What is (was?) Quantitative Easing intended to accomplish? Here’s what Ben Bernanke said at Jackson Hole when he first proposed the program:
The channels through which the Fed’s purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short- term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public.
Specifically, the Fed’s strategy relies on the presumption that different financial as-sets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.
Maybe the most important phrase in those two paragraphs is “I see the evidence as most favorable to the view”. What that means in layman’s terms is that Bernanke – and no one else for that matter – didn’t then – and sure doesn’t now – know how or even whether QE actually works to raise economic growth. The evidence since the first incarnation of QE is mixed. It is a bit curious that Bernanke continued to believe that QE lowered bond yields even after each implementation of the program produced the opposite. One might, as Bernanke obviously did, assume that rates would have been even higher absent QE, but that is dubious at best (although impossible to prove either way). I say that because each iteration of QE produced a rise in inflation expectations that was reversed once the program was wound down. The one effect of QE that we can confirm and quantify is that it raises inflation expectations. I’m not sure what bond market Bernanke is familiar with but the one I know does not look favorably on higher inflation.
Of course, another theory of QE is that this rise in inflation expectations is actually a positive and is the real way QE affects growth. Rising inflation expectations, in theory, should spur spending today in advance of price hikes tomorrow. There is little in the way of actual data to back that up but it does make a good and logical story for the masses. It could be that expectations of rising prices produces the opposite effect by inducing consumers to save more today to pay for the future price hikes. One would be hard pressed to find that in the savings rate data though so maybe the inflation expectations theory of creating growth actually works as the theory suggests. At best though, it is a temporary, palliative effect. Assuming the inflation expectations are correct and prices do rise, the purchasing of goods today just reduces the purchases of goods tomorrow. Even if QE didn’t actually raise prices, it would still only “work” by pulling forward purchases from the future to the present. TANSTAAFL.
But let’s return to the Bernanke theory for a minute and consider what QE hath wrought. Bernanke’s idea was that if he just removed enough safe assets from the available mix, investors would shift their capital to riskier assets. This shift to riskier assets is a nod to Keynes belief in animal spirits as essential to getting an economy out of a slump. This part of Bernanke’s theory has been borne out. One need look no further than the bond market to find evidence that investors did respond as Bernanke predicted. Corporate bond issuance is on a tear to meet the seemingly insatiable demand for yield product. 2013 was a record year for bond issuance totaling over $1.3 trillion and this year has seen no let up. One can’t help but assume that stock prices have benefitted as well with IPOs of ever more dubious companies a highlight of the calendar.
So, clearly, Bernanke was right that QE would incite the old animal spirits, but was he correct that this would lead to better economic growth? One would be hard pressed to find any evidence in the latest GDP report. For those of you who had better things to do than wait for the government to tell you what you already knew, GDP fell by 1% in the 1st quarter. GDP contraction in any quarter is pretty rare outside of recession (as Jeffrey points out here) but hope springs eternal so the consensus is that the 1st quarter was an aberration and will soon be reversed. Of more concern to investors should be the drop in corporate profits buried in the GDP report. There were some mitigating circumstances due to tax changes but the fact is that corporate profits fell in the first three months of the year despite the small rise in EPS reported by the companies of the S&P 500.
That’s where Bernanke’s portfolio balance channel theory rubber meets the road actually. It seems pretty obvious that the reported rise in S&P earnings per share was a function of the boom in corporate bonds. A large portion – over a third – of the corporate bond issuance has been for the purpose of buying back stock and paying dividends. It hasn’t been used to make productive investments – yet – and therefore hasn’t had the intended effect on economic growth. Another use of corporate cash has been in the very active M&A market which globally amounted to over $500 billion in the first quarter alone. With sales growth stagnant, companies are trying to buy growth, something that has a dubious track record to say the least.
In Bernanke’s explanation, investors swap high quality MBS or Treasuries for high quality corporate bonds but reality has seen something a bit different. From 1996 to 2006, a bit over $1 trillion in junk bonds were issued. It took only 3 years to match that total in the QE era. What is more disturbing is that a large portion of that junk debt (and a lot more that isn’t reported via the bank lending channel) is being issued to fund oil and gas exploration companies for the fracking of oil and natural gas. Shale debt has at least doubled over the last four years. Why is that disturbing? Isn’t shale supposed to lead us to the nirvana of energy independence? Well, maybe not. I’ve been a critic of the industry since the boom first started and not because I’m concerned about the environmental impact (although that probably deserves more of my attention). My criticism has focused on the economics of shale.
There are two pieces of the economic puzzle when it comes to shale. First is that most shale oil deposits are not profitable to extract except at current high prices. This drilling/extraction method is not cheap. Breakeven prices vary by region but it is safe to say that no shale oil deposits are profitable below $50/barrel and most areas require much higher prices. An average might be in the range of $65 and there are plenty of areas where the price needs to be above $80 before anyone makes a nickel. I would just note that oil traded, albeit briefly, at $34 in the last recession. Second is the production profile of shale wells; production drops off rather precipitously after the first year (in contrast with traditional wells which deplete over much longer time frames). Combine high extraction costs with rapid depletion and the economics of shale become not only dubious but frankly insane.
We’ve already seen a number of large oil and gas companies take writedowns on their shale investments but the BPs of the world can afford to write these off and move on. Smaller companies find themselves in a more precarious position. As production from their existing wells falls rapidly, they have to drill more wells just to maintain production at current levels. And they are funding that drilling with debt to the point where a number of companies are now dedicating double digit percentages of their revenue to interest costs. In some extreme cases, interest expense has exceeded revenue.
This shale oil and gas ponzi scheme can only go on for so long. For many of these companies it will only take a few dry holes to end their borrowing spree and send them to bankruptcy court. High yield and bank loan investors should take note. Oil and gas is the second largest position in HYG. It was a long time ago, but it probably would be instructive to remember too that Continental Illinois, the original TBTF bank, failed in the mid 80s because it lent too much to the oil and gas industry right before a bust. Any Texans old enough to remember might take the time to remind younger investors about the last oil bust and its effects on the Texas banking industry.
And that brings us right back to Bernanke’s theory of how QE works and whether it in fact raises economic growth. Bernanke was right that QE does indeed change the allocation of capital; more risk has been taken. Whether it is a better allocation seems doubtful. If the first quarter is an aberration and the economy accelerates it might take more time to find out for sure but misallocation of capital due to Fed distortions does have consequences (see Bust, Housing). But if it is a harbinger of things to come, the end of the shale boom is nigh and with it the capital that has been wasted in its pursuit. Bernanke’s theory of QE may amount to nothing more than an off key version of We Shale Overcome.
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