We cannot overemphasize the potential negative effects associated with the probable ending of QE2 at the end of June. QE2 is the Fed's unprecedented attempt to get the faltering economic recovery growing again in the absence of any further expansion of fiscal policy in the face of record federal budget deficits. In this regard the key fact to remember is that we are in a hesitant recovery that will remain restrained by the after-effects of a major credit crisis and the need to deleverage the enormous household debt built up during the boom.
As a percentage of GDP, household debt went from 45% to 68% in the 35 years between 1965 and 2000, and then soared to 98% over the next nine years alone to its peak in 2009. Since the start of the deleveraging process the percentage dropped to 90% by December 31st. In our view the deleveraging has a long way to go. Just to get back to the level reached in 2000 (which itself was historically high), household debt would have to decline by another $3.3 trillion. Since this amounts to about 31% of personal consumer expenditures it is easy to see why the debt has been and will continue to be such a drag on the consumer and the economy in general.
With Congress and the White House under severe political pressure to come up with some meaningful cuts in the budget deficit, the expiration of QE2 has important negative consequences. You may recall that the stock market soared with the implementation of QE1 and the economy started to recover. However, when QE1 was wound down at the end of March 2010 the economy faltered and the stocks dropped 17%. To prevent the economy from dipping into another recession Chairman Bernanke, in mid-August announced the probable implementation of so-called QE2, a program to purchase $600 billion of Treasury bonds by the end of June with the stated purpose of driving up asset values in the hopes that it would spur additional spending.
Although QE2 has helped some segments of the economy and jump-started the stock market, it has had important negative implications as well. Since that time commodity prices have soared while long-term interest rates have climbed and the dollar has weakened. The rise in food and energy prices has caused top-line inflation to increase faster than wages, resulting in declining real income. In addition it has resulted in higher inflation in developing nations as well as the EU, causing them to raise interest rates at the risk of slowing down global growth. Some nations have also instituted capital controls to prevent too many dollars from entering. It is also likely that rapidly rising food and energy prices played an important role in engendering unrest in the Mid-East.
The coming end to QE2 is potentially negative for both the market and the economy. By the time it ends on June 30th the Fed will have bought an average of $3.8 billion of Treasury bonds every working day of the week. That amounts to about 70% of all the Treasury bond issuance since Mid-November. The proceeds, which went to the banks that sold them, were then used to buy up assets, mainly stocks and commodities. Without the Fed in the picture it is difficult to envision anyone else willing or able to step in and purchase the bonds without a really big increase in rates. With no help from the fiscal side the likely outcome is a major decline in asset values including stocks and commodities along with another round of weakening growth in an already fragile economy. It may well be that somewhere down the road there is another round of quantitative easing, but not before some severe economic and financial problems in the interim.