After listening to a substantial portion of Janet Yellen’s testimony on Capitol Hill last week, I came away with the impression that the September “no-tapering” decision was in large part due to the imminent departure of Ben Bernanke on January 31, 2014. With inflation running consistently below the Fed’s target rate, with unemployment above the Fed’s target rate, and with the current Chairman departing, it would have looked rather foolish to taper now and then reverse later should the need arise.
This delay tactic opens the possibility for Janet Yellen to (a) extend this QE business much longer than current expectations or (b) increase QE should inflation and monetary targets remain difficult to attain.
I know many investors are afraid of QE. For one thing, they fear getting “wiped out” by a tsunami of hyper-inflation. In particular, the feedback from my explanation of QE in a recent MarketMail can be summarized with a statement dripping with disbelief: “So you are saying QE is not such a big deal?!”
I am definitely not saying that. The Federal Reserve’s balance sheet is definitely on the rise.
The Basics of Monetary Math at the Fed
As the Fed’s 2008 emergency liquidity programs wound down, the St. Louis Federal Reserve Bank’s adjusted monetary base began to track the growth of the Fed’s balance sheet closely. So did the excess reserves at monetary institutions. At the end of last week, the Fed’s balance sheet stood at $3.907 trillion. Every week, it goes up by roughly the amount of new QE operations within the system.
In other words, the Fed prints and the monetary base goes up. Then it buys bonds with the printed cash (so its balance sheet explodes), but that cash does not circulate excessively. It ends up parked at the Fed (so the excess reserves of banks go up). A bank can make an occasional loan using excess reserves, but they still end up being excess reserves at another bank if that other bank can’t make a good loan, so the endless credit multiplier effect that was historically checked only by the level of required reserves does not play out. Excess reserves are no longer being lent in the interbank market. Excess reserves carry purposefully higher interest (controlled by the Fed) than the fed funds rate (also controlled by the Fed).
The “Great Unknown” in this case is how long this great monetary experiment can continue without causing irreversible damage. I do not believe anyone – including Janet Yellen or Ben Bernanke – has the faintest idea of the answer. This QE business has worked so far, but the major holders of forex reserves, like BRIC countries (China has more forex reserves than the other three combined), have already begun to make political noise. In my opinion, a failure of QE that brings inflation of U.S. debts (or other unforeseen consequences) is likely to cost the dollar its reserve currency status and set back the process of globalization that has been beneficial to emerging and developed economies.
At present, the Federal Reserve balance sheet reminds me of Hoover Dam being filled to the brim with monetary liquidity. The Hoover Dam is big and impressive, but what happens when Lake Mead rises over the dam wall? No one knows, as it has never happened before. This QE business might last much longer, but it is unlikely that it can last ad infinitum. The unwinding of QE is Ms. Yellen’s big challenge.
A QE Tapering Victim: Mortgage REITs
This QE tapering business has pressured all kinds of income investments since last May, but one of the hardest hit vehicles have been mortgage REITs. I wrote an analysis of mortgage REITs in January. They were doing fine until May, when QE tapering speculation caused them to be shunned by investors.
QE tapering speculation has hit the highest-yielding investments the hardest, since this is where many investors were reaching for yield. As a result, mortgage REITs are currently the only sector offering a double-digit yield. Presently, you can earn 10.95% on Market Vectors Mortgage REIT ETF (MORT).
Mortgage REITs are financing structures that use REIT regulations to deliver a higher income stream to investors than would otherwise be possible. As such, they are not operating companies whose businesses grow and pay dividends. They can only issue more stock or debt to buy residential mortgage-backed security (RMBS) or commercial mortgage-backed security (CMBS) to lever them up with repo activity so they can deliver a high income stream to investors. They may have a place in an income investors’ portfolio, in light of the fact that normal REITs offer such paltry dividends.
The yield curve is expected to remain steep, which is key for mortgage REIT funding, as they are in effect a leveraged carry trade of mortgage assets. The real estate market – be it for commercial or residential real estate – is not expected to deteriorate significantly due to QE tapering, so the selloff in mortgage REITs looks more like a panic (and possibly an opportunity) than anything else.
Written by Ivan Martchev