Queasing over Quantitative Easing, Redux

People are good about making binary comparisons for the most part, leaving aside come of the more complex choices highlighted in the book, “Priceless.”  Would you like coffee or tea?  Do you prefer this room painted blue or white?

Where things get complex is when there are a zillion choices, and your quest is to pick the best one, particularly when there are multiple attributes to each possible choice.  Consider the problems of trying to choose the one best stock for the next ten days, months, or years.  The best solution is to redefine the problem and try to choose an excellent bunch of stocks for each period.  Give up on the impossible game to play the possible game.

I follow this logic when I make stock trades.  It is not possible to get the best companies consistently, but it is possible to look at the companies that you are buying, and the companies that you are selling, and conclude that the new portfolio is superior to the old portfolio.  Three or four times a year, it pays to freshen the portfolio, selling the companies with the weakest potential, and buying those with more potential.

Now, binary comparisons underlie many aspects of financial accounting and management.  Think of doing a net present value [NPV] calculation.  We do them frequently, but how often do we ask what they really mean?  The NPV calculation compares the after-tax cash flows of a project to a hypothetical investment, which is to shrink the asset base of the company by buying back stock and retiring debt.

As a young actuary, I was fascinated by how much a small change in interest rates could change the present value of a policy.  I worked with two companies in the structured settlement business, both of which had the same philosophy on asset management — write short policies and long policies, and invest to the middle of them.  Though, with the second one, I took the opportunity to buy ultra-long bonds when they were attractive.

In an interest-spread management business like life insurance, the binary comparisons were in many ways more obvious, as I would swap bonds relatively worse for those relatively better.

Wait, how does this relate to quantitative easing?

The Fed can create liquidity in two ways — it can send the liquidity out to the general economy, raising prices.  Or, it can use the liquidity to buy assets, in most cases, government or high quality bonds, which lowers interest rates in that area, raising the prices of assets so bought.

Quantitative easing has a direct impact and an indirect impact.  The direct impact is that those that issue the bonds that have  been bought face lower yields and are inclined to issue more.  More Agency MBS, more Treasury issuance.  It is an obscure and indirect means of monetizing government debt and Agency MBS.  The government likes nothing better than to have a captive, non-economic buyer of its securities, particularly in a period of extreme deficit spending.

The indirect impact is that as Treasury yields fall, the yields on other debts fall to a lesser degree.  There are many investors out there who need yield, and as safe yields fall, they take more risk in order to achieve their desired income.  The conundrum of QE is that people get torn between income and losing capital by taking too much risk.

This helps to explain why stock valuations are low relative to high-quality bond yields.  The high-quality bond yields, affected by QE are not indicative of the true risks faced in the high quality lending.  Stocks and lower quality bonds are affected to a lesser extent — as it is harder get yield out of quality instruments, most will dip to lower quality instruments.

I learned as a corporate bond manager that every now and then I had to fly the “Jolly Roger,” but for different reasons.  When yield lust consumed the market, I would do painful up-in-credit lose-not-much-yield trades.  When there was panic, I would wave in yieldy bonds that were more than adequately protected.  In one sense, I was doing the market a favor, even though I was trying to make gains for my client.  I was always on the other side  of the money that was panicking.

So, what does QE do?  It lowers the cost of government debt (for now), and drags lower the cost of high quality debt, because there isn’t as much government debt available to buy because of QE.  As for high-yield bonds, and stocks, the effect is weak.

So, will QE improve economic prospects?  In my opinion, no.  Unless QE begins buying high yield debt and stocks (please don’t ever do this), it will not a have any impact on real businesses.  Government should be neutral, and beyond bias — buying the securities of a non-government enterprise should be forbidden — there should be no favorites to the government.  (What’s that you say, we have already had favorites via the rescues of 2008-2009?  Sad but true, but no reason to repeat the error!)

QE leaves investors in an awkward spot.  There are no safe places to place money with any yield.  So, you can earn zero, or take risks that seem uneconomic to gain yield.  Almost makes me want to be a trader, because there is little logic to where I invest. There is no obvious place for me to invest.

If the government thinks that QE will force investors to invest, I have news for them — yes, some will take more risks, but they will lose through their investing. Risky assets are only good at a fair or fear price, not at one where yields or risk margins are dragged low by QE.  Trying to tweak our psyche as a whole is ridiculous, and deserves only scorn by voters and investors.

Go, take your QE with you and destroy the economies of other nations.  Let interest rates rise here, and allow savings to grow, that will be deployed into the businesses of the future, not QE, that invests to protect the past.  We don’t need more homes, autos, and banks.  We don’t need AIG or the GSEs.  Just leave our economy alone, we can live with the booms and the busts, unamplified by central banks and federal governments.

1 Comment

  • Ashwin says:

    ” Unless QE begins buying high yield debt and stocks (please don’t ever do this), it will not a have any impact on real businesses. Government should be neutral, and beyond bias — buying the securities of a non-government enterprise should be forbidden — there should be no favorites to the government.” Exactly – QE only has impact when it becomes explicitly fiscal and once we start printing money to dole out to a few chosen ones, we’re no better than some tinpot dictator doling out favours to his friends.

    “QE, that invests to protect the past.” Not emphasised enough IMO – Isn’t it strange how all the policies favoured by the govt try to protect the incumbent cronies? Why do all the initiatives to seed new businesses or help the poor pale in comparison to the amount of money and effort expended in propping up the status quo?

    Even if fiscal action is necessary, depending on such a high degree of discretionary actions by the Fed or the Treasury is inherently a regressive policy – only the privileged cronies have the access and the ability to front-run and anticipate the actions of the Fed and derive the lion’s share of the economic benefit.

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