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The Nuclear Option

What is "Quantitative Easing"? It means blowing up the economy...

THE U.S. AUTHORITIES at the Treasury and Federal Reserve are clearly scared that this credit crisis will keep feeding on itself, warns Dan Amoss for the Rude Awakening.

So they are determined to stop it. And thus the Treasury and the Fed are starting to implement variations on the "nuclear" option: quantitative easing.

This is what Ben Bernanke was referring to (back in 2004) when he joked about printing dollar bills without limit, the so-called "helicopter drop". Only this fresh inflation of the US money supply – created via quantitative easing in the economists' argon – will be more directed at the capital and mortgage markets, rather than just printing dollars to hand out on the street corner.

Quantitative Easing: Depression-Era Bank Guarantee

I consider two of the Treasury and Federal Reserve initiatives to be particularly important. First, the FDIC will guarantee newly issued bank debt. I think this is a watershed moment in financial market history. It may turn out to be as important as the original Depression-era guarantee of bank deposits. It will deliver a major jolt to the flat-lining credit markets. It is yet another massive subsidy to the banking system, courtesy of those hoarding US Treasury bonds and dollars (whether they know it or not).

Now the banks, "which haven't sold dollar-denominated bonds since September," says Bloomberg, "may raise $400-600 billion under the program within six months."

In the long term, this is probably bad for the banks, because they are giving up their right to pretend that they're free market institutions. But in the short term, I'll bet they'll start putting this idle money to work at a surprising rate.

In recent weeks, commercial banks in the US started hoarding hundreds of billions of newly created dollars at the Fed. A primary reason for this is that many of them were effectively shut out of the debt markets by having to pay rates of 8-10% on unsecured bonds.

The FDIC announcement should change this pretty quickly, which means that all the new fiat money on deposit at the Fed – up to $600 billion at latest count – may find its way first into the capital markets to buy distressed corporate debt at yields of 15-20% and stocks (prompting a year-end rally) and then in the form of new loans to refinance creditworthy borrowers.

Quantitative Easing: Fed Targeting Mortgage Rates

The Fed's second important new inflation policy may be even bigger. With its purchases of Fannie and Freddie debt and mortgage-backed securities, the Fed is now actively targeting mortgage rates – whether or not it officially announces this.

The Fed has committed itself to the purchase of up to $100 billion in Fannie and Freddie debt (which will have the effect of lowering the cost of issuing new mortgages) and up to $500 billion in mortgage-backed securities (which led to an enormous capital gains for any bank or brokerage holding agency paper). The effect of this announcement of new money, targeted directly at Fannie and Freddie, was powerful enough that 30-year mortgage rates immediately fell by about 50 basis points (half of one percent).

This action will go a long way toward reducing home price declines and foreclosures, at the expense of debasing the US Dollar even further. It's even possible that this could mark an end of huge write-downs at the major investment banks. Most of these write-downs had assumed a bleak trajectory of home price declines through next year. But if the rate of housing price declines slows, and the recovery values after foreclosures rise, then the values of mortgage-backed securities and related CDOs (collateralized debt obligations) might actually rise. We'll find out in the coming months.

Skeptics correctly argue that lower rates won't do anything for households with underwater mortgages and negative net worth. But keep in mind that we haven't even seen what types of initiatives the Obama administration and Congress will propose to stimulate housing demand. We can expect they will be creative, invoking a Depression-era climate of "emergency". Maybe the federal government will enact a major tax credit for buying an existing home, or even expedite the immigration process for foreigners with money to buy a home and/or highly demanded skill sets.

In short, the housing price decline's effect on the banking system doesn't worry me; the consequences of all this new inflation are more worrisome. Right now, the market is totally obsessed with what will likely be a manageable decline of a few percentage points in GDP and a jump in unemployment, while totally ignoring the elephant in the room: what kind of global monetary situation we'll be facing as soon as next year, and how long it will be possible to trade rapidly devaluing dollars for vital imports like oil.

Dan Amoss is managing editor for Strategic Investment, one of the world's most respected "big picture" investment advisories. He joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Now Dan develops his investment ideas using Strategic Investment's global network of geopolitical and macroeconomic analysts. He holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

See full archive of Dan Amoss articles

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