reserve has essentially been maintaining that that is what has taken place for the last two years. Bernanke of course does not directly state that we have entered a new economic age where two plus two no longer equals four because he would be laughed out of Washington and even the never questioning U.S. mainstream media wouldn't print such garbage.

Bloomberg also reports that a survey of primary dealers (the people who buy the paper that the Treasury issues) estimates that the Fed will buy $100 billion to $1 trillion in Treasuries by the end of the year. According to Deutsche Bank however, the market has reacted as if $315 billion to $670 billion of quantitative easing has taken place recently. The Fed announced on August 10th that it would be conducting further quantitative easing this year. The stock market then had its best September in seven decades. Money printing is an easy way to juice up stock prices. And since there is an important election on November 2nd, it would make sense to think all or almost all of what is scheduled for 2010 will take place before people vote. It looks like that is exactly what is happening.

While the Fed's actions can make the stock market look good in the short-term (investors need to watch out for what follows however) and can make shorter-term rates like the two-year go down because of all of the buying that it is doing,  longer-term rates will go up if the market sees this as inflationary. The 10-year treasury is the bench mark for everything from home mortgages, to credit cards, to corporate bonds. Higher yields on the 10-year are a drag on the economy. The Fed has supposedly reinstituted quantitative easing to stimulate the economy, although there is little evidence that the Fed has managed to stimulate the economy very much in the last three years. The stimulus has instead come from massive government budget deficits. The Fed seems oblivious to the existence of a liquidity trap, a condition where increased 'money' generated from the central bank just moves around the financial system and never gets into the real economy. Under such circumstances, doing more of the same won't make things any better, but can easily make them worse.

Disclosure: No positions.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

Precious Metals Watch

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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The Fed and G20 meetings from last week both had a consensus that government generated stimulus of the U.S. and global economies should continue. The U.S. and UK and are printing substantial amounts of new money in order to engage in this stimulus. This should have been bearish for the dollar and pound and bullish for the precious metals. While the pound did indeed slide, the dollar went up and precious metals went down. These counter intuitive market reactions, common since the beginning of the Credit Crisis, should end soon.

Spot gold fell as low as $987 in overnight trading. Spot silver was as low as $15.73. The U.S. trade-weighted dollar traded between 77.12 and 77.26 on Friday. It was trading at 76.87 around the opening today. After hitting a yearly low of 75.83 four days ago, the dollar bounced of its support at 76.00. It is trying to head toward 78.00, where it has strong resistance from its 50-day moving average. Stronger resistance is just above that at 78.33, the low from the dollar sell off in the late 1980s and early 1990s.

The Fed reiterated in its post-meeting statement that it "expects that inflation will remain subdued for some time." The mainstream media is filled with commentary about how inflation isn't a problem. Comments like "many economists argue that inflation is only an issue when the economy is humming along" are common. Someone should have told Zimbabwe with its 94% unemployment rate (if that economy was humming, it was tone deaf) that it was impossible that it was having sextillion percent inflation. When discussing all the money printing the U.S. Fed is doing, media articles invariably state that it "isn't so clear whether this will create an inflation headache down the road for the Fed". No article has yet to cite one case in the entire economic history of the world where excess money creation didn't lead to major inflation. Somehow by magic it might not happen in the contemporary U.S. though. Indeed magic is the operative word because that it the only thing that will prevent inflation going forward.

The idea that too much currency creation leads to price rises is not new. The 'quantity theory of money' originated with Copernicus, better known for his 'earth revolves around the sun' theory, in the early 1500s. It was further developed in the following centuries by at least half a dozen other economic thinkers long before Milton Friedman repackaged it as a new idea and won a noble prize for his 'original' thinking. Governments always claim that printing too much money isn't a problem and the lesson that it is needs to be learned over and over and over again. Buying gold and silver has always been the protection from excess government money creation. Smart investors only need to learn this lesson once.

NEXT: The Longer Term U.S. Interest Rate Picture

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21


This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.