Federal Reserve Report: No Need for QE3

I keep reading that some people want to have the Federal Reserve begin a new round of quantitative easing…QE3.

I see nothing in the financial figures that calls for more quantitative easing.

For one, there seems to be no pressure on interest rates.  Looking over the last 13-week period the yield on the 10-year US Treasury (constant maturity) has remained relatively constant.  The weekly average for the week of November 4, 2011 was 2.07 percent: for the week of January 27, 2012 the weekly average was 2.01.  And, the market yield on 10-year Treasuries has been below 2.00 percent all of this week.

The European sovereign debt situation has certainly contributed to this weakness in yields.  Hence, there does not seem to be any demand pressure on interest rates at this time.

Economic growth continues to be modest and consequently is not adding any demand pressure on rates.

The commercial banking system is quiet and even though bank closures average around 2 per week adjustments are being made smoothly and with little or no disruption to the industry. 

Excess reserves in the banking system have fluctuated around $1.5 trillion over the past three months indicating little or no pressure on the financial system on the loan demand front.  This, too, is consistent with the modest economic growth.

Overt Federal Reserve actions have been absent over the past 13-week period indicating that the Fed is allowing operating factors to work themselves out without undue disturbance to the monetary system. 

The big change on the Fed’s balance sheet has to do with the European debt crisis.  Central bank liquidity swaps have risen by a little more than $100 billion since November 2, 2011 as the Fed moved to assist central banks in Europe.  It appears as if part of this increase went to take pressure off the market for Reverse Repurchase agreements with foreign official and international accounts.  The account recording this activity fell by about $41.0 billion over the same time period.

This has resulted in a net increase of about $53 billion in Reserve Balances at Federal Reserve banks but this has had little or no immediate impact on the United States banking system.

Actually, Reserve Balances at Federal Reserve banks declined by $7.0 billion over the past four-week period.  The increase in central bank liquidity swaps was just about totally matched by the decline in reverse repos with foreign official and international accounts as other factors removed reserves.

In terms of Federal Reserve open market operations, the securities account at the Fed actually declined in both the latest 4-week and 13-week periods.  Securities bought outright dropped by a little more than $11.0 billion since November 2 and by a little more than $5.0 billion since January 4. 

Over the past 13 weeks, about $20.0 billion in federal agency issues and mortgage-backed securities ran off in the portfolio.  The Fed only replaced this runoff by a little more than $8.0 billion.  In the latest 4-week period, the runoff in securities was across the board.

The conclusion I draw from the latest Federal Reserve statistics is that the Fed has had a relatively peaceful 13 weeks.  Money continues to flow into the United States Treasury markets seeking a “safe haven” from what is going on in Europe.  This, along with the mediocre economic growth in the country, has taken pressure off the Fed to buy more securities in order to keep interest rates low.  The fact that the securities portfolio at the Fed has declined over the past 13 weeks indicates that the Federal Reserve is letting market forces keep interest rates low and, for a change, is staying out of the market. 

If these conditions continue, I see no justification for any talk about another round of quantitative easing.

The money stock numbers are continuing to maintain excessive growth rates.  The year-over-year rate of growth of the M1 measure of the money stock for the week ending January 24, 2012 is 18.7 percent; the M2 measure of the money stock is growing at 9.7 percent.

Over the past three years I have been arguing that the reason that these money stock growth rates are so high, given the fact that commercial banks did not seem to be lending and that the reserves being pumped into the system by the Fed were going into excess reserves, is that the dire economic conditions have caused individuals and businesses to move their funds from interest bearing assets to transaction assets like currency and demand deposits.  The very low interest rates on the interest bearing assets also contributed to this movement.

Now, however, it seems as this re-arrangement of liquid asset holdings has slowed down.  This is something I think we want to keep our eyes on, for it could be that households and businesses have done all they can do to “be liquid” in bad times.  Thus, we will either see a slow-down in money growth measures (the rates have dropped since the first of November from a 20.0 percent year-over-year rate of growth for M1 and a 10.0 percent rate for M2) or we will see spending starting to increase as these transactions accounts are being used to actually buy things.  It will be interesting to see what happens here.

If people and businesses do speed up their expenditures, this fact would be another reason why another round of quantitative easing would not be necessary.  The Fed would have done enough.   

Post QE2 Federal Resserve Watch: Part 3

I didn’t post a “Post QE2 Federal Reserve Watch” last month because I was on vacation.  You have to go back to September 12 to get Part 2 of the “Post QE2” watch. (http://seekingalpha.com/article/292986-post-qe2-federal-reserve-watch-not-much-banking-system-activity)

Early in September, the excess reserves in the banking system totaled around $1,570 billion.  At the beginning of November, excess reserves were about $1,515 billion. 

A $55 billion drop in excess reserves might seem huge, especially when total excess reserves averaged around $2.0 billion, but in these days decreases or increases of this size don’t really seem to amount to a lot.

Federal Reserve policy for the past two years has basically been to throw all the “spaghetti” it can against the wall and see what sticks.  So far, very little of the “spaghetti” has stuck as total bank loans have not increased that much over the past year although business lending has picked up some at the larger banks (http://seekingalpha.com/article/303929-business-lending-is-increasing-especially-at-the-largest-u-s-banks)

On the money stock side, however, growth has picked up substantially over the past six months or so.  The M1 money stock growth (year-over-year) has risen from just over 10 percent six months ago to more than 20 percent in recent weeks.  

The growth rate of the non-M1 component of the M2 money stock measure also accelerated during this time period, more than doubling from around a 3 percent growth rate in early April to well more than 7 percent in late October. 

The reason for this acceleration seems to be a pick up in the movement from low interest bearing short-term assets like retail money funds and institutional money funds to bank deposits and a pick up in the demand for currency in circulation.  Movements of funds into currency holdings continue to rise at a rapid rate.

The movement of funds from other short-term, interest bearing accounts can be explained by the extraordinarily low interest rates being maintained by the Fed and because of the financial stress being felt by so many families and businesses who want to keep their funds in highly liquid form.  A number of large corporations are also holding onto large cash balances for purposes of acquisitions or their own stock repurchases. 

None of these actions contribute to bank loan growth or economic expansion.  All of these reasons are anticipatory of the need to have liquid assets “near-at-hand” in order to transact.  These are not signs of a real healthy economy.

As far as the banking sector is concerned, the increase in demand and time deposits has resulted in a need within banks to hold more required reserves.  Hence, over the past six months the required reserves of commercial banks have risen $4.5 billion to $96.4 billion from $91.9 billion in early September. 

   

Over the past six months, the required reserves at commercial banks have risen by just under $19 billion. 

This increase in required reserves seems to be the biggest operating factor that the Federal Reserve has had to deal with over the past six months.  Thus, although excess reserves at commercial banks have dropped over the past three months, they have risen over the past six months. 

The item on the Federal Reserve’s statement of “Factors Affecting Reserve Balances of Depository Institutions” (Fed release H.4.1) that is most closely associated with excess reserves in the banking system is called “Reserve balances with Federal Reserve Banks.”  This figure has risen by about $46 billion from May 4, 2011 to November 2, 2011.  The increase came about through a rise of $102 billion in “Total factors supplying reserve funds” and a $56 billion increase in “Total factors, other than reserve balances, absorbing reserve balances.”  The $46 billion is the difference between these latter two amounts. 

The $102 billion increase in factors supplying reserve funds came primarily from Federal Reserve purchases of U. S. Treasury securities, which exceeded the run-off from the Fed’s portfolio of Federal Agency securities, Mortgage-backed securities and the decline in other operating factors that supply reserves to the banking system.

There are two interesting factors that absorbed bank reserves during this time period.  The first interesting factor is the rise in “Currency in Circulation”, which increased by roughly $33 billion from May 4 to November 3.  This movement is a drain on bank reserves and hence causes reserves at commercial banks to decline.   This increase is interesting because currency in circulation usually increases during the summer months due to vacations but decreases in the fall.  Over the past three months, from August 3 to November 3, currency in circulation actually increased by more than $15 billion.  This just adds strength to the argument made above for the increase in currency outstanding.

The other interesting factor is that the Fed’s reverse repurchase agreements to foreign official and international accounts increased by almost $68 billion over the past six months, by $56 billion over just the last three.  This increase also reduces bank reserves. 

Here the Federal Reserve is selling securities under an agreement to repurchase the securities at some stated future time period. These are international transactions and the Fed uses U. S. Treasury securities, federal agency debt, and mortgage-backed securities as collateral in the transactions.  The timing of these transactions are interesting because of the events that have taken place in Europe of the last six months. 

My summary of these movements remains much the same as in previous months.  The Federal Reserve has done just about all it can at the present time to preserve the banking system and allow the FDIC to close as many banks as it has to without major disruption. 

The Fed has thrown just about everything it can into the financial system.  Given the economic weakness in the housing market, the desire of families and businesses to continue to reduce the financial leverage on their balance sheets, and the high level of underemployment in the economy, the demand for loans from commercial banks is very weak, so total bank loans are remaining relatively constant.  A further indication of weakness is the continued movement of wealth into currency holdings and bank deposits, a movement that has resulted in the rapid growth of the money stock measures.  Throwing more “spaghetti” against the wall at this time would not change the behavior of these people or businesses to any degree. 

The Fed may just have to wait until the deleveraging is completed before it sees people starting to borrow again or to hire new workers.  That is, unless the situation in Europe explodes and further ‘search and rescue” missions are needed to preserve western civilization.         

The Current State of Monetary Policy

At the top of my Financial Times this morning reads the blurb: “Did Ben Bernanke Drop the Ball Over QE3?”  This is reference to an editorial by Clive Cook. (http://www.ft.com/intl/cms/s/0/7f55246e-cf2d-11e0-b6d4-00144feabdc0.html#axzz1WPnzI9CU)

In examining the speech given by Fed Chairman Bernanke, Cook takes on the Financial Times essays published last week by Michael Woodford (http://www.ft.com/intl/cms/s/0/aa41c0f2-ce78-11e0-b755-00144feabdc0.html#axzz1WPnzI9CU) and Mohamed El-Erian (http://www.ft.com/intl/cms/s/0/0472f1ea-cd89-11e0-b267-00144feabdc0.html#axzz1WPnzI9CU) that argued against the Fed implementing a QE3.  Cook contends that Bernanke missed a chance…a “chance to jolt ailing America.”

I don’t believe that Bernanke dropped the ball.  I don’t believe that a declared QE3 is necessary.  Whereas Cook believes that a QE3 would “shock” America, I believe that a QE3 would be taken as ho-hum, more of the same. 

In this, I don’t believe that QE1 and QE2 were understood. 

Michael Woodford, the “good” academic states in his essay: “The economic theory behind QE has always been flimsy.”

Get real…this is the “real world”!

QE1 and QE2 were not a result of economic theory.  QE1 and QE2, in my mind, were a response of real people to a desperate real world situation.  In the first case, the financial markets were falling apart.  In the second case, the economy was not growing. 

In both cases, the response of Mr. Bernanke and the Fed’s policy makers were to throw whatever they had against the wall to see what would stick.  There is little in the way of theory behind this.   Some of us believe that in the first case this was not one of Mr. Bernanke’s finest hours. (See my post, “The Bailout Plan: Did Bernanke Panic,” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

In my mind, what was behind these actions was not theory…but history. And, Mr. Bernanke is one of the premier students of the history of the Great Depression and the 1930. 

So, what was behind QE1 and QE2?

In the case of QE1, Mr. Bernanke was aware of the massive monetary history written by Milton Freidman and Anna Schwartz.  The famous conclusion drawn from the Friedman/Schwartz history is that the Federal Reserve allowed the money stock of the United States to decline by one third over the 1929-1933 period. 

Mr. Bernanke and the modern Fed was not going to allow this to take place.  As a consequence, they, Bernanke and the Fed, threw everything they had at the wall.  There was no theory in this.  They were just human beings re-acting in a situation in which there was extreme uncertainty and in which things seemed to be falling apart around them. 

In terms of QE2 we can also go back into the history of the 1930s to get some instruction that might help us understand what the Federal Reserve has been attempting to do over the past year.  The specific case here comes from the period 1937-1938.  The United States economy had been modestly recovering since 1933 but bank lending had not really picked up.  Excess reserves at commercial banks became, for the time under review, excessive.  Since the Federal Reserve’s policy makers did not want to have all these excess reserves around because they felt this reduced their control over the banking system they raised reserve requirements so as to get rid of these “superfluous” reserves.

The consequence? 

There was another collapse of the money stock because the commercial banks “wanted” those excess reserves due to the uncertain times and the slow pickup in business activity.  So, when the Fed took away the excess reserves, the banks reduced their lending activity even more to recover their “excess” reserves and the financial system declined once again.  There was another depression following up on the “Great” one!

Mr. Bernanke, the historian, and the Fed did not and does not want a repeat of the 1937-38 depression.  As a consequence, QE2 was created.  The thought behind QE2 was to throw enough against the wall so that something would stick!  Economic growth was sluggish at best; bank lending was still declining in the summer of 2010; debt loads of businesses, and families, and governments were huge; foreclosures and bankruptcies were at record levels; and under-employment were at levels reached only in the 1930s.  Banks had excess reserves, yet, nothing much seemed to be moving.

Mr. Bernanke and the Fed wanted to escape a replay of 1937-38!

There was little or no theory behind QE1 and QE2.  These two programs were put into place by real people facing extreme situations who did not want to err on the side of not doing enough.  They were people that would let history decide whether or not they acted correctly…and let the theorists debate all they wanted to in their own little worlds. 

And, what are we left with right now?

A commercial banking system that has around $1.6 trillion in excess reserves and about $2.0 trillion in cash assets on its balance sheets.  And, we are told that the central bank is poised to act in the future in anyway needed to shore up the banking system and the economy.  Furthermore, we are told that short-term interest rates are to stay around where they are for two more years. 

Mr. Bernanke, who has overseen both QE1 and QE2, is not afraid to throw more “stuff” against the wall if needed.  This, to me, is current state of monetary policy at the present time.        

Our Two Choices

It seems as if our policy choices have been reduced to two.  First, our basic problem is that there is too much debt outstanding, debt of consumers, debt of businesses, and debt of governments…state, local, and national.  According to Ken Rogoff of Harvard (and co-author of the book “This Time is Different”), “By far the main problem is a huge overhang of debt that creates headwinds to faster normalization and post-crisis growth.” (http://www.ft.com/intl/cms/s/0/1e0f0efe-c1a9-11e0-acb3-00144feabdc0.html#axzz1UdDrJfzK)

During the past fifty years of credit inflation, the incentive existed for economic units to increase financial leverage.  Consequently, we have reached an extreme position of financial leverage, one that many believe is unsustainable.  As Rogoff claims, people attempting to reduce this “huge overhang of debt” will not borrow, will not spend, and this will result in a period of time in which economic growth and the expansion of employment will be modest at best, and downright slow at worst.

The resulting policy choice, therefore, is to allow the debt reduction to take place and let the economy adjust to more “normal” levels of debt.  This “adjustment” is going to have to take place some time and the best thing for the future of the economy is to let it adjust naturally for this adjustment must take place sooner or later.  By not allowing it to take place, we just postpone the final day of reckoning.

The second policy choice is to pursue a significantly aggressive program of credit inflation, one that would force people and businesses to return to borrowing and hence to spending.  Such a policy would help to accelerate economic growth and put people back to work.

This argument is based on the assumption that the United States cannot afford the consequences of a long, slow period of debt reduction and a lengthy period of mediocre economic growth.  The cost of following a “do-nothing” policy in terms of human suffering due to the unemployment and social dislocation created by such a policy would be unacceptable.

The second policy has been the approach taken by the Obama administration, arguing for a resumption of credit inflation, both in terms of government deficits and in terms of expansionary monetary policy.  The question that supporters of this policy debate about is the degree of the credit inflation.  The Obama administration, itself, has tended to follow a more modest level of credit inflation whereas its liberal critics have argued the Obama team has been too timid in how much credit inflation should be imposed on the economy.

Here we get into a debate over timing.  The first policy is needed, according to its proponents, because that is the only way the United States will regain its competitiveness and be able to go forward with the finances of its people in a strong position.  Following the second policy would only postpone the adjustments needed and leave the “day of reckoning” somewhere out there in the future.

The supporters of the second policy argue that we cannot allow economic growth to be so low and unemployment stay so high because of the human cost.  We need to address this now and worry about the debt re-structuring problem later.

The concern over the second policy program has to do with the “tipping point.”  Let me explain.

Right now, the debt overhang appears to be the predominant force in the economy.  Consumers, at least a large portion of them, are not borrowing and spending because of the debt loads they are carrying. (The wealthier consumers seem to be going along fine, thank you.) They are increasing savings in an attempt to get their balance sheets back in line.  Small- and medium-sized businesses are not borrowing to any degree, are not hiring people, and not expanding much at all because they have too much debt on their balance sheets and are trying to keep their heads above water.  Many state and local governments are facing real budget crunches and are cutting back on employment and capital expenditures because of their legal obligations. 

The government fiscal stimulus programs initially attempted by the federal government have been ineffective and disappointing, at best.  The efforts of the monetary authorities to generate bank lending have also been exceedingly ineffective despite historically extreme injections of liquidity into the banking system. Those people supporting the “second policy” continue to call for even more credit inflation whether it be for an new round of “quantitative easing” on the part of the Fed or some other innovative uses of monetary policy. 

The problem with the “tipping point” is this: how severe the tipping point will be if/when the new efforts at credit inflation overcome the efforts of economic units to restructure their balance sheets and eliminate the “debt overhang” connected with the past fifty years of credit inflation. 

The current policy makers seem to believe that the “tipping point” can be managed and the adjustment from debt restructuring to further borrowing can become incremental.  That the trillion or so dollars injected into the banking system by the Federal Reserve can be smoothly removed from the banks once borrowing from them picks up steam.   In this way, faster economic growth could resume again and employers could begin hiring workers at a speedier pace.  

The alternative view is that the “tipping point” cannot be “managed” and that once the gates are open, borrowing will only accelerate and credit inflation will get “out-of-control”, given the magnitudes of liquidity already pushed into the financial system.  Does this mean hyper-inflation?

This discussion leads to a question about whether or not the current policy makers can recognize the “tipping point” (let alone anticipate it) and whether or not they can then smoothly remove all the excess liquidity that has been forced into the banking system.

If one is to look at the record of Chairman Bernanke and the Federal Reserve system one cannot have very much confidence that they will be able to recognize a turning point let alone manage their way through the “tipping point”.  Historically, Chairman Bernanke has had trouble recognizing bubbles, stays with a policy stance far too long and then over-reacts.  Take a look at what happened before the financial crisis of 2008.  The “housing bubble” and the “stock markets bubble” in the middle 2000s were not recognized by Bernanke or the Fed.  Bernanke and the Fed fought the “fear of inflation” for too long into the initial stages of the financial collapse.  And, then Bernanke and the Fed had to over-adjust to the financial crisis they contributed to by “throwing open the windows…and the doors…and whatever…at the Fed” in order to “save the world”. 

Managing a “tipping point”, I would argue, is not one of Ben Bernanke’s strengths.  But, governments, I would argue, are not very good at managing “tipping points.” 

Where does that leave us?  Between a rock and a hard place. 

The government will continue to try to alleviate the suffering of those that have been hurt in the Great Recession and its aftermath.  The Obama administration and the Democrats and the Republicans will compromise on a policy that can still be labeled credit inflation.  The Federal Reserve will continue to look for ways to stimulate bank lending.  And, the only way I can characterize this situation is one of HIGH RISK.  Volatility is going to continue to dominate the financial markets over the next two years or so for the very reasons I have cited above. 

The reason for this is the timing of the “tipping point.”  The private sector is going to continue to push for balance sheet restructuring.  The government is going to continue to push for more and more credit inflation.  This leaves the future highly uncertain.  Consequently, markets will move this way and that way until some leadership and stability are brought into the picture.

Post QE2 Federal Reserve Watch: Part I

Should there be a QE3 or not?

This seems to be the debate now going on given the sluggish performance of the United States economy.  Not only have most of the recent statistical releases been relatively weak, the government also released revised figures for real growth during the two years of economic recovery since July 2009 that were revised downwards from the previously released mediocre data. 

There is no joy in Mudville. 

President Obama is talking up jobs and infrastructure investment and business innovation, but his “room to maneuver” given the debt wars going on is “little” or “none”.  And, the White House is not feeling really good going into the re-election season.

Only a small minority seems to be calling for substantial fiscal stimulus at this time and they do not even seem to be a part of the current discussions going on.  They are like “voices calling in the wilderness” but few are listening. 

Thus, attention is focusing once again on the Federal Reserve and its increasingly unpopular Chairman Ben Bernanke.  Mr. Bernanke seemed to be the savior of the financial system at one time but now seems to be talking about a different world than the one most people live within.  His efforts at stimulating economic growth have achieved very little with the exception of providing liquidity for world commodity markets and stock markets in emerging countries. 

Yet, people keep looking for more “guns” or “tools” to address the economic malaise that we are now going through.  The FED seems to be the only game in town.  So, are we going to get QE3?

QE2 ended on June 30, 2011.  In the first six months of 2011, the Fed caused Reserve Balances with Federal Reserve Banks to increase by $642 billion reaching a total of $1.66 trillion on July 6.  (Just a note: on August 6, 2008, before the deluge, Reserve Balances with Federal Reserve Banks totaled less than $4.0 billion.)

As we know, most of these reserve balances were held as excess reserves, the growth of bank lending in the United States over this time was non-existent.

In July, the Federal Reserve “backed off” from its program of aggressive security purchases with almost all purchases of United States Treasury issues going to offset the run-off of Federal Agency issues and Mortgage-backed securities from its portfolio during the month. 

The only real activity that took place at the Federal Reserve in July was “operating” transactions, basically balance shifting between Treasury accounts and commercial banks.  These “operating” transactions generally “netted” out close to zero and did not result in much change in reserve balances with Federal Reserve banks. 

So, we watch and wait and listen. 

Will the Federal Reserve do anything more?  And, if they plan to do anything…what will it be?

In my analysis, so much of the county has too much debt that people, businesses, and state and local governments are attempting to de-leverage their balance sheets.  Too many financial commitments have been made relative to cash flows that there is a substantial effort increase savings and re-structure balance sheets. 

This is why people, businesses, and governments are not borrowing…and are not spending. 

The efforts of the Fed to stimulate bank lending has failed to this point because the banking system is, itself, still retrenching, financial institutions are still going out-of-business in a steady stream, people aren’t borrowing to buy houses, small- and medium-sized businesses are not hiring and are not borrowing to expand their operations, and state and local governments are downsizing and trying to keep themselves solvent. 

The economy is not growing because too many are trying to get back on their feet, they are trying to keep from drowning, and adding on more spending and more debt is not on their agenda.

Here is where the paradox comes in.  The massive shift in the income/wealth distribution in the country has put a huge burden on the less wealthy while those with more wealth can continue on.  We hear that the “expensive” stores are doing very well…and the dollar stores are not doing all that well.  We hear that there is a pickup in the sales of the more expensive homes, yet sales in the rest of the market continue to decline.  And, so on and so on.

In such an environment of “debt deflation” for a large proportion of the population (see http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation) it is extremely difficult for the government’s economic policy to overcome the drag on spending created by the restructuring of balance sheets. 

Keynes interpreted such a situation as a “liquidity trap”, a situation where the central bank could not drive interest rates any lower because people would just as soon hold cash as hold interest-bearing debt. See David Wessel’s column in Saturday’s Wall Street Journal: http://professional.wsj.com/article/SB10001424053111903454504576490491996443926.html?mod=ITP_pageone_2&mg=reno-secaucus-wsj.

Wessel presents one case for getting out of this trap…a period of (hyper)inflation that would substantially lower real interest rates.  This, one could argue, is what the Fed (unsuccessfully) tried to do in QE2 and it is what would be the objective of following QE2 up with QE3.  But, the strength of QE3 would have to be great enough to get over the “debt deflation” efforts of the people, businesses, and governments that are trying to get their balance sheets back in order. 

Wessel writes, “Failure to arrive at the correct diagnosis, in economics as in medicine, prolongs the illness; so does refusing the remedies. There's a reason the Great Depression lasted for more than 10 years.”  But maybe the correct diagnosis is that the problem is not a liquidity problem but is a solvency problem.  And, the people of a society may take a long time to deleverage their balance sheets when it took fifty years of credit inflation to get them in their current position.
If this is true, having the central bank create a policy of (hyper)inflation will not really resolve the issue but only postpone it for another day…something politicians are very good at.
And, as we contemplate the possibility that the Fed will engage in another round of monetary easing, word comes that the European Central Bank (ECB) is going to engage in the purchase of the sovereign debt of several European nations so as to support eurozone commercial banks and the newly proposed severe budgetary policies of Italy and Spain.  The ECB announcement came after several European commercial banks wrote down the value of the Greek debt on their balance sheets everywhere from 21 percent to 50 percent. 
To the ECB, it seems, the situation in Europe is still a liquidity problem.  But, if this is the incorrect diagnosis, as it may be for the United States, the ECB may have the same success as the Fed’s QE2 had.  Keep watchin’.  

Why Bet on Treasury Securities?

First Warren Buffet and now Bill Gross, of Pacific Investment Management Company, have publically stated that buying United States Treasury securities is not a good bet. (See http://www.bloomberg.com/news/2011-03-31/gross-echoes-buffett-saying-treasuries-have-little-value-on-debt-dollar.html.)

Gross wrote, in his most recent monthly investment outlook, that Treasuries “have very little value.”

One could couch this in other terms: “What is the probability that long term interest rates will go up over the next twelve months?”; and “What is the probability that long term interest rates will go down over the next twelve months?”.

How many people do you know that believe that the higher probability can be applied to the second of these two questions?

Most people I know and respect are arguing over whether the probability that long term interest rates will go up is 75% or 80% or higher.

The only significant argument I hear about falling interest rates on long term Treasury issues is that the Eurozone might collapse and there will be a “run to quality”, a run to United States government securities. Almost all other arguments go the other way.

The economic recovery, however weak, is continuing. The banking system (and the housing industry) is not going to collapse even though the banking industry is going to continue to grow smaller and smaller in terms of the number of commercial banks that are in the system while the biggest banks, including large foreign banks, are going to control more and more of the banking industry itself. The Federal Reserve will continue to keep money flowing into the banking industry so as to keep banks open while the FDIC makes sure that the banking industry shrinks in an orderly fashion.

Are we going to get QE3? Depends upon the rate at which insolvent banks can be closed without disrupting the financial system. The strength of the economic recovery is not the issue. The issue, to me, depends upon what the FDIC can achieve.

The federal government is going to continue to add more and more debt to the total already outstanding.

There just is no credibility in Washington, D. C. concerning the reduction in the cumulative deficits over the next ten years or so. I still believe that the government will add another $15 trillion or more to the federal debt outstanding over the next ten years.

The Libyan situation is a case in point. The federal government is so over-extended fiscally that other demands on its resources are just going to stretch budgets even further and keep the cumulative deficits at near-record levels. Then the government ends up doing two things, neither desirable: the government is limited in what it can do in very important situations; and even if the government cannot do much, whatever it does will increase the cumulative deficit.

Then there are other issues, like the boom in commodity prices worldwide, the acceleration of the merger and acquisition business in America, Europe, and the emerging countries, and currency speculation throughout the globe.

As a consequence, I see no reason to back off my earlier thoughts on the future of the interest rate on long term U. S. Government securities. See http://seekingalpha.com/article/250838-long-term-treasury-yields-and-inflationary-expectations. This post was written when the yield on the 10-year Treasury security was 3.48 percent, roughly two months ago at the beginning of February. Yesterday the 10-year Treasury closed at about 3.46 percent.

At that time I claimed that a forecast of 5.00 percent to 5.50 percent was not out of reason for a Treasury security of this maturity somewhere in the next 12 to 18 months.

The basic reasoning for this: my estimate of the expected long run “real” rate of interest is roughly 3.00 percent, (Similar, I found out, to the belief of the Wharton School’s Jeremy Siegel.)

I further believe that investors will come to build in a premium for inflationary expectations in longer term interest rates in the neighborhood of 2.00 percent to 2.50 percent.

How strongly do I feel about this prediction? I believe that the odds are in the neighborhood of 3- or 4-to one that rates will move into this range over the next 12 to 18 months.

Thus, I would have to agree with Bill Gross (and Warren Buffet) that Treasuries “have very little value” and are not a good “buy and hold” at this time.