SHARE THIS

QE, It Just Won’t Go Away…..

The Federal Reserve has finally thrown its weight behind the long-proposed change in what is known as the Supplementary Liquidity Ratio for banks, ostensibly so that the banks will then be able to buy more government bonds. This, along with the ongoing encouragement of more leveraged flows into the crypto verse, and in particular the promotion of the use of stablecoins which traditionally hold the bulk of their own assets in T Bills, and the tease of privatizations, all seem to part of the same overall plan - namely to get as many entities as possible to create new money by themselves borrowing and then using the proceeds of this money creation to buy some asset issued by the government.

Everything, it seems, is about funding the government and, as we enter a three-month period during which the Federal Deficit is usually quite large for seasonal reasons, we can see just why Mr Bessent and his colleagues are so focussed on this increasingly pressing issue.

As we have never tired of saying, the simple fact is that the US – and many other – governments are trying to borrow much more than their households save, implying that either funds have to be bid away from other existing assets; or sourced from companies and foreigners (most likely) via the medium of damaging higher yields; or the deficits have to be shrunk (however painfully); or the authorities have to employ “funny money” sourced from bank credit. The latter used to be known as “underfunding” but nowadays we just call it QE or even more colloquially, money printing.

Ask the risk of being pedantic, the term under-funding encompasses not only “conventional QE” but also the practice of yield curve riding by banks - a favourite recourse in the USA during the recovery from the LATAM Debt Crisis and again following the 1990s’ S&L Crisis - and the more esoteric “leveraged speculation into entities that then buy treasury debt. Another favourite that falls into this type of policy, and which has been employed of late has been the “reduction of non-monetary liabilities of the central banks”, a process typified by the drawdowns in the US Treasury General Account, the public sector cash balances in Europe, and the unwinding of the Federal Reserve’s own Reverse Repo facility in 2023/24. Clearly, there is more to money printing than just QE, and there has certainly been plenty of money printing occurring in some parts of the World over recent months – particularly within the Euro Zone since France’s difficult moments late last year.

The ECB may not have been buying bonds directly, but commercial banks have been, with the result that our measures of “global QE” have been remarkably buoyant of late. No wonder equity markets have once again developed a Teflon-like quality when it comes to absorbing bad news, and there has been plenty of the latter to digest recently.

When a bank, or someone using newly created credit from a bank buys a government bond, the government of course then receives the money. The money is spent, and is then credited to the recipients’ bank accounts. The banks’ then have more money, that they can then use either to make more loans within the economy, or they can buy more bonds. Either way, financial sector liquidity rises, and asset prices usually benefit if the new money coming into the system from this “underfunding of the deficit” exceeds any that is leaving via net capital outflows, current account deficits or, occasionally, repayments of debt.

In fact, over the last few months, the US has witnessed larger net capital inflows than its current account deficit and there has been little or no retirement of private sector debts, so US liquidity trends have been quite bright. Cue the Teflon-coated equity market……

If, however, the Treasury were to have to rely on real money investors surrendering “old money” to buy bonds, then there is simply a transfer of funds from financial market recipients to people in the real economy – there is no liquidity effect and the deficit is “funded”. Moreover, some countries have, over recent months, been raising more money than they needed to fund their current budget deficits and have been hoarding the surpluses in sterile deposits at their central banks (this is called over-funding), with the result that there has been a net withdrawal of liquidity from countries including Japan, Korea and Taiwan.

Clearly, Mr Bessent and Wall Street especially would prefer that the USA stayed firmly on the underfunding end of the spectrum, as indeed it has for much of the last five years (2022 being the year that it did not and markets were weak…).

In fact, we suspect that it is this topic, rather than events in the Gulf or elsewhere that implicitly at least is foremost in the mind of the market at present. In fact, it seems to us that unless the under-funding of the deficit is continued, then there is a clear and present danger to US asset prices, both in the debt and equity markets. The stakes could not be higher over the next three months as government borrowing starts to rise.

Ultimately, we have no doubt that the US will follow the Eurozone into under-funding its deficits and that, just as we witnessed following the pandemic, this reliance on funny money will undermine the value of money: higher inflation will result. On a longer-term basis, we believe that investors should start to look to acquire protection against inflation. Since in reality this under-funding is just old-fashioned currency debasement; it will be done not by clipping coins or adding lead to the smelters but through the use of credit in the debt markets. However, crossing the Rubicon back to this type of practice will require a catalyst, and we expect that catalyst to be a moment of indigestion in the debt markets in a month or two, something that could also pose a risk to equities, for a while at least. Markets are currently enjoying the tail end of a little mini-QE boom but we fear there may be a pause in proceedings next month before QE comes back in earnest later this year.