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Richard Koo: Unwind Of QE2, With Nothing To Replace It = Biggest Depression Yet

"In other words, if stock and commodity prices are in fact in a bubble and if those bubbles were to collapse, the balance sheets of the financial institutions and hedge funds making investments with the expectation of higher asset prices could suffer heavy damage, exacerbating the balance sheet recession in the broader economy. an increase in DCF values, either." And there you have it: Bernanke's all in gamble that QE2 would have been sufficient to restore the virtuous circle of the economy has failed with less than 2 months to go under the QE2 regime. As such, and with fiscal stimulus a dead end, the Fed has two choices: watch as the economy collapses in flames to a state far worse than its pre-QE1 outset, or do more of the same. That's all there is. The rest is irrelevant. And since the Fed will choose the latter option, the market would be wise to start pricing in precisely the same reaction as what happened following the Jackson Hole speech...although to the nth degree. And some other key observations from Koo: Government borrowing has supported money supply growth Unable to buy more government bonds or private-sector debt, investors have few places to turn In the hope of producing a portfolio rebalancing effect, Chairman Bernanke declared that the Fed would purchase $600bn in longer-term Treasury securities between November 2010 and June 2011. This was roughly equivalent to all expected Treasury debt issuance during this period. From a macroeconomic standpoint, these purchases of government debt meant that—in aggregate—private-sector financial institutions would be unable to increase their purchases of US Treasury securities, because all of the growth in Treasury issuance would be absorbed by the Fed. The fact that US businesses and households were rushing to repair balance sheets by deleveraging meant that—again, viewed in aggregate—private investors would be unable to increase their purchases of private-sector debt. With the private sector no longer borrowing and all new issues of government debt being absorbed by the Fed, US institutions found themselves with few investment options. So funds found their way to equities and commodities The only remaining destinations for these funds were equities, commodities, and real estate. Real estate had just been through a bubble and remained characterized by heavy uncertainty. In commercial real estate, for example, banks—at the request of US authorities—are engaging in a policy of “pretend and extend” and offering loans to borrowers whose debt they would never roll over under ordinary circumstances. That means that current prices do not accurately reflect true market prices. Housing prices, meanwhile, resumed falling late in 2010. UK house prices have been falling since mid-2010, and the Halifax House Price Index dropped 1.4% in April 2011 alone (the decline was 3.7% on a y-y basis). The only remaining options for private-sector investors have been stocks and commodities. That, in my opinion, is why both markets have surged since the announcement of QE2.

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