So I’ve been asked what I’d do to get Ireland past this latest funding crisis.

Answer: I’d announce that in the case of default new Irish govt debt is freely transferable and can be used for the payment of taxes to the Irish govt.

This should facilitate funding for the near term.

Believe it or not I’m still getting a lot of questions about how QE works,
so I’ve reorganized the discussion some:

First, recognize that, in fact, reserves, functionally, are nothing more than 1 day t bills.

And, for all practical purposes, the difference between issuing 1 day t bills and 3 month t bills is inconsequential.

So since currently the shortest thing the Treasury issues are 3 mo bills,
I can say that:

QE- the Fed buying longer term treasury securities- is functionally identical for the economy to the Treasury having issued 3 month t bills instead of those longer term securities the Fed bought.

Now the more tricky part.

The yields on the approx. $13 trillion of various Treasury securities and reserve balances continuously gravitate towards what are called indifference levels.

That means that for any given composition of reserve balances at the Fed and Treasury securities (also Fed accounts), there is a term structure of interest rates that adjusts to investor preferences at any given time.

So, for example, with govt providing investors with the combination of $2 trillion in reserves and $11 trillion in various Treasury securities, the yield curve will reflect investor preferences given the current circumstances.

That means if investors expect Fed rate hikes, the front end of the curve would steepen accordingly. And if instead they expect 0 rates for a considerable period of time, the curve would flatten for the first few years to reflect that.

If the Fed then buys another $1 trillion of securities, reserves go to $3 trillion and there are $10 trillion longer term Treasury securities outstanding.

And to actually purchase those reserves, the Fed would have to drive the term structure of rates to levels where investors voluntarily are indifferent with that mix of offerings, given all the other current conditions.
The Fed doesn’t force anyone to sell anything.
It just offers to buy at prices (interest rates) that adjust to where people want to sell at those prices.

So even if the Fed owned a total of $10 trillion of securities, and there were only $3 trillion left outstanding for investors, if investors believed the Fed was going to hike rates by 3%, for example, the term structure of rates on Treasury securities would reflect that.

What I’m trying to say is that QE does not mean rates will actually go down. The yield curve is still a function of investor expectations.

But the yield curve is also a function of ‘technicals.’
This means the quantity of 30 year securities offered for sale, for example, can alter the yield of that sector more than it alters the yields of the other sectors.

This is because, in general, there tends to be fewer ‘natural’ buyers of 30 year securities than 3 month bills.
For most of us, we are a lot more cautious about investing for 30 years at a fixed rate than for 3 months at a fixed rate.
And it takes relative large moves in 30 year rates to cause those investors to shift our preferences to either buy them if govt wants to issue more, or sell them if the Fed wants to buy them back.

On the other hand, there are pension funds who ‘automatically’ buy 30 year securities regardless of yield because they are matching the purchases to 30 year liabilities.

So altogether, the yield curve is function of both investor expectations for interest rates and the ‘technicals’ of supply and demand (desires by issuers and investors).

And while there might be no amount of 3 month bills the Treasury could issue that would materially drive up 3 month t bill rates, relatively small amounts of 30 year bonds do alter the yields of 30 year securities. Insiders would say the 30 year market is a lot ‘thinner’ than the 3 month market.

So what is QE?

QE is nothing more than the govt altering the mix of investments offered to investors.

The Fed buying longer term securities reduces the amount of longer term securities and increases the amount of reserves (one day securities)

Interest rates, as always, continuously gravitate to reflect current investor expectations of future Fed rate changes and current ‘technicals’ of supply and demand.

QE changes the technicals, and possibly expectations, and results in a yield curve that reflects those current conditions.

So all QE does is alter the term structure rates, as investors express preferences for the term structure of interest rates, given the securities and reserves of the varying maturities offered by the Fed and Treasury and all the current conditions.

That brings us back to the question of what QE means for the economy, inflation, value of the currency, etc.

Which comes down to the question of what the term structure of rates means for the economy, inflation, the value of the currency, etc.

QE is nothing more than a tool for changing interest rates by adjusting the available supply of securities of various maturities (technicals). And it’s not a particularly strong tool at that.

It’s the resulting interest rates that may or may not alter the economy, inflation, and the value of the dollar, etc. and not the quantities of reserves and Treasury securities per se.

And it is clear to me that the FOMC does not fully understand this.

If they did, they’d be in discussion with the Treasury about cutting issuance.

And, additionally, If they wanted the term structure of interest rates to be lower, they would simply target their desired term structure of rates by offering to buy unlimited amounts of Treasury securities at their desired rate targets, and not worry about the mix between reserves and Treasury securities that resulted. Which is what they did in the WWII era. And how they target the fed funds rate.

With today’s central banking and monetary policy with its own currency, it’s always about price (interest rates) and not quantities.

So it was buy the rumor, buy the news, then watch it all fall apart a few days later.

QE was a major international event, with the word being that the ‘money printing’ would not only take down the dollar, but also spread ‘liquidity’ to the rest of the world through the US banking system, via some kind of ‘carry trades’ and who knows what else, or needed to know. It was just obvious…

So the entire world was front running QE in every currency, commodity, and equity market.

And the Fed announcement only brought in more international players, with money printing headlines screaming globally.

Then the ‘risk off’ unwinding phase started, reversing what had been driven by maybe three themes:

1. There were those who knew all along QE probably did not do anything of consequence, but went along for the ‘risk on’ ride believing others believed QE worked and would drive prices accordingly.

2. A group that thought originally QE might do something and piled in, but began having second thoughts about how effective QE might actually be after learning more about it, and decided to get out.

3. A third group who continue to believe QE does work, who got cold feed when they started doubting whether the Fed would actually follow through with enough QE, also for two reasons.
   a. the FOMC itself made it clear opinion was highly polarized, often for contradictory reasons
   b. the economy showed signs of modest growth that cast doubts on whether the Fed might
   think something as ‘powerful and risky’ as QE was still needed.

Reminds me some of the old quip- the food was terrible and the portions were small-
(QE is questionable policy and they aren’t going to do enough of it.)

So risk off continues in what have become fundamentally illiquid markets until some time after the speculative longs have been sold and the shorts covered.

Next question, what about after the smoke clears?

A. The dollar could remain strong even after the initial short covering ends- the modest GDP growth is slowly tightening fiscal, and crude oil prices are falling, both of which make dollars ‘harder to get’

It’s starting a kind of virtuous cycle where the stronger dollar moves crude lower which strengthens the dollar.
Also, the J curve works in reverse with other imports as well. As imports get cheaper, initially
the rest of world gets fewer dollars from exports to the US, until/unless volumes pick up.

The euro zone is again struggling with the idea of the ECB supporting the weaker members with secondary market bond purchases, as ECB imposed austerity measures are showing signs of decreasing revenues of the more troubled members. Seems taxpayers of the core members are resisting allowing the ECB to support the weaker members, and the core leaders are groping for something that works politically and financially. All this adds risk to holding euro financial assets, as even a small threat of a breakup jeopardizes the very existence of the euro.

Japan is on the way to fiscal easing while the US, UK, and euro zone are attempting to tighten fiscal.

Falling commodity prices hurt the commodity currencies.

B. Interest rates are moving higher as spec longs who bought the QE rumor and news are getting out.
But it looks to me like term rates could again move back down after this sell off has run its course.
The Fed still failing on both mandates- real growth is still modest at best, and the 0 rate policy is deflationary/contractionary enough for even a 9% budget deficit not to do much more than support gdp at muddling through levels, with a far too high output gap/unemployment rate.
And falling commodities, weak stocks, and a strong dollar give the Fed that much more reason not to hike.

C. A mixed bag for stocks.
Equity values have fallen after running up on the QE rumor/news, further supported by the dollar weakness that came with the QE rumor news, with the equity sell off now exacerbated by the dollar rally which hurts earnings translations and export prospects.

But a 9% federal deficit is still chugging away, adding to incomes and savings of financial assets, and providing for modest top line growth and ok earnings via cost cutting as well.

Fiscal risks include letting the tax cuts expire and proactive spending cuts by the new Congress which seems committed to austerity type measures.

Low interest rates help valuations but reduce the economy’s interest income.

China acting more like the inflation problem is serious. Hearing talk of price controls, as they struggle to sustain employment and keep a lid on prices, in a nation where inflation or unemployment have meant regime change. Looks to me like a slowdown can’t be avoided with the western educated kids now mostly in charge.

>   
>   (email exchange)
>   
>   On Wed, Nov 17, 2010 at 1:05 AM, Paul wrote:
>   
>   Very interesting — but I have a question:
>   
>   What if the deficit causes “saving” increase in financial assets held by
>   foreigners (via the trade imbalance) rather than US domestic households?
>   

Hi Paul!

That would mean we would get the additional benefit of enjoying a larger trade deficit, which means for a given size govt taxes can be that much lower.

Or, if we get sufficient domestic private sector deficit spending, govt deficit spending can remain the same and we benefit by the enhanced real terms of trade supported by the increased foreign savings desires.

Except of course policy makers don’t get it and squander the benefit of a larger trade deficit/better real terms of trade with a too low federal deficit (taxes too high for the given level of govt) that sadly results in domestic unemployment- currently a real cost beyond imagination.

Fundamentally, exports are real costs and imports real benefits, and net imports are a function of foreign savings desires.

So the higher the foreign savings desires the better the real terms of trade.

Also, with floating exchange rates, the way I see it, it’s always ‘in balance’ as the trade deficit = foreign savings desires.

Best!
Warren