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More Easing to Come

(January 20, 2012)

Dear Subscribers and Readers,

Many analysts expect the Federal Reserve to announce a “QE3” policy as early as next week to the tune of $300 to $500 billion over the next six months (with possibly more in the second half of this year). As I mentioned in previous commentaries, I don't believe such a policy is necessary, as 2012 U.S. economic growth looks decent thus far, and as the Bank of England continues its own QE policy while many emerging market countries are also easing aggressively. Following is a chart (courtesy of Goldman Sachs) showing its monetary policy forecasts for various central banks over the next 12 months. Note out of 30 central banks it covers, only the central banks of New Zealand, South Africa, Russia, Israel, and Thailand are expected to tighten over the next 12 months:

However, I do think there is justification for the Federal Reserve to implement a QE3 policy. For one, Congress has failed to act on the ongoing decline in housing prices—either through active home purchases through the GSEs or implementing another tax credit for first-time homebuyers to boost housing activity. As such, the Fed is forced to bring out the “bazooka” for a relatively minor (but highly impactful) sector of the economy. Make no mistake: A QE3 policy would result in unsterilized purchases of both Treasuries and GSE mortgaged-backed securities, and thus would directly lower mortgage rates. Whether this policy will “spill over” to other sectors of the economy (e.g. higher oil prices) or directly benefit the housing market is highly questionable. Unfortunately, the Fed really has no choice. Secondly, because of the structural deficiency in US$, unsterilized purchases of US$ denominated assets would boost global US$ liquidity, which European banks desperately need (please see below chart).

A very reliable indicator/measure of a potential US$ liquidity squeeze is the growth in the amount of foreign central bank reserves held in the custody of the Federal Reserve.  Whenever the rate of growth of foreign assets held at the Federal Reserve banks decreased substantially, the US$ has almost always rallied—typically resulting in some kind of foreign/global financial crisis.  This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value.   The above chart shows the level of foreign reserves vs. the annual change in foreign reserves (from January 1982 to January 2012).

Ever since the demise of the Breton Woods Agreement in 1973, the world has been on a de-facto U.S. dollar standard.  Therefore, as world trade expanded, the demand for dollar has increased—and with it, the increase of foreign dollar reserves held at the Federal Reserve Banks.  Note that various financial crises or economic recessions (see above chart) usually occur when the annual change of dollar reserves is slowing down or experiencing negative growth.  This growth rate has been as high as 36% in August 2004 but it has been decreasing since the beginning of 2010.  The annual growth rate for January 2012 declined to just 1.2%--its lowest growth rate since August 2001!  The creation of US$ bilateral swaps provided some support for global liquidity, but note that foreign reserves growth declined substantially after the Fed (through its QE2 policy) stop purchasing Treasuries in July of last year. Should the Fed implement a QE3 policy, this will likely rise again—thus providing solid support for global liquidity, and indirectly, European banks.

Meanwhile, U.S. bank lending remains decent and consistent with GDP growth acceleration (see below chart).  Year-over-year change in loans and leases is up 2.9% (highest growth rate since February 2009); and up $171 billion (to $6.94 trillion) over the last 12 months.  Combined with Bank of America's benign earnings report a couple of days ago, this growth in lending should lead to higher profits and higher GDP growth in 2012.  As a result, the U.S. economy should do this year, and I believe U.S. financials will outperform for the foreseeable future—especially if the Fed implements a QE3 policy next week!

Signing off,

Henry To, CFA, CAIA

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