Thursday, 19 March 2009

Disappearing Income

The following are some thoughts on the Fed's announced policy of Quantitative Easing.
How should we interpret the desire of those who will be selling their current holdings of Treasuries and other asset backed securities to the Fed as a replacement for their entitlement to receive a future reliable income stream?
The substitution of immediate liquidity for longer term income is just one of the many troubling aspects of QE. Why would a pension fund or an insurance company want to receive large dollops of cash now rather than a recurring coupon income downstream? Aren't these companies maturity transformation vehicles that need to manage their liabilities with the duration of their holdings of income generating assets? If so then one has to become genuinely intrigued as to why these companies should (or would want to) benefit from the replacement of a long term payment stream by a one-off large payment or credit to their account with the Federal Reserve. Could the reasoning behind the QE move be that some major pension funds and insurance companies have hit the wall in terms of their immediate liquidity requirements?
The economic environment can increasingly be characterized as one of income disappearance. There is an ongoing decline in the number of corporations paying any, or maintaining, their dividends. Continuing rises in the level of global unemployment is leading to a chronic reduction in the returns to labor; and now exacerbated by the QE policy there is even further reduction in the returns to savings and fixed income instruments. All of this is surely pointing to a structural asset deflationary spiral that, in the context of a monetary policy environment of zero based interest rates (actually negative if even modest consumer price inflation is factored in), is now de facto beyond the influence of central bankers. So perhaps it is just a growing sense of desperation which explains the timing of the policy move.
There may even be a further element of desperation to the timing which is not yet manifest.
It is possible to hypothesize, without appearing to be too conspiratorially minded, that there may be some event or realization that has been made by the Fed which is requiring them to be out in front of some new potentially devastating development in the ongoing financial meltdown. The timing of the policy announcement, coming so soon after the Chinese government announced its concerns about the creditworthiness of the US Treasury, is even more than a little puzzling. Could it be that the Fed have realized that the demand from traditional sources (e.g. China, Japan and the Middle East) for the enormous supply of sovereign credit that needs to be funded this year and in coming years can no longer be relied upon?
The positive spin that has been put on the fact that recent Treasury auctions have gone well does not re-assure. The main buyers at these auctions (e.g. PIMCO) know that there is enormous short term liquidity in Treasury instruments, especially so in a risk averse market place, and even before yesterday's declared policy it was widely recognized that the Fed would step in at the first hint of any shortage of buyers at a US Treasury auction.

Very similar reasoning can be applied to the decision made by the Bank of England to engage in its own version of QE which was adopted earlier in March. The UK government faces even larger refunding needs as a percentage of GDP and does not have the benefit of a reserve currency.

Perhaps the rationale for the Fed's timing is to keep up with the leaders in the competitive devaluation scenario. It could be argued that QE is nothing more than a currency debasement strategy thinly disguised. Maybe the FOMC's decision shows that the US is not overly concerned at present about importing inflation from a weaker dollar and does not want to get left behind in the race to the bottom as other currencies are being managed downwards. But this does not seem likely to provide a tangible benefit in the near term as world trade is diminishing, the sale of visible goods is declining and the value of the invisible balance of payments account is something that the US cannot be too cavalier about.

Rather I would suggest that best way to consider the timing of the QE policy is that it is tied pragmatically to the US real estate market and that the Fed is being encouraged by, and hoping to germinate, anecdotal evidence that the bottom may be in sight and that this is a good time to be providing maximum support to the mortgage origination and re-financing market.

Not just in the US but in many parts of the world, central bankers are now becoming desperate to try to ignite some spark under their property markets. Much more so than even supporting equity markets, central banks know that the most damaging form of wealth destruction and the evaporation of consumer confidence is evidenced by the perception that property values remain in free fall.
Will the QE inspired reduction in mortgage rates spark some life into the US property market?
It is highly unlikely on its own to do so because the Fed and other central banks appear to be overlooking the fact that only macro increases in income levels will be able to drive a sustainable recovery path. Residential and commercial property prices/rents are still not genuinely affordable, and will not become so while final demand and levels of employment are declining and, notwithstanding even both of those changing direction, it can be further argued not until the median value of a family home has reverted to a more historically sustainable alignment with median family income.

It is axiomatic (or should be) that spending capital (even phantom capital that the Fed just prints) is not the path to renewed economic growth and the desire to stimulate a new property based asset reflation, based on injecting new capital in place of future income into financial intermediaries is just a variation on the theme that has been tried now for several months and which is clearly not yet showing any evidence that it is working. Unless capital infusions are harnessed in an economically productive manner and the requisite amount of time is provided to enable that capital to generate real increases in long lived income, in one or all of its many forms, the QE initiative is going to lead us towards yet another dead end.

As income sources are rapidly disappearing on a global basis and there is no engine to drive authentic (as opposed to Ponzi based) asset inflation the Fed's chosen path appears to be one of borrowing more from future generations to re-finance the current debt at nominally lower rates. The knock on effect that they are engineering will be extraordinarily low mortgage rates and the Fed's hope is that this may trigger some new arithmetic showing much greater affordability in the housing market.

Apart from the amorality of continuing to pile up ever more inter-generational debt this reliance on trying to engineer abnormally low long term rates to jump start the property market is dangerous, desperate and self-defeating. If buyers are tempted back into the property market by the rigged mortgage rates on offer we will only be back into a new default cycle as these buyers will once again have been seduced into buying homes that, in the fullness of time, they really could not afford.

No comments:

Post a Comment