Author: Mark Dow

This morning’s employment data were not dramatically out of line with the current trend. They did, however, fall meaningfully short of expectations—especially at a point in the recovery where data have historically tended to surprise to the upside. And even though nothing about this crisis and recovery maps to other periods we have lived through, this has to be seen as a significant disappointment.

But it would be wrong to think that this will significantly alter the Fed’s reaction function come September 18^th.

Beyond the obvious that the Fed—unlike those of us in the market—is unlikely to overreact to one data point, there are three reasons why the Fed is likely to stick to its current course and that odds still favor a September tweak to their current policy stance (read taper).

One, the Fed thinks in balance sheet terms. We in markets are slaves to flows, but the Fed all along has said that to the extent QE has a mechanistic effect on financial conditions it comes through reducing the available stock of USTs and mortgages to financial institutions and the broader investing public. And the fact the yields have tended to go higher when the Fed initiated purchases under its series of programs, but each time to lower highs—notwithstanding improvement in the economy—supports its case. In short, the Fed doesn’t view taper as reducing accommodation.

Two, the Fed is increasingly cognizant of the data that suggest QE has passed through to the real economy much less than its staunchest proponents hoped. At the same time collateral costs—though far, far smaller than hard money advocates had forecast—have been creeping higher. At home, markets have been distorted in exchange for less benefit. And abroad, to paraphrase the famous John Connolly quote:  the Fed is our monetary policy, but your problem. Both the risk and the reward may have turned out smaller than many hoped/feared, but be that as it may the risk-reward equation still continues to drift away from more QE. And the Fed gets this.

Three, it’s all about the signal. QE has triggered significant effects in markets and indeed helped buy precious time for household balance sheets to heal and animal spirits to revive. This has been an important contribution. But it is now clearer that the primary channel through which this has taken place is psychological. Most everyone now knows that the money “pumped in” by QE has largely remained as reserves on the balance sheet of the Fed. The money that “flowed” into asset markets here and abroad came from us, not the Fed, as our risk appetites increased.

It was virtually impossible for the Fed to have gauged ex-ante the magnitude of our psychological response to its easing. But because the market response has been so large yet the economy is still far from where the Fed would have hoped to see it by this point in time, the weaning of market psychology off of the Fed teat now has to be handled in a balanced and incremental fashion. Signaling will play a central role in this process.

The Fed already took the first step in this process.  Many Fed members seem anxious for the data to let them take that next step. And this morning’s data won’t do much to alter this monetary landscape.

Here’s an excerpt from the Q2 letter to investors from John Hathaway, of Tocqueville Asset Management’s Gold Strategy Fund. All you really need to read is the first paragraph.

7/3 John Hathaway – Tocqueville Gold Strategy Investor Letter, Second Quarter 2013

Tocqueville Gold Strategy Investor Letter

Second Quarter 2013

John Hathaway

In light of the dramatic developments of the past six months, this letter addresses seven key investor concerns:

What is happening to gold?

In our opinion, the severe pressure on gold prices since April 16, 2013 has been caused by a coordinated bear raid orchestrated by large bank trading desks and hedge funds. The method used was naked shorting of gold contracts on the futures exchange (Comex), which means that physical gold was never sold, only paper. Gold was rarely, if ever, delivered to a buyer. Trades were settled in cash. The notional amounts of the transactions on many days exceeded annual mine production, absurd on the face of it. The motive was most likely to break the gold price for profit. The result is that short positions of these traders are higher than at the bottom in 2008 (chart below), after which gold rallied 167% and mining shares 256% (basis XAU).

The sentiment has dramatically shifted on precious metals. The gold bugs have gone silent or are desperately trying to reframe their pitches, the bears have gotten loud, and people previously claiming neutrality—in no small part out of fear of the wrath of the gold bug crew—now feel free to pile on. With sentiment having shifted so far, is the slide in precious metals over?

Short answer: no. Here are a few points from the longer answer.

Gold is a bubble. The selloff is not recent. It has been going on for two years. What has changed is that we’ve entered the acceleration phase of the decline.

If you have resisted this idea up until now, you’re still in time to come clean with yourself. The legs on which the post-QE phase of the gold ramp was built have cracked. No hyperinflation, no systemic collapse, no fiat debasement. The biggest misconception of all—that ‘printing money’ causes inflation—has been thoroughly discredited by anyone who followed the debate closely. In fact, collective fears seemed to have tipped in the direction of deflation.

This shift in thinking has been mirrored in the precious metal markets. They reacted to QE1 and QE2, but by the time QE3 rolled around monetary stimulus lost its juice, as investors increasingly got past the arm waving and came up to speed on how monetary policy actually works.

You can see this on this chart:

The leftmost yellow line shows the sharp upward turnaround in the price of gold when the Fed first went nuclear in November 2008. Similarly, when Fed Chairman Bernanke dropped heavy hints at Jackson Hole in August 2010 that more monetary easing would follow, the precious markets responded strongly and positively (2nd yellow line).

However, as time marched forth and the inflation/debasing that motivated much of the rush into gold didn’t materialize, the economy continued to heal below the surface, and the positioning in gold became heavy, the shiny metal rallied progressively less to every accommodative twitch out of the Federal Reserve. Those of us watching this market closely also noticed the gold’s correlations to other assets were also changing. Gold’s positive correlation to the equity market was all but gone, and it’s negative correlation to the US dollar had declined considerably. In fact, things had changed to such a degree that by the time QE3 was trotted out, there was a brief bump in the gold price, followed by a sharp reversal. Gold has been on a one-way slide ever since (3rd yellow line).

So, how far do we fall?

It is important to note that the peak in precious metals coincided with the peak in emerging markets equities (silver and EEM peaked, in fact, the same week). This is not random. The commodity boom had two phases (both, BTW, turbo-charged by the arrival of ETFs). The pre-QE phase was driven in large part by the paradigm shift in emerging markets and the extrapolation of their appetite for ‘scarce’ commodities. Both asset classes are now well into their unwind. (More on that here, for those interested.)

The post-QE phase of the commodity boom was more narrow. In fact, it may surprise many readers that the price of oil is roughly unchanged since QE started. The big run up in the price of oil came in the pre-QE phase, driven by the EM story, as you can see here:

The gist is that the post-QE commodity rally was heavily concentrated in precious metals. This matters a lot if you want to make an educated guess as to how far gold can fall. The chart is pretty ominous:

Why does this mater a lot? The implication is that if you believe—as markets increasingly do—that the Fed will let it’s book of QE roll off and their much discussed exit strategy will transpire without systemic collapse or rapid inflation, we are likely to revert roughly to pre-QE levels for precious metals. (NB: You may still believe catastrophe awaits, but by now you should at least concede that the scope for saying “no, no, not yet; I was just early” is unambiguously contracting.)

What does that reversion look like? Here:

I am not a huge fan of targets. But I am a big fan of concepts. And if you think the market got its monetary gloom and doom QE analysis wrong, it does make sense that pre-QE levels is where cruel reversion is likely to take us. That range you see on the chart above is $700-$900 for gold. (If you think any of the emerging market/pre-QE phase of the gold rally should unwind, then gold would have to fall of course further.)

There is another reason to think there is much more selling to come. The chart below shows Total Known ETF Gold Holdings.

You can see that gold holdings have fallen less than the gold price. As an economist would say, this means the price elasticity of gold demand is very low.  In other words, the price of gold fell disproportionately to the quantity of gold the sellers were able to unload.

Many like to say “for every seller there is a buyer, so what’s the big deal?” This misses the important point of elasticity.  It is not symmetrical. And elasticities are extremely sensitive to animal spirits. Buying $300mm of gold can move the market up by less than a percent in a normal market. But when sentiment for gold turns adverse, selling $300mm can drive it down, say, 2-3%.

The upshot is this often leads others who have decided to sell but have not executed to freeze. Just like when it comes to selling your house and you don’t “like” the market price. This leaves a backlog of trapped longs and results in many praying for an uptick. I think we all know how this story ends.

The trapped long chart for silver is even worse:

There are ways to manage your position and (importantly) your mental capital if you are a trapped long. If you haven’t been involved and are looking to go short, there are also ways to get into a short position that mitigate the risk of ‘chasing’.  I intend to write a post later today on how to go about these strategies. Until then, good luck.

Do you think the selling in the Treasury complex is over–at least until next Friday’s NFP? It you are a trader, this is really the only question you have to ask yourself right now.

There has been massive pain in the fixed income world over the past three weeks. The backup in Treasury yields finally attained the speed necessary to shake carry traders across the FI spectrum into shedding risk. It got particularly ugly in EM local fixed income and currencies (more on that later). The risk-shedding eventually spilled over into the equity markets.

Odds are good now that we are at that kind of win-win juncture for FI risk that you don’t that often see. Kind of a David Tepper moment for FI traders. I think the selling in the T-plex has been strong enough for long enough that it would take big fundamental news to drive them further down from here. And I can’t see anything important enough in front of the NFP to fit that bill.

This leaves us with two basic scenarios. One, if the equity market rebounds, the ‘fear discount’ now built into a lot of FI instruments will come out and Treasuries should stabilize if not rally, given the speed, fear and volume behind the recent selling.

Two, if, instead, the equity market sells off further from this point—which we got a taste of on Friday—then Treasuries will rally, as they tend to when risk aversion rises far enough or fast enough in equities. In fact, we got a taste of this on Friday as well. This scenario should trigger at a minimum a modest rally in the some of the FI instruments hit hardest by the bond selloff.

Both scenarios have implications for the dollar and tend to be bearish, but more on that below.

Of course, if your scenario doesn’t envision Treasuries stabilizing, then you stay just out of the way.

If, however it does, you then have to consider the follow-up, investor question as well: Has the market too aggressively discounted the timing of the Fed’s exit process? This is not the same as the first question. If you believe the answer to this question is also yes, then this is probably a good entry point to buy beaten up FI instruments for a longer timeframe, not just for a trade (FWIW, less than 3 months is the trading bucket, more than 3 the investment bucket).

Three FI sectors warrant separate discussion here, IMO: Agency mortgage REITs, currencies and EM local currency bonds.

Agency Mortgage REITs

• Selloff started last September
• The sector is now retail-dominated and emotional
• I put the current discount to NAV at ~10%–but this is a guesstimate, conditioned in no small part by the magnitude of the decline in book value last quarter
• The sector is in cyclical downswing, but discount to NAV and carry offer good protection right now against being wrong, even when dividends are cut.

Ccy, PMs and EM local FI

Correlations have been low, making things tricky. Positioning is heavy and will be the driving force in the near term, IMO, especially if the equity market tumbles further. If you believe USTs will stabilize, you are likely to see a decent rally in funding and hedging currencies (EUR, GBP, AUD, NZD, CAD), and in JPY where positioning is so heavy even higher UST yields were unable to lift USDJPY. You’ll also likely see a squeeze in precious metals, where a lot of shorter-term traders and CTAs are positioned short. Even though I dislike precious metals in the longer term, I think odds right now favor an especially good trading opportunity in the gold miners. There’s a fair number of people long dollars against the majors and precious metals at this point. Caveat: short dollars anywhere except JPY gets a lot trickier if USTs stabilize and SPX sells off hard.

It is less clear how much EM currencies rally if the big dollar sells off, if at all. This is an area where there still is short-dollar positioning, and, frankly, it is humongous. USDMXN has moved 80 big figures and long-term holders were only just roused from their slumber last Wednesday. My guess is any rally in EM currencies will be used by institutional investors to lighten up, driven by this wake up call and their longer term cyclical views.

The big trade for many macro types has been long EM currencies and short a basket of developed currencies. This allows macro guys to be long EM ccys while diversifying away much of the EURUSD risk by using a funding basket. Shorting AUD hedges SPX and Asia slowdown risk as well. This trade is as old as dirt. Problem is there are many more guys holding dirt these days. And RM, both dedicated and crossover, have piled into EM local ccy bonds (look at the ticker $EDD). Few outside the asset class know how large it has grown relative to the target market. And those in the asset class have kept mum to increase AUM.

These local bonds are too difficult to sell in size, so if redemptions get large enough where RM funds have to reduce bond holdings, it will get ugly. In the meantime, the big investors will buy dollars against their EM local bond holdings to protect those positions as best they can. Few investors in EM local ccys bonds realize the extent to which overall returns in the space are driven by currency and not the bonds themselves.

I know EM fundamentals are better in most EM countries these days, but that is not much of a defense once we tip over into the liquidation mindset—and odds are good that we have. The participation in the asset class is just much, much broader than it has ever been. Plus, the sell-side market-making is a lot thinner. So, even if you think USTs stabilize, this is not the asset class to play. Many large players will be looking for the exit on any decent bid.

I spend more time than I probably should exchanging views with other market participants, most of whom are friends. It can take up a lot of time. My exchanges with one guy in particular, a macro guy with a strong background in economics, usually capture best where I’m at. I’ve posted my side of these exchanges a few times in the past. The similarity in backgrounds usually leads to a very efficient exchange of ideas—even when we don’t agree. We just speak the same language.

I had the impulse this weekend to write up my views because I changed my positioning last week. But, busy with other stuff, I never got around to it. Lucky, my macro/economist friend wrote me an email today soliciting my views. This forced me to hammer them out. Here they are, excising, of course, the personal pleasantries in the first para, and the salutation in the last:

“As for the markets, I just took down much of my long equity exposure, the day USDJPY broke 100. I think the dollar has more to rally and, even though the correlation to equities has been low, if for whatever reason the dollar rally accelerates, stocks could take a breather. I have had a good run so I don’t mind taking equity risk down and re-assessing. I am keeping positions in less than a handful of key equity names and will continue to watch. Still have long AAPL, short precious metals, for example.

My only high conviction positions right now are: being long dollars (biggest position is USDMXN, which I think is technically most vulnerable) and short silver, gold and a little bit of oil. My view on there being a bubble in commodities that is unwinding has not changed, despite the mini-crash in precious metals last month. On a scale of 1-10, risk is now a 5 for the book. I had been running closer to 9 for a while.

I am still bullish on the fundamentals in the US. Europe’s day of reckoning will come, but in my base case it is a fair ways down the road. EM will grow less than expected, but expectations are not too high. I don’t expect any blowup in EM. Further upside in USDJPY is mostly idiosyncratic here, and fairly heavily positioned, but USDJPY coming off hard would be one of the clearest indications of risk off/position liquidation I can think of.

I feel there is too much fear of a Fed exit (there is risk, of course, but IMO we are overpricing it, both in timing and magnitude of impact). And the wedge between valuations and fundamentals is less than what ppl argue, not least because the macro continues to heal under the surface (HH debt better, jobs slowly better, budget improving fast and not “priced in”).

US growth will still be anemic—structural/latent globalization issues will keep a lid on US wage growth, but too many ppl are too deeply pessimistic and are hanging their hats on the Fed blowing things up–because all their theses so far have been wrong. It’s like at the end of the football game and the team is betting everything on the long pass (the Hail Mary play) because they are so far behind in the score.

The above language may seem a bit cryptic and not fully fleshed out, but I hope it’s better than not putting the views out at all.

There is zero correlation between the Fed printing and the money supply. If you don’t believe this, you owe it to yourself to study up on monetary policy until you do.

This is an issue that brings them out of the bunker like no other in economics. But if you are an investor, trader or economist, understanding—and I mean really understanding, not just recycling things you overheard on a trading desk or recall from econ 101—the mechanics of monetary policy should be at the top of your checklist. With the US, Japan, the UK and maybe soon Europe all with their pedals to the monetary metal, more hinges on understanding this now than ever before.

And, as we saw this week, even many of the Titans of finance and economics have it wrong.

“Wrong? You’re saying they’re wrong? They have tons of money. They have long track records. I mean, they’ve seen it all.  How can you say that? That’s just arrogant.  Besides, did I mention they have tons of money?”

Here’s why the Titans are wrong

Brad DeLong had an entertaining piece on whales, super whales and men who hate the Fed, but the answer is much simpler than the one he offers. In fact, if you’ve ever been in the belly of a hedge fund, you know the answer to most everything is much simpler than it appears to the mere mortals on the outside.

The bottom line is the titans are working from the wrong playbook. We’re all, to varying degrees, slaves to our experiences. Their formative experiences, almost to a man, were in the early 80s. This is when they built their knowledge and assembled their financial playbooks. They learned words like Milton Freidman, money multiplier, Paul Volcker, Ronald Reagan, and the superneutrality of money. Above all, they internalized one dictum: real men have hard money.

This understanding implies that an increase in bank reserves deposited at the Fed (i.e. “printing”) eventually feeds credit growth and thereby inflationary pressures; in other words, no base money increase, no credit growth. Only one problem: reality disagrees.

Here are the facts

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.

How is that possible? I thought in a fractional reserve system base money had to grow for credit to expand?

The answer is structural. The financial deregulation that began in the early 80s (significantly, the abolition of regulation Q) and the consequent development of repo markets fundamentally changed the transmission mechanism of monetary policy. Collateral lending is now king. Today, length of collateral chains and haircut rates—neither of which are determined by the Fed—define the upper bounds of the money supply, not base money and reserve requirements.

What about the relationship to inflation? Isn’t base money correlated to that? Here’s a graph, from this piece by central banking expert Peter Stella.

 

The X axis shows 5-yr growth rate of base money (loosely defined) and the Y axis shows annual yoy inflation. That’s right. Nobody home here, either.

Don’t confuse liquidity with credit

The Federal Reserve only provides liquidity. The amount of liquidity it puts in the reserve system has no direct impact on the issuance of credit by banks or shadow banks. Only banks and shadow banks can create credit. And they lend either out of cash on hand or by repo-ing treasuries, mortgages, or deposits, if cash on hand is insufficient. And collateral that is pledged once can be pledged over and over and over (collateral chain). So, even though credit increases, the total amount of banking reserves on deposit at the Fed remains unchanged (though composition across banks may change).

So if the banks and shadow banks can just as easily repo their Treasury and mortgage holdings to finance lending, and there is no link between base money and credit creation, why is the Fed doing QE in the first place?

By keeping rates low well out the yield curve and providing comfort that the Fed will be there to fight the risk of recession and deflation, it creates an environment that enables, over time, a normalization of risk taking in the real economy. Our revealed belief is that the Fed can chop these nastier outcomes off the left-hand side of the distribution. As a result we start feeling better about putting our getting our money back out of the mattress and putting it back to work.

Risk taking always starts in financial markets, but eventually bleeds it way into the real economy. And, if you listen carefully, you can hear over the pitched squeals of fixed income investors, who are suffering from sticker shock and low yields, that this is exactly what’s transpiring. The time bought with aggressive monetary policy is allowing household balance sheets to the labor market to slowly heal. Heck, even the fiscal position is rapidly improving.

Again, it is important to underscore that it is the indirect psychological effects from Fed support and the low cost of capital—not the popularly imagined injection of Fed liquidity into stock markets—that have gotten investors to mobilize their idle cash from money market accounts, increase margin, and take financial risk. It is our money, not the Fed’s, that’s driving this rally. Ironically, if we all understood monetary policy better, the Fed’s policies would be working far less well. Thank God for small favors.

This is not a semantic point. I can hear traders saying “yeah, whatever, who cares, don’t fight the Fed, just buy”. But this concept has huge implications for the phase where the Fed decides to remove the training wheels. If the Fed money is not directly propping up the stock market and the economy underneath has been healing, the much talked about wedge between “Fed-induced valuations” and “the fundamentals” is likely considerably smaller than the consensus seems to think. It’s less “artificial”. In short, what all this means is the day the Fed lets up off the gas might give us a blip, or maybe that long-awaited correction, but ultimately the Policy Bears will end up getting crushed, again.

The other, more mechanical, implication is that financial sector lending is neither nourished nor constrained by base money growth. The truth is the Fed’s monetary policy can influence only the price at which lending transacts. The main determinant of credit growth, therefore, really just boils down to risk appetite: whether banks and shadow banks want to lend and whether others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share?

These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around–in large part because of what Econ 101 misguidedly taught us about the primacy of price, incentives and rational behavior. If you answer the behavioral questions and ignore the endless misinformation about base money—even when it’s coming from the titans of finance—as an investor you’ll be much better off.

I’ve written a couple of times already about the yield spread between 2s and 10s being an excellent contemporaneous indicator of risk appetite in equities. Macro guys look at a variety of “flattener/steepener” indicators, but this one is the granddaddy. It is something stock-jockeys often overlook.

The downdraft that started in March presaged the April volatility. It is a tribute to market strength that we only got volatility and not a more meaningful sell off.

It is now turning up. It’s worth you while, IMO, to sit up and take notice.

This is the question I always fantasize an insightful CNBC interviewer will ask of his/her guest after the guest offhandedly mumbles something about ‘the yen carry trade’.

Odds are, though, it’ll never happen. 

What is a carry trade and why is it so pervasively misunderstood?

First, a quick bit of history (Quick. I promise).

Back in the mid-90s it became increasingly clear that the BOJ was going to become much more aggressive in the battle against Japan’s deepening deflationary pressures. This unleashed monetary experimentation that eventually brought us concepts like ZIRP (Zero Interest Rate Policy) and QE. Fun stuff.

This produced the following investment backdrop: Japanese rates quickly going to zero, US rates north of 5 percent, and influential economists (including He whose name cannot be uttered) exhorting Japan to induce yen depreciation to reverse inflationary expectations. With this scenario, what was a hedge fund to do? Short the yen against the US dollar. In size.

Not only could you expect yen depreciation, but the large interest rate differential gave the trade a sizable tailwind, or, as fixed income guys refer to it, positive carry. On this position, the yen would have had to move against you (appreciate) 5 percent per year to breakeven. This led, over the 1995-98 period, to a move in USDJPY from 80 to 140. Since the positive carry was a sizable part of the ex-ante total return, it soon became known as the yen carry trade. (Side note: the memory of the move from 80-140 is behind much of the hedge fund community’s enthusiasm for the long USDJPY position today.)

But this yen carry trade was largely unknown outside of practitioners until 1998. Up until that point it was the purview of secretive hedge funds and fixed income wizards. The smart guys. However, that year, triggered by the Russian default, markets saw a disorderly unwind of the considerable risk built up in the previous few. From Russian GKOs to Danish mortgages to NJA currencies, it seemed everything was “funded” by a short yen position. Long-Term Capital Management—and the Wall Street prop desks that saw their trades and copied them for their own books—was at the center of much of this. But many, many others, notably Julian Robertson’s Tiger Management, experienced enormous pain.

The phrase ‘the carry trade’ soon became common parlance in finance. So common, in fact, that these days any time anyone shorts the yen—or any currency with below average interest rates for that matter—it gets referred to by some strategist or equity investor as ‘the carry trade’.

People say this because: one, it vaguely fits people’s memory; two, jargon makes people sound ‘in the know’ like the smart guys; and, three, to the legions of those still consumed by their anger at the Financial World it is laden with all the right pejorative connotations—secretive speculators blowing up our world.

But it is wrong.

Think about it. Who has lower interest rates today, the US or Japan? Right. There is no carry there. How about Europe vs. Japan? Right again. Investors short the yen because they are betting on yen depreciation. Carry plays no role.

What, then, do the pros consider a carry trade? The calculus is really simple. If, when you establish the position, the majority of your ex-ante return comes from the interest rate differential between the asset you short (this can include cash) and the asset you go long, then you are putting on a carry trade.

This implies that the price volatility of the paired trade is low RELATIVE to the interest rate differential.

Example: if you buy the Australian dollar against the US dollar, the interest rate differential these days is about 3 percent. Not a lot of carry. The volatility of the pair these days, while very low by historical standards, is still about 10 percent. This means your return will be dominated by the appreciation/depreciation of the pair, not by the carry. You can say this trade has positive carry to it, but you cannot call it a carry trade.

The classic carry trade in currencies came from the days where many emerging markets had pegged FX regimes and high interest rates—due mostly to shallow financial markets and lack of policy credibility. But those days are mostly gone. There are very few true carry trades left in the currency space. Currency volatility relative to potential carry is just too high. The only real carry trades these days are in credit—like them or not. And with low policy rates and steep yield curves in the main financial markets, some of them are quite attractive.  Carry on!

by Mark Dow and Michael Sedacca

Few would still argue against the assertion that the Federal Reserve has been central to the financial stabilization and economic recovery from the 2008 crisis. They fixed the plumbing and are now trying to incentivize animal spirits to pump water through the pipes. The debate has now migrated to exit strategies and whether growing side effects from exceptional monetary accommodation outweigh incremental benefits.

Nonetheless, it is the Fed, views are heated, and many misperceptions persist. The concept of money printing resonates strongly and intuitively with almost everyone, but most of the intuitive reactions to the Fed’s QE are turning out to have been wrong. Here are some of the major ones that linger.

1. Money printing increases the money supply. The Fed does not control the money supply; they control base money (or outside money), which is a small fraction of the broader money supply. In our fractional reserve system, the banks (loosely defined) control the other 90% or so of the money supply (a.k.a. inside money). And the banks have not been lending. This is why the money supply has not grown rapidly in response to years now of QE.
2. QE is “pumping cash into the stock market”. The truth is little of this money finds its way into the stock market. When the Fed implements QE, they are buying low-risk US Treasuries and agency mortgages from the market, mostly from banks. About 82% of the money the Fed has injected since QE started has been re-deposited with the Fed as excess reserves. With the remaining 18%, banks have tended to buy other fixed income assets of a slightly riskier nature—moving out the risk spectrum for a bank doesn’t mean jumping into equities, especially given the near-death experience that most of them have just gone through.Of course, not all of the USTs and MBS were purchased from banks. And some of the money does end up in equities. But, really, not all that much. The other big holders of USTs/MSBs who’ve been selling to the Fed for the most part have fixed-income mandates too, and they are also unlikely to take the cash from the Fed and cross over into equities with it.So, the natural question is why—if the above is true—have equities gone up so much in response to QE? The simple answer? Psychology and misconception.By taking an aggressive stand, the Fed signaled to markets that “I’ve got this”. The confidence that the Fed would do everything it could to protect our economic downside stabilized animal spirits. Then it slowly but surely enabled risk taking to re-engage. The fact that so many people believe that the Fed would be “pumping money into the stock market” and so many buy into the aphorism “don’t fight the Fed” (notwithstanding September 2007 to March 2009) made the effect that much more powerful.In short, this largely psychological effect on markets—one that I (Mark) had initially underestimated—bought time for household balance sheets to heal and is allowing fundamentals to catch up somewhat with market prices.
3. QE will create runaway inflation. “Yet” has become the favorite word of the inflationistas. As in, “Oh, it’ll come, just hasn’t yet”. And the magnitude of that expected inflation has been dialed down from ‘hyperinflation’ to ‘high inflation’.But some continue to hang on. The most extreme inflationistas insist that it is here now and the Fed is cooking the books. The reality, of course, is the Fed has nothing to do with the compilation of US inflation statistics, which is done by the BLS. Moreover, for those who are worried that all departments of government are conspiring against the American people, you would also have to believe the MIT is in on it too. MIT runs the Billion Price Project, a means of testing, using broad-based internet price sampling techniques, the extent to which the government’s measure of CPI reflects reality.But, there really has been no inflation, even with rounds of QE and interest rates stuck at zero. What we have learned in this crisis has driven home the points that the lending and borrowing that drive the money supply are more sensitive to risk appetite than they are to the price of money.Is it possible that this will end in a bout of inflation? Yes. But the odds are lower than consensus had been thinking and they are dropping—fast , as inflation continues to be well anchored and people come to understand better how the transmission mechanism of monetary policy actually works.
4. QE is the reason we have high oil/gasoline prices. This very deeply-held view is just as deeply mistaken. As the chart below shows, post crisis/post QE, oil prices on average (red line) have gyrated around 80-90 dollars per barrel with no ascending trend. The ascending trend came well before we knew what QE even was, in the 2002-2007 period. And the most rapid phase of its rise took place as the Fed was raising rates from 2004-2006.Paying high prices makes all of us angry, and it feels good to have someone to lash out at, but, alas, reality disagrees.What, then, caused the rise in the price of oil? In brief, the rise of China after it joined the WTO in 2002 and investor allocations to commodities as a “new asset class”, with trend followers, speculators and prop desks front-running the pack. Remember this was a period in which leverage was building and speculative juices flowing full steam.In any event, it’s pretty clear it was not a result of the Fed and QE.
5. QE has debased the dollar. Good luck convincing people this hasn’t been the case. This is an excellent example of repeating a falsehood until it becomes accepted as true.
   Again, roll tape…This is the trade-weighted broad-dollar average. It, much like the oil chart above, shows all the action took place before QE and the crisis. From 2002 to 2007 the Big Dollar, as currency specialists like to call it, depreciated some 20%. And the fastest depreciation came…that’s right, when the Fed was raising policy rates. Since the crisis the Big Dollar has been roughly unchanged, with gyrations suspiciously similar to oil’s.

Bottom line: Anyone alleging debasement is working from hearsay and priors, not the scorecard. And there are some pretty high-profile people still throwing around the ‘debasement’ word.

In fairness, the Fed did assume that their exceptional monetary accommodation might result in some depreciation of the dollar. But because the US is a closed economy (exports and imports make up a relatively small share of GDP) the Fed felt—correctly in our view—that it should be setting monetary conditions based on the larger domestic economy. And if dollar depreciation were to ensue, so the thinking went, it would at the margin be positive for US growth, as long as the depreciation was orderly.

Why, then, did the dollar depreciate so much in the 2002-2007 period? Pretty much the same reasons as with oil: it was a period of risk-taking, leverage and deepening optimism regarding emerging markets. All three factors led to dollar selling—well before QE ever made its first appearance in the US.

In sum, much of the received wisdom surrounding the Fed and the effects of its actions is misplaced. Through repetition and ex-ante biases, deep misunderstandings have become ingrained in market psychology.

Importantly however, the recent rise in the dollar and fall in commodities suggest that these long-held misguided views are becoming dislodged. There is plenty of risk ahead and the Fed’s task is far from easy or over. But the Fed, for the most part, is ahead of the curve. Make sure you and your views don’t get caught behind it.

Every once and a while you have to go back and see how your views have held up. Good traders do this as a matter of course. Economists, well, not so much.

This interview, with @aarontask from July 2010, covers economic views ranging from QE to fiscal austerity, to deleveraging, growth and comparisons to Japan.

Bottom line: I underestimated the psychological impact of QE2, but the rest holds up okay. If you are vapid enough to be interested in my economic babblings, this is as good as any tour d’horizon of the economic mechanics I work from.