This article was excerpted from Dwight Johnston’s new white paper for TRUST for Credit Unions: “What Lurks Under U.S.S. QE?”
Quantitative Easing, commonly called QE, has been a part of the conversation since 2009 when the first QE program began. Since then, there’s been QEII, QE 2.5 (Operation Twist), and now QE Infinity. The Federal Reserve doesn’t actually refer to the program as QE Infinity, but market participants and economists quickly tagged the program as such since there was no expiration date.
The QE program is beloved by stock and bond traders but often feared by economists and many market analysts. Both sides of the debating aisle frequently dispense with the QE term altogether in favor of a simple, easy-to-understand phrase that requires no explanation — “money printing.” The only problem is that calling it “money printing” is wrong. The Fed does not print money.
Regardless of what credit unions choose to call it, this policy has a lot of people concerned about the longer-term risks.
So Nostradamus, What Is The Future?
The Fed’s QE policy has failed to produce either the hyper-inflation forecasted by many economists and money mavens, or the positive economic impact foretold by the Chairman of the Federal Reserve Ben Bernanke.
Bernanke still believes the tide will turn and perhaps he is correct. The economy certainly “feels better,” but maybe that is just the smoke coming from the stock market. A year from now, credit unions may be looking back and applauding Bernanke’s dogged determination. In one scenario, the Fed would likely have ended the QE program with a balance sheet base of $3.25 to 3.50 trillion.
But Americans could also be looking at the very same results they are seeing now – slow growth with very low inflation. In this second scenario, the Fed would likely have continued buying and balances would be roughly $4 trillion. While the former certainly seems the desired result, financial institutions have learned to live with and feel okay about the latter.
The problem with all of this is the Fed’s balance sheet. The source of the monetary base — money held in the hands of the public and bank reserves at the Fed — represents a source of highly combustible fuel.
As the economy improves and confidence rises, businesses will borrow again for productive purposes and consumers are likely to take on more debt. This activity will grow even more substantially as the stock market and housing market continue to improve and banks themselves expand their lending, causing the multiplier and velocity of money to increase.
Here is an another example of what could happen in this scenario. If the peak in the multiplier was over 9 and the multiplier bottoms at 3, what happens if the multiplier moves to 6, the midpoint? That $12 trillion in money supply zooms to $24 trillion.
The most basic definition of inflation is too much money chasing too few goods. If this amount of money enters the system, many shudder to think what would happen to inflation. Of course this wouldn’t happen overnight, but the timing of the jump could be shorter than most anticipate. It only took about five years for the multiplier to fall from the peak to the trough. Getting back halfway would not require more than a couple of years under the right circumstances.
What would happen to rates in this environment is anyone’s guess. But in this highly leveraged environment, it wouldn’t be pretty. Interest rates would shoot higher, ultimately forcing stocks lower, and the table would be set for a return of the ugly 80’s style stagflation. But how much should financial institutions worry about this, the third and worst possibility?
With The Jury Still Out, What Signs Can We Look For?
All three outcomes are possible. The good (economy grows but inflation remains in check), the bad (slow growth with little or no inflation), or the ugly (hyper-inflation and recession). While it is difficult to proclaim one clear, winning bet, those who crunch the numbers will likely become increasingly concerned about the “ugly” outcome. However, the other two outcomes are at least equally likely.
There is no single sign that will alert credit unions as to how things might play out, but a good go to indicator will be the bond market, which has had this one right since late 2006. The yield curve started to flatten, which was the first warning flag that the economy was going to slowdown. Over the past five to six years, rates have fallen in a steady trend despite steady predictions from Wall Street of higher rates and higher inflation.
The bond market has recently shown signs of waning confidence that rates will stay near the bottom, but it is still too early to say the end of the low rate cycle is at hand. In fact, it’s easy to see how the bond market might have one last hurrah in the next few months.
What credit unions need to watch for is a sharp increase in bond market volatility, which indicates that uncertainty is creeping into the minds of big bond investors. Rallies will be few and far between, and each rally in bond prices will be followed by new lows. If rates start moving up in a stair step fashion, it’s time to move to the sidelines. Then, credit unions will need to observe how the bond market reacts to any Fed responses regarding increases in inflation or evidence that the money supply is beginning to ramp up.
If the market deems the responses as casual and not forceful, rates will surge as confidence in the Fed goes off the rails. In this highly leveraged, low-rate environment, confidence is a huge part of the equation. How high could rates go? Of course no one knows. Don’t expect to buy 10-year notes at 14% as was done in the 80’s but — given that the industry is coming from the lowest yields on record — any big jump in rates will be a shock to the system.
While credit unions will have to be mindful of economic data, jobs reports, and the inflation numbers (which haven’t mattered for years but will again someday), the bond market holds the key.
Managing Through The Fog
Credit unions are well positioned for rising rates. Although a huge, sudden jump in rates would cause angst among those with heavy concentrations of longer-term mortgages, a reasonable increase in rates would be a huge relief for many, especially smaller credit unions.
Regardless of the current balance sheet structure, all credit unions need to make sure a serious stress test is performed that can help identify weaknesses in the balance sheet. Most credit unions already run stress tests, but how much critical analysis of the results is done? If the economic environment shifts to one of higher loan demand and deposits flowing out and into the stock market, what will an institution’s liquidity position look like? What would the market value be for its longer-term securities? Credit unions should give these stress reports more than a glancing look before they hand them off to examiners.
The full version of Dwight Johnston’s new white paper for TRUST for Credit Unions: “What Lurks Under U.S.S. QE?” can be downloaded here.
Dwight Johnston, President of Dwight Johnston Economics, has over 35 years of investment experience with financial institutions in a variety of roles. For the past fourteen years, beginning with his role as economist for WesCorp FCU, Dwight has focused on economic and market information and education for credit unions. He is the author of a popular Daily and Long-term Commentary and is a frequent speaker at credit union board planning sessions and industry conferences.
Trust Mutual Funds is a family of institutional mutual funds offered exclusively to credit unions. Callahan Financial Services is a wholly owned subsidiary of Callahan & Associates and is the distributor of the Trust mutual funds. Goldman Sachs Asset Management. L.P. is the investment adviser of the Trust mutual funds. To obtain a prospectus that contains detailed fund information including investment policies, risk considerations, charges and expenses, call Callahan Financial Services, Inc. at 800-CFS-5678. Please read the prospectus carefully.
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