Friday, February 4, 2011

QE Head Winds

QE is a mighty force.  In ordinary times, global food riots and contraction in the labor force (36,000 jobs added does not cover the 150,000 needed for population growth) would cause a fierce sell off in equities.  Not in these abnormal times where the perceived deep pockets of the Fed keep a perpetual bid in the market.

The day QE ends there is a very high probability the race to the exits will be swift and fierce.  Investors are asking themselves how long can this go on.  The vast majority are saying QE2 will not end in June but rather continue indefinitely.  Perhaps the majority are correct although group think rarely works.  The Fed's ultimate goal with QE was to drive demand back into the economy.  Whether it be perceived inflation (x will cost more tomorrow so I'll buy it today) or perceived wealth the theory is growth in demand causes growth in the economy thus causing more demand until finally the economy is self-sustaining.

In the process the banking system is generating income by playing the role of broker between the Fed and Treasury.  So on the surface, from an academic standpoint it sounds good.  Like everything in life though there are unintended consequences.  These miscalculations or unforeseen problems can negate the benefit of the original plan.   One such problem is surfacing rapidly and if not addressed will create another shock to an already fragile banking system.

An economy grows through the creation of credit and the banking system is the heart of credit formation.  The US economy is held hostage right now as the banking system, conservative in nature takes its time to return to health.  The banking system has a balance sheet with vast exposure to residential and commercial real estate.  Should there be another leg down in that sector of the economy the banking system will be challenged as it was in 2008.

Unfortunately for the banking system, home prices have begun their second leg down once the final tax credits wore off in October 2010.  This new leg down could experience a rather vicious  cycle.  Studies have shown a strong correlation between the level of negative equity in a home and one's decision to strategically default.  The industry is currently working through a massive shadow inventory that will cause pricing pressure for years.   The more prices fall, the more the shadow inventory grows due to strategic defaults and thus the problem grows.

The last thing the industry needs right now is anything that puts additional downward pressure on price.  Unfortunately due to the Fed's QE monetary policy and horrific US fiscal policy a very real threat has risen in the form of higher interest rates.

Here's an example.  The debt service on a $300,000 mortgage at 4.75% for 30 years is $1,564 per month.  The debt service on the same mortgage at 5.00% is $1,610.  In other words that buyer in a 5.00% interest rate environment can now afford a home 3% lower in price.  Over the past three months, the ten year treasury has risen 100 basis points in yield.  That's four times the example above.

Should this trend continue the bank balance sheet risk and reduction in wealth affect from one's home will have massive implications to an already fragile economy.  The economy will be faced with a reduction in demand and in the formation of credit.  Two very strong headwinds and two which easily can outweigh the benefits of the original goals of QE.


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