The U.S. Takes One Giant Step Toward Monetizing The Debt

The U.S. Takes One Giant Step Toward Monetizing The Debt

While the average person finds more frustration than solace attempting to understand the actions of the Federal Government and its effects on the economy, I write this blog post to illuminate the fork in the road we are coming to, andexplain the very significant differences in QE2 vs. the first round of quantitative easing (QE1).

The term quantitative easing essentially means that our Federal Government is going to purchase certain assets targeted to offer relief from current fiscal pressures to what we will call a designated beneficiary(s).As a parent you engage in this action when you bail out one of your children from a severe financial mess, while encouraging your other children to seek their own solutions to their financial emergencies (your problems are not our problems, but we are pulling for you). QE1 was comprised of many liquidity efforts known by different acronyms but was primarily a governmental act of purchasing $1.25 Trillion of mortgage backed securities and Freddie and Fannie Agency debt.

At Alpha Fiduciary, we made a tactical decision to purchase the 20 year treasury index at that time, because we knew that the intended beneficiaries of MBS purchases (troubled U.S. banks) would take the cash in exchange for distressed mortgage backed securities and park that cash(excess reserves) in Treasuries with the Federal government.

To restate, the first round of QE was focused on repairing severely damaged bank balance sheets caused by poor lending decisions at these banks. Congress certainly owns some of the responsibility for setting the stage for the ludicrous decisions made with the intent that no person was excluded from the American dream of home ownership. We know from the statistics of Lottery winners who end up broke just a few years after taking tens or even hundreds of millions in lump sum winnings, that not everyone is cut out to manage the responsibilities of having wealth.

The bottom line effects of QE1 were that not only did the Fed purchase $1.25 Trillion of distressed debt from these banks, but they paid $2.5 Billion a year in interest to these banks (.25%) with the intention that the banks would start lending again.Of course in retrospect, it would seem that lending was seen by the banks as a more risky move than paying large bonuses to bank employees. Whatever you think about QE1 It did serve the purpose of repairing (albeit temporarily) bank balance sheets. As I mentioned, the shortcoming of QE1 was that banks did nothing to help main street and thus with the confluence of uncertain Washington policy and tight credit the economy is stuck in a rut, which sets the stage for QE2.

This is where the similarities end; Where QE1 was intended to benefit the banks and eventually flow to the consumer, QE2 is specifically designed to benefit the Federal Government with the hopeful added benefit of stimulating the economy, hence the fork in the road depending on the outcome.

The Fed will begin buying $110 billion per month of Treasuries, not coincidentally that totals to exactly the projected deficit of the Federal Government next year. What this means is that we have entered a new chapter in that our Federal Government is going where many others have tried and none, to my knowledge, have succeeded in thatthey are monetizing the Federal debt.

I should point out that this is being orchestrated by the same Ben Bernanke who stated in June 2009 that, "cuts in spending or increases in taxes will be necessary to stabilize our fiscal situation, but the Federal Reserve will not monetize its debt".

I awoke before 4am on this my daughter 21st Birthday because I wanted to read the G20 comments to judge how the world stage views the Feds QE2. In summary China stated, "considering the influence of the policy moves in the major international reserve currencies on the global economy, it is necessary for the issuer of the international reserve currency (the U.S.) to report to and communicate with the G20 group before it makes major policy shifts".

This is tantamount to China calling on the G20 to consider that the dollar should not remain a reserve currency. This has obvious implications for the value of the dollar in the future (tactical trade coming?).

Remember that Treasury Secretary Tim Geithner promised just a few weeks ago, that the U.S. would retain its "strong dollar" policy, which of course led to conflicted US banks and their trust companies telling their clients it was time to average down and buy more dollars! When you toast to the new year in a few weeks you might also say a prayer, If you are so inclined, that fifteen major developed country governments are able to raise $ 10.2 trillion to repay maturing bonds and finance their budget deficits. According to the International monetary Fund (IMF), this debt level equals close to 30% of their combined annual economic output(GDP) and most certainly is one reason for the G20 discomfort toward U.S. fiscal policy, as it has a destabilizing effect on the global financial stage.

To be clear, the fed had only two choices: austerity or money printing. If QE2 works business will improve, correspondingly unemployment will decline and state federal tax receipts will increase.If it fails, we can expect very difficult decisions around the corner as the fed either has to hike interest rates to defend the dollar, or suffer devaluation and a federal government having to slash, not trim expenditures, to have any chance of servicing the mushrooming carrying costs on the debt.

Please understand the gravity of this, the fed slashing spending is the fed slashing GDP, and taken two steps further, If GDP declines the fed gets lower revenues which will necessitate further spending cuts. QE2 Is a very risky bet which if understood can be mitigated in the portfolios of investors utilizing a tactical multi asset class approach while monitoring all of the appropriate leading indicators of the economy to gauge the success of the bet.

Be well!

www.alphafiduciary.com

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