Dangerous Addiction 

Doug Nolan

July 20 – Reuters (Karen Pierog): 

“Risk-off sentiment that drove Monday’s sell-off on Wall Street and rally in U.S. Treasuries widened credit spreads on corporate bonds to multi-month highs. 

The spread on the ICE BofA U.S. High Yield Index, a commonly used benchmark for the junk bond market, spiked from 318 bps on Friday to 344 bps as of the last update late Monday, its highest level since late March, according to Refinitiv data. 

It was also the biggest widening in a day since last June.”

The S&P500 dropped 1.6% in Monday trading, as U.S. stocks followed global equities lower. 

The VIX Index spiked to 25, a two-month high, while 10-year Treasury yields dropped to a five-month low 1.17%. 

Germany’s DAX and France’s CAC 40 indices sank 2.6% and 2.5% - to lows since May. 

Hong Kong’s Hang Seng Index fell another 1.8%, with the Hang Seng China Financials Index trading this week at an eight-month low. 

Global “Risk Off” was gathering momentum.

July 20 – Bloomberg: 

“Fresh signs of a cash crunch at China Evergrande Group sent shares and bonds of the world’s most indebted developer to new lows on Tuesday, stoking fears of broader market contagion. 

The property giant’s stock tumbled to the lowest level since April 2017, extending its two-day loss to 25%. 

Several of Evergrande’s local and offshore bonds sank to records, with its dollar note due 2025 falling to as low as 54 cents. 

Bonds of other junk-rated Chinese borrowers declined, while a gauge of developer shares dropped to a nearly three-year low. 

The nation’s bank stocks also slumped.”

July 20 – Bloomberg (Rebecca Choong Wilkins and Alice Huang): 

“Rising concerns over the financial health of China Evergrande Group are weighing down the broader market of high-yield bonds as contagion fears rise. 

Property developers are leading declines among China’s offshore junk bonds Tuesday. 

Kaisa Group Holdings Ltd.’s 2025 note fell 3.3 cents on the dollar to 92.3 cents, and Guangzhou R&F Properties Co.’s bond due 2023 declined 1.6 cents to 96.8 cents… 

Deepening doubts over Asia’s biggest issuer of dollar junk bonds are spilling over into other parts of the offshore market as investors cut their exposure to riskier borrowers.”

After a brief respite, Chinese Credit stress contagion was again escalating – at least early in the week. 

But the S&P500 then surged 3.6% in four sessions to end the week at all-time highs.  

No adjustments.  

No corrections.

July 22 – Bloomberg (Alexander Weber, Jeannette Neumann and Carolynn Look): 

“Christine Lagarde promised that the European Central Bank has learned from the errors of past crises and won’t derail the current economic recovery by withdrawing emergency support too early. 

The ECB president spoke Thursday as the central bank put into action the new monetary policy strategy it hammered out over the past 18 months. 

It revised guidance on interest rates, tying policy shifts more tightly to hitting its new 2% inflation goal, and said it won’t necessarily react immediately if price growth exceeds that target for a ‘transitory’ period. 

The measures reinforce the ECB’s efforts to convince markets that it will keep ultra-loose policy… in place for as long as needed to revive price stability.”

German bund yields ended the week at a five-month low negative 0.42%. 

Italian yields declined another nine bps to 0.62%, with Greek yields down two bps to 0.65%. 

Ten-year Treasury yields ended the week at 1.28%, despite abundant evidence from company quarterly earnings reports of heightened inflationary pressures and further price increases. 

Again this week, it seemed rather obvious that QE and associated liquidity excess have severely distorted both global bond and stock markets. 

“One myth that’s out there is that what we’re doing is printing money. 

We’re not printing money. 

The amount of currency in circulation is not changing.” 

- Chairman Ben Bernanke, CBS’s 60 Minutes, March 2009

“Sometimes you hear that the Fed is printing money in order to pay for the securities that we acquire… 

As a literal fact, the Fed is not printing money to acquire these securities… 

The amount of currency in circulation has not been affected by these activities. 

What has been affected is… reserve balances. 

Those are the accounts that commercial banks hold with the Fed, and they’re assets of the banking system – and liabilities of the Fed – and that’s basically how we pay for those securities. 

The banking system has a large quantity of these reserves, but they are electronic entries at the Fed – they basically just sit there. 

They’re not in circulation. 

They’re not part of any broad measure of the money supply. 

They’re part of what’s called the monetary base. 

They certainly aren’t cash.” 

- Fed chair Ben Bernanke, presentation at George Washington University, May 2012

While the Bank of Japan first dabbled with QE in 2001, it was the Federal Reserve’s adoption of quantitative easing during the 2008 financial crisis that initiated a fundamental change in global monetary management. 

The globe’s preeminent central bank, guardian of the world’s reserve currency, unleashed monetary inflation around the globe. 

It was one of the most momentous governmental policy actions of the past century.

I argued back in 2008 against Dr. Bernanke’s assertion that the Fed wasn’t “printing money.” 

I didn’t want to believe he was being blatantly untruthful. 

Yet it seemed more than semantics – “printing money” versus “currency in circulation” and “cash.” 

I was left with the uncomfortable feeling the astute academic economist turned preeminent Fed theorist and lead official didn’t fully comprehend the nature of contemporary market-based finance.

It was exhausting. 

I would try to explain how Fed purchases created new reserve balances that flowed into the banking system in exchange for new deposits. 

These new bank deposits created purchasing power in the securities and asset markets, as well as for the real economy. 

Invariably, I would get responses akin to Bernanke’s assertions: “They are electronic entries between the Fed and the banking system; they basically just sit there. They can’t be in two places at once.” 

Conventional analysis completely disregarded the simultaneous expansion of bank deposits. 

There was no serious discussion of QE logistics and impacts. 

Granted, the Fed’s initial QE program worked to accommodate the deleveraging of speculative securities holdings. 

Much of the Fed’s balance sheet expansion was essentially a transfer of positions from leveraged speculators (i.e. Lehman and the broker/dealers, AIG and other non-banks, hedge funds, commercial banks, etc.) to the Federal Reserve. 

While Fed QE did create new bank deposits, there was during that cycle the simultaneous unwind of securities Credit (deleveraging). 

The end result was somewhat of a “wash” in terms of the monetary aggregates. 

Importantly, there was generalizing from the workings of QE during the 2008/2009 deleveraging episode, and how the mechanism would function during different market and economic backdrops. 

We’ve witnessed since March 2020 a QE program that, rather than accommodating deleveraging, actually spurred further speculative leverage. 

The Fed’s QE-related purchases created new Fed liabilities exchanged for bank deposits, while additional deposits were created during the process of expanding speculative leverage (also from lending in the economy). 

M2 expanded about $300 billion in 2009. 

It surged $4.9 TN, or 32%, in the first 15 months of the pandemic (March 2020 through May 2021).

These days, it would be indefensible for Bernanke or anyone else to suggest the Fed is not directly responsible for a massive inflation of the “money” supply – i.e. “printing money.” 

And finally, there is a credible investigation of the impact of QE – compliments of The Economic Affairs Committee of the U.K.’s House of Lords, with their insightful report, “Quantitative Easing: A Dangerous Addiction?” 

We can only hope this commences a serious debate regarding the precarious effects of history’s most monumental global monetary inflation.

Cogent insight from the UK report: 

“What is quantitative easing? 

Quantitative easing is a monetary policy tool that central banks can use to inject money into the economy through the purchase of ‘financial assets’, usually government bonds. 

Quantitative easing is also known as ‘asset purchasing’… 

Whenever the Monetary Policy Committee decides that it needs to undertake additional quantitative easing, the Bank of England creates new money to purchase Government or corporate bonds from private sector entities, such as pension funds or insurance companies. 

Once the Bank of England has purchased bonds from, for example, a pension fund, the pension fund receives new money in the form of a deposit in a commercial bank. 

The commercial bank has the deposit (a liability to the pension fund) and additional interest-paying reserves—a type of money that commercial banks use to pay each other—in the Bank of England (an asset).”

The Economic Affairs Committee should be commended for its 62-page comprehensive examination of the Bank of England’s QE program. 

I’ve extracted key passages that certainly apply to the Federal Reserve, along with global central banks more broadly.

“While the UK can be proud of the economic credibility of the Bank of England, this credibility rests on the strength of the Bank’s reputation for operational independence from political decision-making in the pursuit of price stability. 

This reputation is fragile, and it will be difficult to regain if lost. 

While the Bank has retained the confidence of the financial markets, it became apparent during our inquiry that there is a widespread perception, including among large institutional investors in Government debt, that financing the Government’s deficit spending was a significant reason for quantitative easing during the COVID-19 pandemic. 

These perceptions were entrenched because the Bank of England’s bond purchases aligned closely with the speed of issuance by HM Treasury. Furthermore, statements made by the Governor in May and June 2020 on how quantitative easing helped the Government to borrow lacked clarity and were likely to have added to the perception that recent rounds of asset purchases were at least partially motivated to finance the Government’s fiscal policy. 

We recognise that it is not easy to distinguish actions aiming to stabilise bond prices and the economy from actions oriented to funding the deficit. 

Nevertheless, if negative perceptions continue to spread, the Bank of England’s ability to control inflation and maintain financial stability could be undermined significantly.”

“We took evidence from a wide range of prominent monetary policy experts and practitioners from around the world. 

We concluded that the use of quantitative easing in 2009, in conjunction with expansionary fiscal policy, prevented a recurrence of the Great Depression and in so doing mitigated the growth of inequalities that are exacerbated in economic downturns. 

It has also been particularly effective at stabilising financial markets during periods of economic turmoil. 

However, quantitative easing is an imperfect policy tool. 

We found that the available evidence shows that quantitative easing has had a limited impact on growth and aggregate demand over the last decade. 

There is limited evidence that quantitative easing had increased bank lending, investment, or that it had increased consumer spending by asset holders. 

Furthermore, the policy has also had the effect of inflating asset prices artificially, and this has benefited those who own them disproportionately, exacerbating wealth inequalities. 

The Bank of England has not engaged sufficiently with debate on trade-offs created by the sustained use of quantitative easing. 

It should publish an accessible overview of the distributional effects of the policy, which includes a clear outline of the range of views as well as the Bank’s view.”

“No central bank has managed successfully to reverse quantitative easing over the medium to long term. 

In practice, central banks have engaged in quantitative easing in response to adverse events but have not reversed the policy subsequently. 

This has had a ratchet effect and it has only served to exacerbate the challenges involved in unwinding the policy. 

The key issue facing central banks as they look to halt or reverse quantitative easing is whether it will trigger panic in financial markets, with effects that might spill over into the real economy.”

“The Bank of England expects these actions to have effects that will boost the economy. 

These effects are sometimes referred to as ‘transmission mechanisms’ and they include: 

Portfolio rebalancing: by buying large amounts of Government bonds, quantitative easing pushes up their price and lowers their interest rate for investors. 

Because interest rates on Government bonds tend to affect other interest rates in the economy, the Bank of England hopes that this will lower long-term interest rates offered on other loans, such as mortgages or business loans, making it cheaper for businesses and households to borrow and spend money. 

When investors sell assets to the Bank of England, their bank accounts are credited with the proceeds which provides liquidity. 

Some, or all, of that new money will be spent on purchasing a range of financial or real assets, such as shares or property, thus raising their price. 

Those higher asset prices should stimulate spending, either directly or by lowering the cost of financing new investment.”

“Signalling: by purchasing bonds, the Bank of England in effect signals to the financial markets and lenders that it will keep interest rates low for a longer period of time. 

This reduces long-term interest rates in the economy and provides some certainty to banks that people can afford to borrow money. 

Market liquidity: by buying Government bonds, the Bank of England reassures investors that they can sell these bonds if they wish. 

That makes them a safe asset to hold and reassures investors that they will be able to access liquidity by selling them even when financial markets are in distress. 

Wealth effects: quantitative easing can boost a range of financial asset prices, such as bonds and shares. 

This increases the value of these assets, which makes businesses and households holding them wealthier. 

The Bank of England hopes that this makes them more likely to spend money on goods and services, which would boost economic activity.”

“Some witnesses warned of the risks of giving central banks too many objectives which may bring them into conflict. 

Otmar Issing, President of the Center for Financial Studies and former Chief Economist at the European Central Bank, said, ‘Too many targets make it almost impossible to focus monetary policy on maintaining price stability.’ 

Daniel Gros, Distinguished Fellow at the Centre for European Policy Studies, said, ‘The more independent a central bank is, the narrower its mandate has to be.’ 

Lord Macpherson of Earl’s Court… said, ‘if we overload the Bank with objectives—bear in mind that it only has so many instruments—we risk dragging it into political areas where it will be criticised unnecessarily.’”

Answering the report’s overarching question, former Bank of England governor Mervyn King’s Bloomberg Opinion piece was titled “Quantitative Easing Is a ‘Dangerous Addiction’: QE is not a cure-all. 

Central banks have seemed to assume that any adverse shock justifies another round of bond buying. 

QE has become a universal remedy for almost any macroeconomic setback. 

But only certain shocks merit a monetary-policy response. 

The explanations provided by central banks to justify the scale of QE in 2020 changed over the course of the year, and failed to distinguish between shocks that justified a monetary response and those that didn’t… 

QE poses risks for central-bank independence. 

The committee looked closely at the relationship between QE and the public finances. 

QE has made it easier for governments to finance exceptionally large budget deficits in the extraordinary circumstances of Covid-19.”

I am not alone in recognizing the Dangerous Addiction – the central role QE has played in dangerously fueling massive government indebtedness, market dysfunction, speculative assets Bubbles, and inflation. 

The debate has begun. 

Tragically, it’s too late. 

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