SmartChart/Cycle Update


Wednesday 11-10-2010

 DI: SELL per the INTRADAY guidelines  Key numbers: Intraday Break Point: Buy above 1219.75 sell below 1219 Cycle: current reading is 615 Cycle Stage: buy
 POMO: New schedule due out on November 10th

Premarket talks about those items that directly affect what we will be doing each day in the market. Premarket has NOTHING to do with macro economics. Ok, here is the deal: we wait for the corrective move to complete with todays outside range day issuing a sell signal. The Next daily buy we jump on. By then we will have Ben’s schedule etc. the above report comes out tomorrow at 10am, it front runs the Chicago Activity Index

READ THE LAST SENTENCE: So yes I have had, long before published articles like this, my reasons for being overly cautious. It is indeed new ground directly managed by the FED.

Daily Growth Index Shows Signs of Bottom Forming
Posted: 08 Nov 2010 09:00 PM PST

Since the middle of October our Daily Growth Index has begun to show signs of forming a bottom to the contraction event in consumer demand that we have been closely monitoring throughout 2010:


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(Click on chart for fuller resolution)

This upturn is most clearly visible in our "Contraction Watch," where the day-by-day courses of the 2008 and 2010 contractions are plotted in a superimposed manner with the plots aligned on the left margin at the first day during each event that our Daily Growth Index went negative. The plots then progress day-by-day to the right, tracing out the changes in the daily rate of contraction in consumer demand for the two events:


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(Click on chart for fuller resolution)

Several points should be made about the upturn clearly visible in the above charts: -- Our Daily Growth Index is a 91-day trailing "quarter" moving average of our Weighted Composite Index (converted from a nominal base-100 index into a +/- percentage). As a result of the moving average process this upward movement in the index is largely a consequence of very depressed July and August levels in the Weighted Composite Index now falling out of the average. -- The current daily values of the Weighted Composite Index now entering the averaging process correspond with a Daily Growth Index contracting at about a -4% rate. While this is a substantial improvement over the July and August values (which reached a nearly -9.5% daily contraction rate on August 1), it still represents substantial year-over-year contraction -- far short of a new round of "green shoots." -- We have commented before that the "Contraction Watch" chart above has something resembling a gently sloping plateau in the blue 2010 line that starts at about Day 50 in the contraction and extends perhaps as far as Day 170. We understand that the sharp downturn after Day 170 is a reflection of poor year-over-year comparisons to a period in 2009 when the "Cash for Clunkers" and Federal Home Buyer Tax Credits were in full effect. But the sloping plateau represents year-over-year 3 James M Edwards 602.441.4303

comparisons to a less stimulated point in the consumer economy, and may therefore be an indication of a new longer term baseline level of spending -- some 1.5% to 2.5% below 2009 levels. We think that it would be prudent to reserve enthusiasm for the current upturn until the blue line breaks above that zone. -- The true severity of any contraction event is the area between the "zero" axis in the above chart and the line being traced out by the daily contraction values. By that measure the "Great Recession of 2008" had a total of 793 percentage-days of contraction over the course of 221 days, whereas by November 7 the 2010 event had reached 899 percentage-days of contraction over the course of 296 calendar days. The damage to the economy is already 13% worse than in 2008, and the 2010 contraction has already lasted 34% longer than the entire 2008 event. If the blue 2010 contraction line in the above chart follows a recovery trajectory similar to what the red line experienced in 2008, we would project that the final tally for the 2010 event would be about 1350 percentage-days of contraction, about 70% worse than in 2008:

(Click on chart for fuller resolution)

In the above chart the red vertical bar represents the -793 percentage-days of contraction in consumer demand that we measured in 2008. The blue vertical bar represents the same measure (to 4 James M Edwards 602.441.4303

date) for the 2010 event. But since the 2010 event is not yet over, we have projected the eventual full extent of the 2010 event with the purple vertical bar. That projection is an average of several recovery scenarios, all of which conservatively assume that the bottom has already been reached and that the plateau visible in the "Contraction Watch" chart is not a new norm for consumer frugality. Since late spring our primary concern about the 2010 contraction has been about its duration, rather than the maximum contraction rate observed. An indication of the longevity of this contraction is that even our longer term moving averages have reached record levels of contraction:

(Click on chart for fuller resolution)

To us it was almost incidental that during 2010 the 91-day contraction rate eventually reached (and even slightly exceeded) the maximum contraction rate recorded in 2008. To our eyes the real problem in the above chart is that our 365-day trailing year index has exceeded its lowest level of 2008 by over 50%. We are far beyond wondering about how many dips there may be. Our concern is simply that this episode is something neither we nor any policy makers at this side of Japan have seen before.


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Market Outlook:
Trading Outlook is concerned with intermediate and long term macro economics. It has a bearing on INTERMEDIATE and LONG TERM thinking. The FED is not ignorant of the unemployment but their mandate is save the big banks FIRST. If you really want a SOLUTION you get rid of this FED and replace it with a central bank for ALL the banks in the country and then make employment the responsibility of Congress. The entire structure of the FED is one of CARTEL for the primary dealers.

Comments are concerned with news links, commentary from other sources and any other news worthy item(s). It deals with what can change the macro economic landscape; with what is brewing under the surface.

There are going to be severe consequences for Bernankes QE2 actions. John Mauldin this week sums those up pretty well but they don’t cover any ground I have screamed about earlier. I’ve warned about velocity of money, I’ve warned about GDP, I’ve warned about employment and I’ve warned about liquidity traps. In fact I was preparing for severe shorts just before Bernanke saw the SAME data and prepared QE2. I warned of a severe and devastating decline and that is exactly what we would have seen had it not been for QE2 and a fake 1.1 trillion in spending (which by the way, is about the amount of money we’ve lost due to unemployment). I’ve warned that Bernanke has done what he can do and that now is the time for FISCAL reform. Bernanke is at his LIMIT and unless we get solid FISCAL reform the ONLY THING BERNANKE has done is extend the time for PAIN. Although we are temporarily safe once the program is over you will see that the economics are NO BETTER but the markets will be at nose bleed levels. It will be the short of the century IF the FISCAL order has not been changed.
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Thoughts on Liquidity Traps
by John Mauldin November 5, 2010

In this issue: A Few Thoughts on the Employment Numbers Bernanke Leaps into a Liquidity Trap How to Spot a Liquidity Trap Toy Blocks London, The End Game, and Changes

I am in London finishing my new book, The End Game, which will be out after the first of the year, as soon as Wiley can make it happen. Working with my coauthor, Jonathan Tepper, we are making good progress. We intend to quit (a book like this is never finished) tomorrow afternoon. I am going to beg off from personally writing a letter this week, but will give you something even better. Dr. Lacy Hunt offers us a few cogent thoughts on the unemployment numbers. The headline establishment survey came in much better than expected, but the household survey was much weaker. In addition, Dr. John Hussman wrote a piece last week that I thought was one of his best, on liquidity traps and quantitative easing, and that's included here, too. We are embarking on a course through uncharted waters. No one (including the Fed) has any idea what the unintended consequences will be. I remarked a few weeks ago that the Fed is throwing an inflation party and not sure whether anyone will come. Last night at dinner, Albert Edwards of Societe Generale noted that not only do they not know whether anyone will come, they do not know what they will do if they do come, how much they will drink, or when they will leave. My quick takeaway is the $600 billion is not all that much, and the buying is concentrated in the middle of the curve, where it is likely to do the least in terms of lowering rates (they are already low!), so also likely to do the least damage. Mohammed El-Erian thinks that if nothing happens the Fed will be forced to continue, which is a dangerous thing. I wonder whether they might just shrug their shoulders and say, "We tried, and now it is up to the fiscal side of the equation." We shall see. It will be important to listen to the speeches of the Fed


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governors to get some idea. Before we jump in, let me give you a few thoughts I am picking up in Europe. The yield spreads on Irish and Spanish bonds are blowing out even as we speak, as well as those on the rest of the periphery. While all eyes are on the Fed, the real action may be in Europe. We will visit that thought in the near future. Now, first to Lacy.
A Few Thoughts on the Employment Numbers

By Dr. Lacy Hunt, Hoisington Investment Mgt. Co. The October employment situation was dramatically weaker than the headline 159k increase in the payroll employment measure. The broader household employment fell 330k. The only reason that the unemployment rate held steady is that 254k dropped out of the labor force. The civilian labor force participation rate fell to a new low of 64.5%, indicating that people do not believe that jobs are available, but this serves to hold the unemployment rate down. In addition, the employment-to-population ratio fell to 58.3%, the lowest level in nearly 30 years. While not actually knowing what happened to the net job change in the nonsurveyed small business sector, the Labor Department assumed that 61k jobs were created in that sector. This assumption is not supported by such important private surveys as those from the National Federation of Independent Business or by ADP. Just a month ago the Labor Department had to revise downward the job totals due to a serious overcount of their statistical artifact known as the Birth/Death Model.


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The most distressing aspect of this report is that the US economy lost another 124K full-time jobs, thus bringing the five-month loss to 1.1 million in this most critical of all employment categories. In an even more significant sign, the level of full-time employment in October was at the same level that was reached originally in December 1999, almost 11 years ago (see attached chart). An economy cannot generate income growth by continuing to substitute part-time work for full-time employment. This loss of full-time jobs goes a long way to explain why real personal income less transfer payments has been unchanged since May. The weakness in real income is probably lost in an environment in which the Fed is touting the gain in stock prices and consumer wealth resulting from the latest quantitative easing (QE), but QE has unintended negative consequences for real household income. Due to higher prices of energy and food commodities, QE may result in less funds for discretionary spending for consumers whose incomes are stagnant. Also, with five-year yields falling below 1%, rates on CDs and other types of short-term bank deposits will decline, also cutting into household income. At the end of the day these effects will be more powerful than any stock-price boost in consumer spending, which, as always, will be very small and slow to materialize. To have a broad-based recovery, the manufacturing sector must participate.
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Contrary to the ISM survey, manufacturing jobs fell 7k, the third consecutive drop, resulting in a net loss over the past three months of 35k. In summary, the latest economic developments indicate a slight worsening of underlying fundamental conditions.
Bernanke Leaps into a Liquidity Trap

John P. Hussman, Ph.D. "There is the possibility ... that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control." - John Maynard Keynes, The General Theory One of the many controversies regarding Keynesian economic theory centers around the idea of a "liquidity trap." Apart from suggesting the potential risk, Keynes himself did not focus much of his analysis on the idea, so much of what passes for debate is based on the ideas of economists other than Keynes, particularly Keynes' contemporary John Hicks. In the Hicksian interpretation of the liquidity trap, monetary policy transmits its effect on the real economy by way of interest rates. In that view, the loss of monetary control occurs because, at some point, a further reduction of interest rates fails to stimulate additional demand for capital investment. Alternatively, monetary policy might transmit its effect on the real economy by directly altering the quantity of funds available to lend. In that view, a liquidity trap would be characterized by the failure of real investment and output to expand in response to increases in the monetary base (currency and reserves). In either case, the hallmark of a liquidity trap is that holdings of money become "infinitely elastic." As the monetary base is increased, banks, corporations, and individuals simply choose to hold onto those additional money balances, with no effect on the real economy. The typical Econ 101 chart of this is drawn in terms of "liquidity preference," that is, desired cash holdings plotted against interest rates. When interest rates are high, people choose to hold less cash because cash doesn't earn interest. As interest rates decline toward zero (and especially if the Fed chooses to pay banks interest on cash reserves, which is presently the case), there is no effective difference between holding riskless debt securities (say, Treasury bills) and riskless cash balances, so additional cash balances are simply kept idle.


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A related way to think about a liquidity trap is in terms of monetary velocity: nominal GDP divided by the monetary base. (The identity, which is true by definition, is M * V = P * Y - the monetary base times velocity is equal to the price level times real output). Velocity is just the dollar value of GDP that the economy produces per dollar of monetary base. You can also think of velocity as the number of times that one dollar "turns over" each year to purchase goods and services in the economy. Rising velocity implies that money is "turning over" more rapidly, so that nominal GDP is increasing faster than the stock of money. If velocity rises, holding the quantity of money constant, you'll observe either growth in real output or inflation. Falling velocity implies that a given stock of money is being hoarded, so that nominal GDP is growing slower than the stock of money. If velocity falls, holding the quantity of money constant, you'll observe either a decline in real GDP or deflation. The belief that an increase in the money supply will result in an increase in GDP relies on the assumption that velocity will not decline in proportion to the increase in money. Unfortunately for the proponents of "quantitative easing," this assumption fails spectacularly in the data - both in the U.S. and internationally - particularly at a zero interest rate.
How to Spot a Liquidity Trap

The chart below plots the velocity of the U.S. monetary base against interest rates since 1947. Since high money holdings correspond to low velocity, the graph is simply the mirror image of the theoretical chart above.
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Few theoretical relationships in economics hold quite this well. Recall that a Keynesian liquidity trap occurs at the point when interest rates become so low that cash balances are passively held regardless of their size. The relationship between interest rates and velocity therefore goes flat at low interest rates, since increases in the money stock simply produce a proportional decline in velocity, without requiring any further decline in yields. Notice the cluster of observations where the interest rate is zero? Those are the most recent data points.

One might argue that while short-term interest rates are essentially zero, longterm interest rates are not, which might leave some room for a "Hicksian" effect from QE - that is, a boost to investment and economic activity in response to a further decline in long-term interest rates. The problem here is that longer-term interest rates, in an expectations sense, are already essentially at zero. The remaining yield on longer-term bonds is a risk premium that is commensurate with U.S. interest-rate volatility (Japanese risk premiums are lower, but they also have nearly zero interest-rate variability). So QE at this point represents little but an effort to drive risk premiums to levels that are inadequate to compensate investors for risk. This is unlikely to go well. Moreover, as noted below, the precise level of long-term interest rates is not the main constraint on borrowing here. The key issues are the rational desire to reduce debt loads, and the inadequacy of profitable investment opportunities in an economy flooded with


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excess capacity. One of the most fascinating aspects of the current debate about monetary policy is the belief that changes in the money stock are tightly related either to GDP growth or inflation at all. Look at the historical data and you will find no evidence of it. Over the years, I've repeatedly emphasized that inflation is primarily a reflection of fiscal policy - specifically, growth in the outstanding quantity of government liabilities, regardless of their form, in order to finance unproductive spending. Look at the experience of the 1970s (which followed large expansions in transfer payments), as well as every historical hyperinflation, and you'll find massive increases in government spending that were made without regard to productivity (Germany's hyperinflation, for instance, was provoked by continuous wage payments to striking workers). Likewise, real economic growth has no observable correlation with growth in the monetary base (the correlation is actually slightly negative but insignificant). Rather, economic growth is the result of hundreds of millions of individual decision-makers, each acting in their best interests to shift their consumption plans, saving, and investment in response to desirable opportunities that they face. Their behavior cannot simply be induced by changes in the money supply or in interest rates, absent those desirable opportunities. You can see why monetary-base manipulations have so little effect on GDP by examining U.S. data since 1947. Expand the quantity of base money, and it turns out that velocity falls in nearly direct proportion. The cluster of points at the bottom right reflect the most recent data.


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[Geek's Note: The slope of the relationship plotted above is approximately -1, while the Y intercept is just over 6%, which makes sense, and reflects the longterm growth of nominal GDP, virtually independent of variations in the monetary base. For example, 6% growth in nominal GDP is consistent with 0% M and 6% V, 5% M and 1% V, 10% M and -4% V, etc. There is somewhat more scatter in 3-year, 2-year and 1-year charts, but it is random scatter. If expansions in base money were correlated with predictably higher GDP growth, and contractions in base money were correlated with predictably lower GDP growth, the slope of the line would be flatter and the fit would still be reasonably good. We don't observe this.] Just to drive the point home, the chart below presents the same historical relationship in Japanese data over the past two decades. One wonders why anyone expects quantitative easing in the U.S. to be any less futile than it was in Japan.


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Simply put, monetary policy is far less effective in affecting real (or even nominal) economic activity than investors seem to believe. The main effect of a change in the monetary base is to change monetary velocity and short-term interest rates. Once short-term interest rates drop to zero, further expansions in base money simply induce a proportional collapse in velocity. I should emphasize that the Federal Reserve does have an essential role in providing liquidity during periods of crisis, such as bank runs, when people are rapidly converting bank deposits into currency. Undoubtedly, we would have preferred the Fed to have provided that liquidity in recent years through openmarket operations using Treasury securities, rather than outright purchases of the debt securities of insolvent financial institutions, which the public is now on the hook to make whole. The Fed should not be in the insolvency bailout game. Outside of open-market operations using Treasuries, Fed loans during a crisis should be exactly that, loans - and preferably following Bagehot's Rule ("lend freely but at a high rate of interest"). Moreover, those loans must be senior to any obligation to bank bondholders - the public's claim should precede private claims. In any event, when liquidity constraints are truly binding, the Fed has an essential function in the economy. At present, however, the governors of the Fed are creating massive distortions in
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the financial markets with little hope of improving real economic growth or employment. There is no question that the Fed has the ability to affect the supply of base money, and can affect the level of long-term interest rates, given a sufficient volume of intervention. The real issue is that neither of these factors is currently imposing a binding constraint on economic growth, so there is no benefit in relaxing them further. The Fed is pushing on a string.
Toy Blocks

Certain economic equations and regularities make it tempting to assume that there are simple cause-effect relationships that would allow a policy maker to directly manipulate prices and output. While the Fed can control the monetary base, the behavior of prices and output is based on a whole range of factors outside of the Fed's control. Except at the shortest maturities, interest rates are also a function of factors well beyond monetary policy. Analysts and even policy makers often ignore equilibrium, preferring to think only in terms of demand, or only in terms of supply. For example, it is widely believed that lower real interest rates will result in higher economic growth. But in fact, the historical correlation between real interest rates and GDP growth has been positive - on balance, higher real interest rates are associated with higher economic growth over the following year. This is because higher rates reflect strong demand for loans and an abundance of desirable investment projects. Of course, nobody would propose a policy of raising real interest rates to stimulate economic activity, because they would recognize that higher real interest rates were an effect of strong loan demand, and could not be used to cause it. Yet despite the fact that loan demand is weak at present, due to the lack of desirable investment projects and the desire to reduce debt loads (which has in turn contributed to keeping interest rates low), the Fed seems to believe that it can eliminate these problems simply by depressing interest rates further. Memo to Ben Bernanke: Loan demand is inelastic here, and for good reason. Whatever happened to thinking in terms of equilibrium? Neither economic growth nor the demand for loans is a simple function of interest rates. If consumers wish to reduce their debt, and companies do not have a desirable menu of potential investments, there is little benefit in reducing interest rates by another percentage point, because the precise cost of borrowing is not the issue. The current thinking by the FOMC seems to treat individual economic actors as little, unthinking toy blocks that can be moved into the desired positions at will. Instead, our policy makers should be carefully examining the constraints and interests that are important to people, and act in a way that responsibly addresses those constraints. A good example of this "toy block" thinking is the notion of forcing individuals to spend more and save less by increasing people's expectations about inflation (which would drive real interest rates to negative levels). As I noted last week, if
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one examines economic history, one quickly discovers that just as lower nominal interest rates are associated with lower monetary velocity, negative real interest rates are associated with lower velocity of commodities (hoarding). Look at the price of gold since 1975. When real interest rates have been negative (even simply measured as the 3-month Treasury bill yield minus trailing annual CPI inflation), gold prices have appreciated at a 20.7% annual rate. In contrast, when real interest rates have been positive, gold has appreciated at just 2.1% annually. The tendency toward commodity hoarding is particularly strong when economic conditions are very weak and desirable options for real investment are not available. When real interest rates have been negative and the Purchasing Managers Index has been below 50, the XAU gold index has appreciated at an 85.7% annual rate, compared with a rate of just 0.1% when neither has been true. Despite these tendencies, investors should be aware that the volatility of gold stocks can often be intolerable, so finer methods of analysis are also essential. Quantitative easing promises to have little effect except to provoke commodity hoarding, a decline in bond yields to levels that reflect nothing but risk premiums for maturity risk, and an expansion in stock valuations to levels that have rarely been sustained for long (the current Shiller P/E of 22 for the S&P 500 has typically been followed by 5- to 10-year total returns below 5% annually). The Fed is not helping the economy, it is encouraging a bubble in risky assets, and an increasingly unstable one at that. The Fed has now placed itself in the position where small changes in its announced policy could have disastrous effects on a whole range of financial markets. This is not sound economic thinking but misguided tinkering with the stability of the economy.
Implications for Policy

In 1978, MIT economist Nathaniel Mass developed a framework for the liquidity trap based on microeconomic theory - rational decisions made at the level of individual consumers and firms. The economic dynamics resulting from the model he suggested seem strikingly familiar in the context of the recent economic downturn. They offer a useful way to think about the current economic environment and appropriate policy responses that might be taken. "The theory revolves around a set of forces that for a period of time promote cumulative expansion of capital formation, but eventually lead to overexpansion of capital production capacity and then into a situation where excess capacity strongly counteracts expansionary monetary policies. "The capital boom followed by depression runs much longer than the usual short-term business cycle, and is powerfully driven by capital investment interactions. The weak impact of monetary stimulus on real activity arises because additional money has little force in stimulating additional capital investment during a period of general overcapacity. Instead, money is withheld in


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idle balances when profitable investment opportunities are scarce." In one illustration of the model, Mass introduces a monetary stimulus much like what Alan Greenspan engineered following the 2000-2002 recession (which was also preceded by an unusually large buildup of excess capacity, leading to an investment-led downturn). Though Greenspan's easy-money policy didn't prompt a great deal of business investment, it did help to fuel the expansion in another form of investment, specifically housing. Mass describes the resulting economic dynamics: "Following the monetary intervention, relatively easy money provides a greater incentive to order capital... But now the overcapacity that characterizes the peak in the production of capital goods reaches an even higher level than without the stimulus. This overcapacity eventually makes further investment even less attractive and causes the decline in capital output to proceed from a higher peak and at a faster pace. Due to persistent excess capital which cannot be reduced as fast as labor can be cut back to alleviate excess production, unemployment actually remains higher on the average following the drop in production." In what reads today as a further warning against Bernanke-style quantitative easing, Mass observed: "Even aggressive monetary intervention can do little to correct excess capital... Once excess capacity develops, the forces that previously led to aggressive expansion are almost played out. Efforts to prolong high investment can produce even more excess capital and lead to a more pronounced readjustment later." Mass concluded his 1978 paper with an observation from economist Robert Gordon: "Why was the recovery of the 1930's so slow and halting in the United States, and why did it stop so far short of full employment? We have seen that the trouble lay primarily in the lack of inducement to invest. Even with abnormally low interest rates, the economy was unable to generate a volume of investment high enough to raise aggregate demand to the full employment level." I've generally been critical of Keynes' willingness to advocate government spending regardless of its quality, which focused too little on the long-term effects of diverting private resources to potentially unproductive uses. His remark that "In the long-run we are all dead" was a reflection of this indifference. Still, I do believe that fiscal responses can be useful in a protracted economic downturn, and can include projects such as public infrastructure, incentives for research and development, and investment incentives in sectors that are not burdened with overcapacity. Additional deficit spending is harmful when it fails to produce a stream of future output sufficient to service the debt, so the expected productivity of these projects is the essential consideration. Given
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present economic conditions, it appears clear that Keynes was right about the dangers of easy monetary policy when an economic downturn results from overcapacity. As I noted last, better options are available on the fiscal menu.

A Primer on Quantitative Easing: What Is It and Will It Save the Economy?
By Hans Wagner Created 10/29/2010 - 18:28

Quantitative Easing (QE) is a hot issue. But even though the term is used frequently by journalists, analysts and investors, most people are only repeating what they heard someone else say. Let's see if we can shed some light on QE: the challenges the Fed is facing, the actions it's likely to take, and what an investor should do to prepare. The upcoming announcement from the Federal Reserve will be one of the most important in recent months. The question is what you should do to be ready when the news is announced. Some Basics Quantitative easing is a strategy employed by a central bank like the Federal Reserve to add to the quantity of money in circulation. The premise (which is largely theoretical and untested) is that if money supply is increased faster than the growth rate of Gross Domestic Product (GDP), the economy will grow. To understand the rationale behind the strategy, it helps to look at the basic relationship among GDP, money supply and the velocity of money. In general, GDP equals money in circulation (M) times the velocity of the money through the economy (V): GDP = M * V Velocity is the speed at which money passes through the hands of one person or company to another. When money is spent quickly, it encourages growth in GDP. When money is saved and not spent, the GDP of the country slows.Today, one of the problems the United States faces is people and companies are saving their money and paying down debt instead of spending it. When people spend less and save more, the velocity of money falls and drags down economic growth. Through quantitative easing, the Federal Reserve will try to counteract falling velocity by increasing the money supply. It has two primary tools with which to do it.
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The first way the Fed manages money supply is via the federal funds rate. Banks with excess reserves can lend money to other banks that need additional reserves before closing their books for the day. The federal funds rate is the interest rate the banks charge each other for these overnight transactions. The Federal Reserve sets the federal funds rate. As one of the most important interest rates in the world, it is widely quoted in the press.

The current fed funds rate is between 0% and 0.25%. Essentially banks can "borrow" at a very low rate of 0 – 0.25%, making their cost of funds very low. Theoretically, this should encourage banks to lend funds to individuals and businesses at higher rates -- if they can borrow at 0% and lend to someone else at more than 0%, they make money. The second tool the Fed uses is the open market operation (OMO). The Fed uses OMOs to buy or sell securities that banks generally own -- mortgages, Treasury bonds, and corporate bonds. When the Federal Reserve buys securities, they trade the security for cash and increase the money supply. When they sell securities back to banks, they decrease the money supply. In the past, the Federal Reserve has not resorted to this approach to manage the supply of money in the economy. But starting in 2008, it started buying large amounts of mortgage-backed securities (MBS) and Treasuries in order to add more money to the economy and help stabilize the banks. Where We Are Today Since the Federal Reserve has lowered the fed funds rate to 0 – 0.25%, banks have access to cheap money. The Fed was hoping that access to cheap money would encourage the banks to lend to their customers at reasonable rates. But it hasn't been that easy. The Fed has run into two problems. First, many companies and individuals are afraid to borrow. They lack confidence in the economy. They prefer to save their cash and pay down existing debt. This phenomenon is reflected in the rising savings rate and the falling level of consumer and corporate loans. Not only has money supply not increased, but increased saving has slowed the velocity of money through the economy. Second, banks are afraid to lend because they're afraid they won't get it back. Should the company or individual run into financial difficulty, the bank may be stuck with a loan loss. So instead of investing in loans, the banks are turning back around and buying high-quality securities like long-term Treasury bonds. Today, a 10-year Treasury is paying a yield of around 2.5%. With a cost of funds of 0.25%, this gives the bank an interest rate spread of 2.25% -- a very nice profit with almost no risk.


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All of this means the Federal Reserve's attempt to stimulate the economy with low short term rates is not achieving its desired goal. The economy remains in slow growth mode. And relatively high long-term Treasury yields (when compared to 0% short-term yields) have perversely created an incentive for banks to stop making loans except to the U.S. Treasury. How Will Quantitative Easing Help? The Federal Reserve recognizes that banks are using very cheap short-term money to purchase longer-term securities and pocketing the difference in interest income. So the Federal Reserve has decided it wants to drive down longer term rates and remove the incentive to buy Treasuries. If the Federal Reserve buys enough 2-year, 3-year, 5-year and 10-year Treasuries, they force an increase in their prices. And bond prices are inversely related to bond yields: when prices go up, yields go down. A lower yield means banks cannot make as much money using the overnight money at 0 – 0.25% and buying long-term Treasury bonds, since the yield on those bonds will be pushed lower and lower. The hope is the banks will then be encouraged to lend more, thereby stimulating the economy. The Bottom Line Most people expect the Federal Reserve to announce they will add another $1 trillion in new money to the economy by buying Treasuries. I don't think the Fed will go that far that soon. Announcing a large number commits the Fed to buying that many Treasuries and it doesn't give it the flexibility it needs to adjust the program as its effects ripple through the economy. Rather, I believe the Fed will announce it stands ready to purchase 2, 3, 5 and 10-year securities in blocks of about $100 billion a month. The exact makeup will depend on the Fed's view of where it can get the biggest benefit for the money spent. By carrying out the quantitative easing over a series of months, the Federal Reserve allows itself some flexibility to adjust purchases based on updated forecasts of the economy. It also allows the Fed to communicate its intentions over time, cutting down on the number of surprises inflicted on the fragile economy. If the Federal Reserve buys $100 billion of intermediate-term Treasuries each month, it will place downward pressure on the interest rates of the Treasuries they purchase. But because the Fed has already telegraphed its intentions to the market, rates have fallen significantly in anticipation of the official quantitative easing announcement. Therefore, we are likely to see a brief move up in longer-term rates as bond traders close out their profitable positions.


James M Edwards 602.441.4303

After the initial shake out in the stock and bond markets, it's certain that economist will continually monitor the economy to gauge QE's effectiveness. If the program is encouraging more lending, the economy should start to grow faster. But if lending does not pick up, it is telling us borrowers and/or lenders lack confidence in the future and are unwilling to compromise their balance sheets. If this happens, the economy will remain in slow growth mode. Fed Chairman Ben Bernanke is sure to make regular announcements on the state of the program. If he indicates they will buy more Treasuries in the future, it means the economy is not responding as well as he hoped, and he wants to add more money to the system. If he suggests the Fed will reduce purchases, it indicates his belief that quantitative easing is working and the economy is improving. As far as trading, the short-term downside vastly outweighs the upside, if only because of uncertainty. If you are a short-term trader, you might want to move to cash to avoid the inevitable volatility that will ensue, as this is a sell on the news event. If you are a longer-term investor, be sure to add some downside protection to your portfolio. You may also want to own some longer-term Treasuries, since the whole point of QE is to drive up the price of those specific securities. Don't be prepared to hold them forever, though. At some point (hopefully), the economy will grow again and bond prices will come back down. This round of quantitative easing will be studied for years. We are in uncharted territory and the risks should not be underestimated. Capital preservation is important to success. Take steps to reduce your risk until we have a better idea of the longer term effects of this next round of QE.


James M Edwards 602.441.4303


James M Edwards 602.441.4303

Standard CFTC disclaimer:
The risk of loss in trading commodities can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. In some cases, managed commodity accounts are subject to substantial charges for management and advisory fees. It may be necessary for those accounts that are subject to these charges to make substantial trading profits to avoid depletion or exhaustion of their assets. The disclosure document contains a complete description of the principal risk factors and each fee to be charged to your account by the commodity trading advisor ("CTA"). The regulations of the Commodity Futures Trading Commission ("CFTC") require that prospective clients of a CTA receive a disclosure document when they are solicited to enter into an agreement whereby the CTA will direct or guide the client's commodity interest trading and that certain risk factors be highlighted. This disclosure document will be provided via electronic mail or hard copy upon request to any interested parties. This brief statement cannot disclose all of the risks and other significant aspects of the commodity markets. Therefore, you should examine the disclosure document and study it carefully to determine whether such trading is appropriate for you in light of your financial condition. The CFTC has not passed upon the merits of participating in this trading program nor on the adequacy or accuracy of the disclosure document. We are required to provide other disclosure statements to you before a commodity account may be opened for you.

Written by James M. Edwards 602-441-4303 Please do NOT redistribute the letter.


James M Edwards 602.441.4303

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