QE3 NOT LIKE GRANDPA'S QE

Quantitative Easing 3 Actually Mentioned

Today Wall Street Journal reporter Jon Hilsenrath broke the story that drove up equities after their fall yesterday. He reported remarks from Federal Reserve officials suggesting a new round of quantitative easing. See, http://online.wsj.com/article/SB10001424052970. Suggested new rounds of easing are very different from the conventional two rounds of  easing.

Previously we witnessed two rounds of basic Federal Reserve Open Market Operations using Repurchase Agreements. Here, the Fed loans printed cash to primary dealers (major banks), and primary dealers pledge their U.S. treasuries as collateral. With low interest rates on the loaned Fed money and collateral pledged, money has been made by investing in higher yielding risk assets such as stocks, commodities and certain currency pairs.

Inflation is commonly associated with QE, and is a basic consequence of the cheap cash being plowed into risk assets, especially commodities. Across the globe, commodities have come under increasing demand from those that actually use materials for manufacturing. This contrasts with the investor that simply can profit off increasing demand.

Twist Past QE into Today's QE Proposal

However, today the method of quantitative easing is called “sterilized”. Sterilization means that the added money to the system will not push inflation. The Fed is very sensitive to inflation at this point due to oil prices, and food prices. Sterilization could be more theoretical than practical.

Quantitative easing part three is different in many other respects. First, sterilization of the effort is purportedly accomplished by reversing the proposition. That is, from the Fed lending money to the Fed borrowing money, in a Reverse Repurchase Agreement. Basically primary dealers loan money to the Fed, and the Fed pledges its U.S. treasuries as collateral to primary dealers. For a good explanation on this see, http://www.newyorkfed.org/aboutthefed/fedpo

QE3 proposes to pour out U.S. securities, as opposed to cash. Why would the Fed be looking at pouring out securities instead of cash? Not only inflation...Look also at looming propositions for European securities, or simply European bonds. Any trigger of Credit Default Swaps (CDS) amid the biggest sovereign debt restructuring in history, and anyone can take a guess on net results.

Only disaster is for a $3.2B net loss on CDS's to turn into an immeasurable loss by a counter-party bank not making their obligated payment on a CDS...due to inadequacy of collateral.  Consider recent stress tests of European banks versus extensive efforts of ECB to shore up liquidity.

Only Way QE3 Can be Justified

Through the above scenario, potential for banking failures spreading across Europe exists. Reading between the lines, there was a reason that banking liquidity in Europe froze. To keep the Euro currency alive, there is a reason why the European Central Bank bought such huge quantities of troubled sovereign bonds, in exchange for loans to European banks. ECB bought troubled securities, or accepted them as collateral, to create a demand, and flooded banks with cash.

Now, the cash can be loaned to the Fed in exchange for a backup security...the U.S. Treasury bond, or Euro bonds, depending on the market. Deposits from other banks at the ECB remain at “elevated” or historical highs. Essentially the banks that took advantage of the recent ECB LTRO are waiting to see what the haircut for Greek bonds will look like.

Supporting evidence for such Fed efforts is Europe's Central Bank balance sheet, which titters south on the continuum of liquidity. Consider its huge inflation in assets versus capital and reserves. It's leverage is also historical against its capital and reserves. Then, look at the quality of its assets, pledged as collateral against its recent rounds of LTRO. See http://www.ecb.int/press/pr/wfs/2012/html/fs120306.en.html, and http://www.ecb.europa.eu/press/pr/date/2012/html/pr120228.en.html

Appearances seem to appear to look like the Fed knows that collateral in Europe will have to be supported. With the support of collateral, goes support of ECB created liquidity. ECB bought declining collateral in a down market to save a market. Now, European banks have cash to help sustain Europe and collateral in general. But the problem is that European collateral might take a loss, depending on Greek results.  

Yes, cause certainly exists for supporting the value of international collateral, supported by the reverse repos of the Fed. It logics out.