When Quantitative Easing version one was announced a year ago, I wrote in these pages that they would be back for more. The reason I knew so was that the Government tends to give us bad news in small bites. It does so for several reasons. Let’s face it, the political process is not set up to be forthright. Politicians tend to over-promise and under-deliver. This is just that process in reverse. This is true no matter which party is in charge. The backlash from really big bad news is larger than the backlash from a succession of smaller pieces of the same bad news. Vinegar tastes better when you’ve had a pickle first. This is all human nature, but it’s effective at keeping the natives from revolting. It also engages us into a process where we are forced to throw “good money after bad”. We might not have agreed to that upfront if we had all the facts. So there’s the why’s, let’s talk about the what’s.
Quantitative easing is the process of the Government buying its own bonds in the open market. Why would it do so? First we need to understand that the Treasury issues bonds each Wednesday in an auction process. The Federal Reserve is currently buying bonds back to the tune of about $70 billion a month. While these two divisions of the Government may technically be separate entities, the end result is the same. Why would we issue and then buy back? Wouldn’t it be simpler to just stop issuing in the first place? It would unless you had something else up your sleeve. Who would do such a silly thing? If you were GM and were selling cars, and then buying them back, what do we know? I would say GM will certainly lose money on that trade. Why would GM produce and sell, and then buy back their own production? Who wants to be on both sides of their own trade? Only someone who wants to control the price of inventory. That is exactly what is happening with QE2. The Fed has attempted to push interest rates to zero, but can’t quite get the market to go there. So if we artificially push prices higher, then the yields could actually be less than zero. This has the effect of weakening the dollar, and hopefully making our exports more appealing to foreign buyers. But this also assumes the Government is willing to lose money on its own trades.
Since I anticipate that quite a bit of money gets “spilled” in this swap, I’m going to suggest that the primary bond dealers are set for a windfall. This would also have the effect of giving the financial firms a little “bolstering” in a way that will come under the radar of disclosure. It’s just a hunch, but I’m guessing that Citigroup (C), Goldman Sachs(GS) and JP Morgan (JPM) will report surprisingly good results soon.