Over the last couple of months one of my main assumptions is that the US economy has reached self reinforcing escape velocity. The Fed overstaying their welcome at the easy monetary policy party will be the economy’s chief problem, and not the other way round.

My belief is that the mountains of stimulus have finally ignited and the problem will be with the fire quickly raging out of control as opposed to smouldering out. In essence, the velocity of money has finally stopped declining and the excess reserves are finally being put out into the system in the form of new loans.

According to the stats, the actual velocity of money has not yet stopped declining, but that doesn’t worry me as I believe it would first show up in the market before the chart actually reflects the increase:


After all, the Fed’s three QE program have been collecting on banks’ balance sheets as excess reserves and eventually have to be put out into the system as loans:


But what if I am wrong? What if the US economy is not capable of reaching escape velocity without even more QE?

I cannot rule out this possibility. After all, at the end of QE1, the market felt that the economy was ready to stand on its own feet, but as soon as the Fed stopped expanding its balance sheet, the economy quickly sagged. And then again at the end of QE2 the market thought that the economy was finally ready, but once again, it proved too early.

There is a possibility that this time will be no different and that as the Fed stops expanding its balance sheet, the economy will again sputter.

I still don’t think this will be the case, but I need to at least acknowledge this possibility.

And if that does occur, then what are the consequences? Everyone mistakenly assumes that QE is positive for bonds, but the data does not support this belief. Have a look at the US 10 Year Yield with the QE programs highlighted:

http://themacrotourist.com/images/Azure/QEUS10Apr1414.pngUS 10 Year Treasury Yield</a> </div>

During periods of QE yields actually rose. The biggest rallies in the bonds market (declines in yields) occurred as the QE programs drew to a close and the economy sagged.

And if you stop to think about it for a moment, it makes sense. QE is designed to inflate the economy. What is a bond investor’s worst fear? Inflation.

If QE is successful in its goal of reflating the economy it will actually cause the bond market to go lower, not higher. Therefore more QE is ultimately bond negative, not positive.

If the economy has not reached escape velocity and the Fed is indeed intent on winding down its QE3 program, then I would be forced to re-evaluate my negative bond bias. This scenario of no QE would be very bond friendly as credit would contract as the economy returned to its deflationary tendency.

Remember, if the velocity of money does not ignite due to increase credit creation, then the natural state of the economy will be one of credit being paid down. There is simply so much debt outstanding that absent extraordinary measures, credit will not expand. That is why we have had so much QE without inflation picking up.

The real problem lies in the fact that as the Fed is required to balance this deflationary tendency, they have put so much high powered reserves into the system that any increase in velocity will have an exaggerated effect.

Over the last 5 years as the economy has failed to produce the much worried about inflation from the unprecedented Quantitative Easing programs it has become quite fashionable to say that traditional monetary theory has been broken. The whole idea of MV=PQ has been largely thrown out the window.

http://themacrotourist.com/images/Azure/FriedmanApr1414.pngMilton Friedman’s Licence Plate</a> </div>

I don’t buy for one second that this theory should be abandoned. In fact, when something so obvious is refuted, you know that the ultimate policy mistake is only going to be all the worse.

Remember Cheney’s “deficits don’t matter comment?” The “Crooks and Liars” blog sums the situation up nicely;

…on December 6, 2002, the Bush Administration fired its top two economic advisers: Treasury Secretary Paul O’Neill and White House economic adviser Lawrence Lindsey due to the continuing lagging economy (when Bush took office, unemployment was 4.2%. In Dec of 2002… more than a year after 9/11… the rate jumped from 5.7% to 6.0% in one month). In November of 2002, when O’Neill, a “deficit hawk”, tried to warn Vice President Dick Cheney that growing budget deficits… expected to top $500 billion that fiscal year alone… posed a threat to the economy. Cheney cut him off, saying, “You know, Paul, Reagan proved deficits don’t matter.”

Ten years ago it became very fashionable to not worry about deficits. Bush went to war, increased medicare and at the same time, put in a tax cut with the mistaken belief that deficits didn’t matter. We all now know that deficits do matter and that they only don’t matter in the short run.

So when market pundits claim QE is not going to cause inflation because MV=PQ no longer applies, take a big breath, ignore them and protect your portfolio against what you know will be coming (eventually).

But I am getting off topic. The real purpose of this post is to talk about the possibility that I am wrong – not to reinforce my opinion. And as one of my good buddies says, “I am never wrong, my timing just sucks sometimes.” I of course am wrong all the time, but I also find my timing sucks (most of the time).

And although I think that eventually the QE programs will ignite and cause very significant inflation, there is a chance that the end of QE3 will prove to once again be a false start for a self reinforcing recovery. If that is the case, then I need to be on the lookout for my bond positions are set up exactly the wrong way.

For now, I am just acknowledging that this is a possibility and preparing myself for signs that the US economy is not as prepared for the removal of QE3 as I thought…

Cannabis stocks up in smoke

I have written a little bit of the speculation in Cannabis stocks, but for the most part I have just steered clear as the madness that enveloped these stocks was just stupid scary.

Well, this past month the high has worn off and investors have been left with nothing more than bloodshot eyes and empty potato chip wrappers everywhere.

http://themacrotourist.com/images/Azure/CANNApr1414.pngCANN – Advanced Cannabis Solutions</a> </div>

It seemed like such a well thought out idea, I am really shocked that it didn’t work out.