Why There Will Be QE3

U.S. economyA debate has been raging in the financial press, among economists and even among the Federal Reserve board members themselves. Will there be a third round of quantitative easing, QE3, made by the U.S. Central Bank?

Fed Chief Ben Bernanke introduced the idea of QE3 a few months ago, saying it would be focused on buying mortgage-backed securities. However, just a few weeks ago, he seemed to pour cold water on the notion of QE3.

Our budget deficit is on pace in 2012 to exceed $1.3 trillion and I’m sticking to my call of a budget deficit in excess of $1.0 trillion for 2013.

This means that the U.S. Treasury is going to have to issue a lot of U.S. government debt in order to pay for this shortfall in the budget deficit.

At the end of 2011, the Federal Reserve owned over $1.6 trillion dollars of U.S. Treasuries—U.S. government debt—while state and local governments owned roughly $700 billion.

At the end of 2011, China was the largest foreign owner of U.S. government debt at $1.15 trillion and the second largest foreign owner of U.S treasuries was Japan, at just over $1.04 trillion.

China and Japan purchases combined represent 15% of all U.S. government debt—U.S. Treasuries outstanding. Add the U.S. Treasuries owned by state and local governments, and these three entities purchased 20% of all U.S. government debt outstanding.

In the last six months of 2011, China sold more U.S. Treasuries than it ever has before—over $16.0 billion. China has made it clear that it wants to diversify out of U.S. government debt. Now, China is putting its money where its mouth is.

For each of the last 10 years, China has increased its holding of U.S. government debt. However, over the last two years, there has been little growth in the amount of U.S. Treasuries China has purchased. As a matter of fact, China, over the last six months, has become a seller of U.S. government debt!

Japan, dear reader, is in trouble. Its budget deficit is 56% larger than its revenues! As such, the Bank of Japan has no choice but to print money to make up the difference.

The Japanese government is attempting to double the consumption tax in its country, in order to increase revenues, to help make up the revenue shortfall. However, with deflation that has persisted for 20 years, and a consumer whose income has not risen, this will prove challenging.

Considering how much money Japan is going to need in the near future, it is conceivable that not only the country will stop buying U.S. treasuries, but also that Japan may sell U.S. government debt to help alleviate its situation at home.

As for state and local governments that own $700 billion of U.S. government debt—U.S. Treasuries—I’ve been writing often in these pages about the plight of many of the troubled states and local governments.

So I ask myself, as the U.S. Treasury needs to issue more U.S. government debt to meet the trillion-plus budget deficits in this country, where are the buyers going to come from?

If China is selling U.S. Treasuries, Japan is in so much trouble it needs to take care of itself, and many of the U.S. states and local governments are in similar situations to Japan, then how can these entities, which represent roughly 20% of all the purchases of U.S. government debt, buy more U.S. Treasuries?

Add to this the fact that the Federal Reserve itself represented just over 12% of all purchases of U.S. government debt while it was printing money, and you are left with a 32% shortfall in purchases of U.S. Treasuries.

So, if these entities stop buying, who will step in and buy U.S. government debt? Welcome, dear reader, to QE3. I don’t think it’s a question of whether QE3 will be launched, but rather a question of when. (Also see: Money Printing by Any Other Name.)

Michael’s Personal Notes:

The U.S. unemployment numbers for February were released Friday, and jobs growth was better than expected. The U.S. created 227,000 jobs in February. More importantly, jobs growth for December and January were revised higher, adding 61,000 (source: Bureau of Labor Statistics).

While these were decent numbers, a closer look shows that we still have a lot of work to do to return to levels of jobs growth seen before the crisis hit in 2008.

I’m glad to see the improvement in U.S. jobs growth, but unfortunately, it looks like workers took any job that was available, and not necessarily well-paying jobs.

Professional and business services jobs growth resulted in 82,000 jobs added in February, but more than half—45,000—were temporary positions. Health care and social assistance added 61,000 jobs, while food services and drinking places added 41,000 jobs.

This translates to 65% of the jobs growth created being in the low-paying category. As a consequence, average hourly earnings rose by just three cents—one can say unchanged from January. From February 2011 to February 2012, average hourly earnings have only risen 1.7%.

Without strong growth in wages, consumer spending will continue to come under pressure. I’ve been arguing how real disposable income is actually declining, and certainly these wage numbers do not help repair this problem.

A closer look at the February jobs report reveals that the unemployment rate remained unchanged from January, at 8.3%. This means that the number of people looking for work remained unchanged.

The long-term unemployed, those people out of work for more than 27 weeks, remained basically unchanged at 5.4 million people.

U6, as reported by the Bureau of Labor Statistics, is a broader measure of the unemployment rate, because it takes into account discouraged people as well as those working part-time who want full-time work. The U6 unemployment rate dropped to 14.9% and is improving from last year’s 16.7%. But this is still an extremely high number.

The “labor participation rate” measures all people in the working age population (from ages 16-64) who are actually employed. In January, the rate hit a 30-year low of 63.7%; that is, only 63.7% of the people who can work and want to work are actually working. In February, it improved somewhat to 63.9%, but it still remains stuck at 30-year lows.

The fact that the U.S. economy is experiencing jobs growth at all is a good thing. It has been a string of six months where jobs growth has been positive here in the U.S., which has helped bring the unemployment rate down somewhat.

When I personally look at the job numbers of the past few months and see what kind of jobs people are taking and the rate at which they are being paid (average hourly earnings), and I think of the trillions in dollars in the government has thrown at the economy in the hope of creating jobs, I’m just not impressed.

Where the Market Stands; Where it’s Headed:

Friday, we officially celebrated the three-year anniversary of the bear market rally in stocks that started on March 9, 2009. Yes, dear reader, the stock market has gone up 100% since March of 2009. I’ve thrilled to have made the call back then that we were entering Phase II of the bear market—the rally that would bring investors back into the stock market. And I’m happy to have kept my readers in stocks since then

And the bear market isn’t over yet. Central bank money printing and government debt gone mad simply continue to extend the rally. (Also see: The Next Step for the Stock Market.)

What He Said:

“Partying Like a Drunken Sailor: The party continues. Stocks are making new highs and people are spending like there is no tomorrow. Why? I really don’t know. Big (cap) stocks, they just continue going up. Wall Street bonuses are at record levels. Popular consumer goods are flying off the shelves. Designer clothes, fast and expensive cars, restaurants with one-hour waits…people are spending in America today at an unbelievable clip. 1932, 1933…who remembers those years? The depression of the 1930s was the biggest bust of modern history. 2005, 2006, 2007…welcome to the biggest boom of the same period. When will it all end? Soon, my dear reader. Soon.” Michael Lombardi in PROFIT CONFIDENTIAL, February 7, 2007. Michael started talking about and predicting the financial catastrophe we began experiencing in 2008 long before anyone else.