Death Of The Dollar Standard Part 2

As we covered yesterday, both bonds and Gold are screaming: “The central banks haven’t solved the problems!”

“But. the Fed!”, some say. “The M2 money stock is SHOOTING THROUGH THE ROOF! The printers are real! Number go UP!”

Today, we’ll dismantle this fallacy for what it truly is.

By the way, the velocity of M2 was updated on July 30th and saw another sharp decline. If you take a closer look at the M2 stock you see three parts absolutely skyrocketing: savings, demand deposits, and institutional money funds. Inflationary? No.

So, the printers aren’t real.

I’m sorry for the memes this may kill as a result.

Quantitative easing (QE) is the biggest part of the Fed’s operations to help the economy get back on its feet. What is QE?Upon doing QE the Fed “purchases” treasury and mortgage-backed securities from the commercial banks. The Fed forces the commercial banks to hand over those securities and in return, the commercial banks reserve additional bank reserves at an account in the Federal Reserve.

This may sound very confusing to everyone so let’s make it simple by an analogy.

I want to borrow a camera from you I need it for my road trip. You agree but only if I give you some kind of security, e.g., 100 bucks as collateral. You keep the 100 bucks safe in your house and wait for me to return safely. You just wait and wait. You can’t do anything else in this situation. Maybe my road trip takes a year. Maybe I come back earlier. So long as I have your camera, the 100 bucks stays with you.

In this analogy, I am the Fed.

You = commercial banks.

Camera = treasuries/MBS.

100 bucks = additional bank reserves held at the Fed.

Revisiting 2008 briefly: the true money printers

The true money printers are the commercial banks, not the central banks. The commercial banks give out loans and demand interest payments. Through those interest payments, they create money out of thin air! At the end, they’ll have more money than before giving out the loan.

That additional money can be used to give out more loans, buy more treasury/MBS Securities, or gain more money through investing and trading.

Before the global financial crisis commercial banks were really loose with their policy. You know, the whole “Big Short” story, housing bubble, NINJA loans and so on. The reckless handling of money by the commercial banks led to actual money printing and inflation until the music suddenly stopped. Bear Stearns went belly up. Lehman went belly up.

The banks learned from those years and completely changed, forever. They became very strict with their lending resulting in the Fed and the ECB not being able to raise their rates. By keeping the Fed funds rate low the Federal Reserve wants to encourage commercial banks to give out loans to stimulate the economy. But commercial banks are not playing along. They even accept negative rates in Europe rather than taking risks in the actual economy.

The GFC of 2008 completely changed the financial landscape and the central banks have struggled to understand that. The system wasn’t working anymore because the main players (the commercial banks) stopped playing with each other. That’s also the reason why we see repeated problems in the repo market.

How QE actually decreases liquidity before it’s effective

The funny thing about QE is that it achieves the complete opposite of what it’s supposed to achieve before actually leading to economic recovery.

What does that mean? Let’s go back to my analogy with the camera.

Before I take away your camera, you can do several things with it. If you need cash, you can sell it or go to a pawn shop. You can even lend your camera to someone for a daily fee and collect money through that.

But then I come along and just take away your camera for a road trip for 100 bucks in collateral.

What can you do with those 100 bucks? Basically nothing. You can’t buy anything else with those. You can’t lend the money to someone else. It’s basically dead capital. You have to just look at it and wait until I come back . . . if I come back.

And this is what is happening with QE.

Commercial banks buy treasuries and MBS due to many reasons, of course, they’re legally obliged to hold some treasuries, but they also need them to make business. When a commercial bank has a treasury security, they can do the following things with it:

1.Sell it to get cash

2.Give out loans against the treasury security

3.Lend the security to a short seller who wants to short bonds

Now the commercial banks received a cash reserve account at the Fed in exchange for their treasury security. What can they do with that?

1.Give out loans against the reserve account

That’s it.

The bank had to give away a very liquid and flexible asset and received an illiquid asset for it . . . Well done, Fed!

The goal of the Fed is to encourage lending and borrowing through suppressing yields via QE, but it’s not happening and we can see that in the H.8 data (assets and liabilities of the commercial banks). There is no recovery to be seen in the credit sector while the commercial banks continue to collect treasury securities and MBS. On one hand, they need to sell a portion of them to the Fed on the other hand they profit off those securities by trading them – remember JPM’s earnings.

So, we see that while the Fed is actually decreasing liquidity in the markets by collecting all the treasuries it has collected in the past, interest rates are still too high. People are scared, and commercial banks don’t want to give out loans. This means that as the economic recovery is stalling (another whopping 1.4M jobless claims on Thursday July 30th) the Fed needs to suppress interest rates even more.

You know what that means: More QE!

You know what that means: More liquidity dries up! . . . Well done, Fed!

We heard JPow saying last Wednesday that the Fed will keep their minimum of 120 billion QE per month, however (and this is important), they can increase that amount anytime they see an emergency.

That’s exactly what he will do.

He will ramp up the QE machine again, removing more bond supply from the market and therefore decreasing the liquidity in financial markets even more. That’s his Hail Mary play to force Americans back to taking on debt again. All of that while the government is taking on record debt due to “stimulus” (which is apparently only going to Apple, Amazon, and Robinhood).

Who pays for the government debt? The taxpayers. The wealthy people. The people who create jobs and opportunities.

In the future, they have to pay more taxes to pay down the government debt (or at least pay for the interest). This means that they can’t create opportunities right now due to the government going insane with their debt – and of course, there’s still the Coronavirus.