Don’t Look Now But The Wealth Effect Is Over

The government’s “ingenious” solution to end the Great Recession was to recreate the same wealth effect that engendered the credit crisis to begin with: The definition of the wealth effect is an increase in spending that comes from an increase in the perception of wealth generated from equities and real estate.

Our Treasury and Federal Reserve figured the best way to accomplish this was to rescue the banking system by; taking interest rates to zero percent, buying banks’ troubled assets, and recapitalizing the financial system. Most importantly, our government loaded banks with excess reserves. This process, known as quantitative easing (QE), pushed lower long-term interest rates through the buying of Treasury Notes, Bonds and Agency MBS.

It is imperative to understand the QE process in order to fully understand why the tapering of asset purchases will lead to a collapse in asset prices and a severe recession.

The QE scheme forces banks to sell much higher-yielding assets (Treasuries and MBS) to the Fed, and in return the banks receive something know as Fed Credit, which pays just one quarter of one percent. For example, the Five-year Note currently yields 1.75 percent and the Seven-year Note offers a yield of 2.30 percent. The Fed is currently buying $30 billion worth of such Treasuries per month and $25 billion of higher-yielding MBS.

In fact, the Fed has purchased a total of $3.5 trillion worth of MBS and Treasuries since 2009 in a direct attempt to boost equity and real estate prices. QE escalated in intensity as the years progressed. The year 2013 began with the Fed promising to purchase over a trillion dollars’ worth of bank debt--without any indication of when the QE scheme would end…if ever.

Therefore, financial institutions did exactly what rational would dictate.  These banks bought bonds, stocks and real estate assets with the Fed’s credit because not only were the yields higher, but they also understood there would be a huge buyer behind them—one that was indifferent to price and had an unlimited balance sheet. Since these assets offered a yield that was much greater than the 25 basis points provided by the Fed and were nearly guaranteed to increase in price, it was nearly a riskless transaction for banks to make. This QE process also sent money supply growth rates back up towards 10% per annum, as opposed to the contractionary rates experienced in 2009 and 2010.

Of course, most on Wall Street fail to understand or refuse to acknowledge that ending QE will cause asset prices to undergo a necessary, but nevertheless healthy correction. However, looking at the evidence since the tapering of asset purchases began, it is clear that the Fed’s wealth effect has ended.

The Fed announced in December of last year its plan to reduce asset purchases beginning in January of this year. Its base-case scenario would be to reduce QE by $10 billion per each Fed meeting. Since the start of this year, asset prices have stopped rising. According to the Case-Shiller National Home Price Index, home values have actually dropped 0.33% during the last 3 months of the survey.  In addition, the Dow Jones Industrial Average and the NASDAQ have both dropped in price over the past four months. Only the S&P 500 has managed to eke out a very small gain so far this year—and one third of the year is over.

Real estate and equity values have already lost their momentum, as the Fed is removing its massive support for these assets. In a further sign of real estate weakness, the Commerce Department recently announced that New Home Sales fell three months in a row and plummeted 14.5 percent in March from the prior month’s pace. But Wall Street will try to convince investors that the spring allergy season—also known as the pollen vortex--is unusually bad this year. Therefore, nobody wanted to go outside and purchase a new home, even after all the snow melted.

The bottom line is as the central bank stops buying assets from private banks, these institutions won’t have the need or the incentive to replace them, and the direct result will be a contraction in the money supply.

But nearly every market strategist believes the Fed’s taper will have an innocuous effect on markets. They believe this because of their conviction that new bank lending will supplant the money creation currently being done for the purpose of buying new assets. But what would cause banks to suddenly start lending to the public?

The government has overwhelmed banks with new regulations and announced on April 8th that it will force banks to add $68 billion to their capital, which will negatively affecting balance sheet growth. The public sector is still greatly in need of deleveraging because Household Debt to GDP ratio is still over 80%, opposed to the 40% it was in 1971. Real disposable income is not increasing, which has left the consumer with little ability to take on more debt. There just isn’t any reason to believe that consumers will suddenly ramp-up their borrowing.

It wasn’t any coincidence that the size of the Fed’s balance sheet and the S&P 500 were both up 30% last year. But very soon the amount of QE will be close to, if not exactly at zero. And without banks supporting asset prices by consistently creating new money at the behest of the Fed, stocks and home prices have nowhere to go but down.

I anticipate the reduction of the wealth effect to intensify as the taper progresses. Since the economic “recovery” was predicated on the rebuilding of asset bubbles, a long delayed and brutal recession will start to unfold later this year.

The real question investors need to answer is to determine how long Janet Yellen will wait before admitting the economy is completely addicted to QE, and that there is no escape from the Fed’s constant manipulation of money supply growth and asset prices.

Having raised significant funds ahead of this huge selloff in order to profit from the launch of the Fed’s next massive round of debt monetization should prove to be one of the most important investment strategies of a lifetime. This is exactly the reason why Pento Portfolio Strategies has been in 75% cash since January.

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Michael Pento is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

mpento@pentoport.com

twitter@michaelpento1

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