Why is Quantitative Easing by the FED deflationary?
Quantitative Easing (QE) is defined as an action by a central bank to purchase long term securities (such as US Treasury bonds) from the open market in order to increase the money supply and encourage lending, investment and credit growth. In a debt-based monetary system, the expansion of debt leads to an increase in money supply, and thereby increasing growth.
Oftentimes, QE is seen as inflationary, as the money supply is increasing, which is then used to fuel credit growth and growth in the economy, leading to increased demand for goods and services, leading to inflation. The misconception of the QE from the Federal Reserve (The Fed) is that it is inflationary.
QE in its current form by the FED removes liquidity from the market. The nuance lies in the mechanics of the interaction between primary dealers (PD), commercial banks (Cs) and the Federal Reserve (The FED). When the bond purchases take place, the money that is paid is deposited in a reserve account at the Federal reserve. This reserve account is held in name only by the primary dealer and not transferred to the primary dealer itself. Consequently, while the PD can collateralise this account to spur lending growth, in the current market environment, credit conditions are in contraction from the chart below:
Figure 1: Net % change in domestic banks tightening standards for commercial loans to large and middle market firms (blue) and small firms (red).
Second, QE in its current form only yields inflation if the primary dealers generate credit growth (they are willing to lend) and that the credit they issue does not default. Furthermore, due to the significant expansion of the FED balance sheet, the PDs are having to purchase treasuries in the open market from other market participants to fuel the FED’s bond buying programme as those bought directly from treasury auctions are insufficient to meet demands.
The myth of inflation and the impact on yields.
In recent weeks, with news of vaccine approvals, there is hope amongst market participants that economic growth will prosper and that markets will continue to rally higher. Copper, which can be considered a benchmark for economic growth for its wide application to infrastructure and electronics, has rallied aggressively since the March low. This would be an indication of strong economic growth.
Figure 2: Copper Futures (current month) [HG1!]
While this paints a narrative of strong growth, we have in fact seen a spiralling pandemic emerge across the United States and Europe, with countries still struggling to contain the virus. The vaccine optimism is a strong start but will take many years to deliver in sufficient quantities to negate any economic impacts such as lockdowns, record unemployment, and poor economic fundamentals.
In stark contrast to rallying copper prices, all-time high prints on the S&P500, rife retail speculation and many successful IPOs in recent weeks, the bond markets paint a much bleaker picture of what is to come…
Firstly, Consumer Price indexes remain weak across the board with Y-o-Y Core CPI at 1.6 per cent in the U.S., 0.2 per cent Core CPI in the EU, and 0.5 per cent in the U.K. Additionally, unemployment remains elevated, and exports from Europe and other developed economics such as Japan remain weak to negative.
Figure 3: Money Multiplier
Secondly, a more telling indicator for a deflationary case is seen in Figure 3- The Money Multiplier, above. This is shown as the M2 Money (all money available in an economy) divided through by monetary base (which is the total amount of currency (U.S. Dollars) in the public or held in banks including central bank reserves. The figure shows, in 2008, the sharp decline as the great financial crisis struck. We can see again that there is a downturn into the beginning of the COVID crisis.
Finally, further evidence for lower yields (deflation) can be seen in the latest Treasury Auction in Figure 4, below. This shows the latest 30-year treasury auction from December 10, 2020, where market participants including PDs and CBs, as well as foreign central banks competitively bid for the 30-year bonds. This is in realisation of the fact that the FED will purchase these eventually as part of its QE program, so demonstrates a low risk, guaranteed return on capital for these banks.
The more interesting point of note is low yield on the bid. We see that, currently the 30-year yield is 1.634 per cent as of Friday 11th December 2020 close. Now, we see that the median bid (midpoint average) is close to the market price, but more interestingly, the low bid is 0.080 per cent - this implies that a market participant is willing to pay a much high price than the market (price moves inverse to yield on bonds), in the hope that someone (The Fed) will buy the security at a higher price. Banks, who are not in the business of losing money, are willing to pay much more than the market price for 30-year bonds, as it is their belief that rates are moving significantly lower.
Figure 4: Treasury Auction for 30year bonds from December 10, 2020.
From this brief snapshot of evidence, there is an obvious disconnect between equity markets and the underlying economic picture, which is demonstrated perfectly by the bond market. Ultimately, the jury is not out on the case for inflation and there is strong possibility for things to get much worse through an insolvency event (seen through decreasing liquidity in figure 3), before they get better.
Economic Calendar for CPI https://uk.investing.com/economic-calendar/
TradingView - Copper Futures HG1!
St. Louis FED – FRED Database
Treasurydirect.gov - Treasury Auction Data