STOCK MARKET WATCH -- Monday, 29 October 2012

[Demeter]

29. On The Fullness And Boldness Of QE's Manipulation Of American's Behavior

http://www.zerohedge.com/news/2012-10-28/fullness-and-boldness-qes-manipulation-americans-behavior

With equity markets having reverted to pre-Draghi and pre-Bernanke levels, retail mortgage rates and MBS spreads now above pre-QEtc. levels, and the fundamental reality of the world's credit-driven growth peeking through into the new normal 'muddle-through'; it seems increasingly evident that central banks' actions (or the anticipation of such) are all that keeps advanced economies from crumbling back onto their non-vendor-financed rational valuations. The question is - who are the central banks really trying to help? Baupost's Seth Klarman provides the most clarifying and thought-provoking assessment of both the Fed's actions (quantitative easings specifically) and the moral hazard implicit in their deeds (as well as words):

Via Seth Klarman of Baupost's Q3 Letter:

Our Thoughts on QE3



On September 13 the Federal Reserve initiated QE3, a variation of the first two quantitative easings, involving the government buying back $40 billion per month of mortgage securities while maintaining the Fed's near-zero interest rate policy through mid-2015, nearly a full seven years after the financial market collapse of 2008. The goal of QE3 is to drive interest rates on 30-year mortgages lower (they reached an all-time record low of 3.36% in early October) while concurrently lifting housing prices (and inevitably the stock market), triggering a theoretical wealth effect that would potentially bolster consumer spending.

While QEs 1 and 2 had no lasting impact, they did give a short-term boost to the stock market But because that effect was ephemeral, it's hard to comprehend why anyone would believe that QE3 will turn out better. QE3 is bold in its apparently unlimited duration, which may be intended more to demonstrate the Fed's determination rather than any actual conviction that it will work. Perhaps the oddest part of the ongoing QE scheme is that everyone can see in its fullness and boldness the attempted manipulation of Americans' behavior. (If people know they are being manipulated, do they behave exactly the same as if they don't know?)

While anyone would be glad to have a cheaper mortgage as a result of QE3, would they really believe this would make their home worth more? It's more of a credit holiday, whereby the government offers you better terms than previously available. In addition to making explicit the implicit U.S. government guarantee of more and more of the U.S. residential mortgage market, the rousing stock market approval of this measure is seen as a free lunch. But of course it is not free. For one thing, buying mortgage securities with newly printed money has the same inflationary risk that QEs 1 and 2 posed. This probably explains why gold rose strongly in response to this announcement.

Also, artificially low interest rates have a cost to the government. As we know from the recent U.S. housing price collapse, mortgage lenders can indeed lose money. The guarantor of the U.S. housing market has a huge contingent liability. Moreover, the U. S. housing market was clearly overbuilt (by five million homes, according to some estimates) as of 2007, yet cheap financing may attract temporary incremental demand which home-builders might interpret to be permanent and thus overbuild all over again. This highlights the deleterious second and third order effects of well-intended but ill-conceived government programs.

It is clear that someday the Fed will decide that the economy has strengthened sufficiently to end and then potentially reverse QE and zero-rate policies. (I'M NOT HOLDING MY BREATH--I THINK WE CROSSED A BLACK HOLE'S EVENT HORIZON, MYSELF--DEMETER) Any possible sale of trillions of dollars of securities owned by the Fed, at such time would most likely be at a substantial loss given that interest rates would likely have risen and bond prices have fallen. Also, when people with a 30 year, 3.5% mortgage seek to move at a time when new mortgages now cost 5% to 6% or more, buyers will pause, reducing demand and driving house prices lower. QE3 may deliver a dose of helium to housing prices, but eventually helium leaks out of balloons, and gravity pulls them to earth. What kind of policy is this: untested; inflationary; eroding free market signals; diverting more of the country's resources toward housing at the expense of priorities such as infrastructure, technology, or science and medical research; and inevitably only a temporary fix with no enduring benefit?

Finally, we must question the morality of Fed programs that trick people (as if they were Pavlov's dogs) into behaviors that are adverse to their own long-term best interest. What kind of government entity cajoles savers to spend, when years of under-saving and overspending have left the consumer in terrible shape? What kind of entity tricks its citizens into paying higher and higher prices to buy stocks? What kind of entity drives the return on retirees' savings to zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? Not the kind that should play this large a role in the economy.