When the credit crisis erupted in the summer of 2008 and the S&P 500 began to crash, the Fed’s Balance sheet was flat and at a very low level for the remainder of that year and into early 2009. It was at that point that QE 1 began. The Fed began buying up MBS securities (Mortgage Backed Securities) they were the derivatives behind the collapse of several major institutions and brokerage houses.
The beginning of the QE program marked the exact bottom in the S&P 500 index. We then had a huge almost uninterrupted run up in price from 700 level to near the 1100 level in January 2010. It then moved lower but found further buying running to 1200 in April 2010 where it stalled out and fell off quite sharply surrendering nearly 200 points before it bottomed again in July 2010. Would you believe during this time (during the decline in S&P) the Fed’s Balance Sheet began flatlining again and actually began to shrink somewhat.
Thus, the reasoning goes that the 200 point loss (16% loss in 3 months) in the S&P was due to the fact that the Fed’s first Quantitative Easing program was coming to an end and traders began to fear the worst, meaning NO MOH FREE DOUGH or end of the liquidity injections into the banking system. It was this free money, which had fueled the enormous rally in US stock markets over the course that past year.
Then from April 2010 to August 2010, the stock market basically went nowhere. Traders were believing that the worst of the credit crisis fallout was behind them but they could not see any signs of strong economic growth, at least growth in sufficient size to justify taking the stock indices any higher. You might even remember that it was during time April 2010 drop in stock prices that the phrase, “green shoots” ala financial media, ala "The Maria's, Michelle's and Erin's, I had to stop eating Kashi, I was so full of green shoots, well you get the picture. So what happened to the green shoot, well they died on the vine when it appeared that QE1 was ending and there was nothing to take its place. And as noted earlier during this time frame the Balance Sheet of the Federal Reserve was shrinking.
In September 2010 it was announced that since the economy was still encountering strong headwinds, another tool would be needed to stave off deflationary pressures and provide more liquidity to “gradually increase inflationary pressures” which would be necessary to break any deflationary mindset. And even though the QE2 program was not to be implemented until November 2010, the stock markets went gaga and launched into another rally taking the S&P 500 past the old April high and onto new heights near 1330's before the correction. So once again we see a correlation between the further expansion of the Fed’s Balance Sheet with QE2 and the move in S&P.
The conclusion we can draw through all of this is very simple – it is the expansion of the Fed’s Balance Sheet through both QE1 and QE2 which has supplied the liquidity driving equity markets higher. Without this liquidity the economic expansion has been far too fragile to continue on its own. So any talk about the Fed supposedly withdrawing this liquidity one has to believe that the economic recovery is of sufficient strength to hold its own without it. So QE isn't going anywhere!
So that is all well and good now lets look at whats not working, the Fed has been attempting to keep interest rates artificially low and make credit cheap and plentiful well since the QE started the rates have gone from 3.2 to 4.7 until the recent pullback on the 30 year.
Fed can't stop printing money or say if the starts selling the treasuries they bought as a result of QE (thats what they are doing, Peter to pay Paul) it will cause an undesired effect pushing rates higher above the short end of the yield curve. The net result would be a tightening of credit and slowing its growth precisely at a time in which higher energy costs are crimping both businesses and consumers (Crude over 100).
Can anyone seriously believe that if crude oil prices remain near current levels and gasoline subsequently stays closer to $4.00 that the Fed is going to actually attempt to shrink the size of its balance sheet by selling off Treasuries. Higher interest rates would be catastrophic for a real estate sector which is still in the ICU and isn't responding to treatment, or QE in this case? If you think the rate of job hiring is anemic now, what do you think will happen if interest rates start moving higher on withdrawal of liquidity or even talk of it, YIKES.
The last point I wish to make and is a bit unrelated to this but is relevant – The unstated purpose of the Fed’s QE2 program was to keep interest rates low to lower borrowing costs for the US federal government. When your national debt is over 14 trillion and rising, when annual budget deficits are above one trillion and the rate of economic growth is not generating sufficient tax revenues to give any hope of seriously closing these budget deficits in the immediate future, it becomes a simple exercise in math that the cost of servicing this huge sum of debt is far easier in a low interest rate environment. When you dealing with numbers of this magnitude, a measly 1% raise in rates carries enormous consequences for US borrowing costs and interest rate payments.
The situation is that the Fed is stuck. It cannot withdraw any liquidity without creating an entirely new set of problems that would more than likely have to be once again dealt with by adding more liquidity and repeating the cycle. Hence QE3 etc, etc, etc...
If this were not already enough, the Japanese are now selling US Treasuries to repatriate money back to their country for rebuilding purposes (Japanese insurance companies hold large numbers of US Treasuries which they will need to sell and convert to yen to pay claims – that is the reason for the big rally in the yen on Friday and the weakness in the Treasuries).
PIMCO sold their US Debt, China is selling, if the dollar keeps going down who will be left to lend us money or if they do they are going to want to get paid more on their investment, that means higher rates, and we can't afford to do that for the reasons I stated previously. God help us, this won't end well.
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