The Ride of Your Life

Jim Brown
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The Fed announced QE3 in a program that could add $1 trillion to the Fed's balance sheet in 2013 and commodities and equities soared. Thank you Uncle Ben.

Bank of America analyst Priya Misra sent out a note saying BofA does not expect any substantial improvement in employment for the next 18-24 months. BofA also believes the Fed will buy treasuries again at the end of Operation Twist in December. The combination of 18 months of QE3 and the extension of the treasury operation could add another $1 trillion to the Fed's balance sheet in 2013 and possibly another $1 trillion in 2014. Granted that is a huge assumption that the Fed would continue to create money at that pace but Bernanke all but said they were not going to stop until the economy was significantly better.

Misra believes the Fed will eventually hold 65% of the entire bond market with maturities over five years along with 33% of the entire mortgage market by 2014. These amounts are staggering but definitely possible.

That type of QE along with new stimulus announced by India, ECB, China, Brazil, BOE, etc will produce an ocean of cash to float commodity and equity prices higher. Congratulations your dollars are going to get a lot cheaper.

In the past I have shown images of inflated currencies that were victims of hyperinflation. In some inflationary spirals the amount of currency in circulation made the actual bills so cheap they were burned for heat because they were cheaper than coal. In Zimbabwe they went through a period of inflation that was so severe they had to print new notes of higher denominations every couple weeks. In 1980 the Zimbabwe dollar (ZWD) was worth about $1.25 USD. By 1998 government reforms crushed the economy and people could not carry enough physical currency to pay for daily items. The government embarked on a program to print new banknotes (ZWN) in higher denominations.

May 5th, new notes with a denomination of 100 million and 250 million ZWN.

May 15th, new notes of 500 million ZWN (worth $2.50 at the time)

May 20th, new notes of 5 billion, 25 and 50 billion.

July 21st, new notes of 100 billion.

By August 1st inflation was officially 2,200,000% with some economists claiming 9,000,000%. As of July 2008 the ZWN fell to approximately 688 billion to $1 US dollar or 688 trillion pre August 2006 Zimbabwean dollars.

While that example is extreme our world history is full of other examples only slightly less disastrous thanks to hyperinflation.

I am not claiming the U.S. is headed down that path BUT if the Fed continues on the QE3 path we are headed for a serious problem in the very near future. QE in any form is the creation of new money to flood the money supply. That excess money devalues the dollar and pushes up the value of commodities.

For instance the value of an ounce of gold is roughly $1770 today. That is in U.S. dollars. It is valued at different amounts in British pounds, euros, yen, yuan, Brazilian reals, Canadian dollars, etc. Our dollar can change to the point where it takes $2500 to buy an ounce of gold but the cost to buy it in the other currencies would actually remain the same or even go down.

I lived through hyperinflation in the late 70s. I had a home mortgage at 21% interest. I had a dozen rent houses I acquired from banks when the prior owners abandoned them because the utility bills were higher than the house payments because of high natural gas prices. I don't want to go there again.

If the Fed's QE3 program runs for as long as the BofA analyst believes we could see the price of gold at $3000 and oil at $200. Personally I believe the Fed would halt the program before inflation got that far out of hand BUT there are additional problems with that scenario.

Assume inflation rose to 4% or 5%. That would begin to exert strong negative influences on the economy. How does the Fed combat inflation? They raise interest rates. In this case in order to avoid hyper inflation they would have to raise them quickly and by a large amount.

We all know what happens when the Fed raises rates. The market crashes.

It would appear to me that we are soon going to be faced with one of two scenarios. Either inflation is going to rise significantly or interest rates are going to rise significantly. Actually that is only one scenario since one begets the other.

The only saving grace is that this will not happen for many months. The QE3 program will proceed naturally until the economy begins to accelerate. Unfortunately after three years of a zero interest rate program (ZIRP) by the Fed there is plenty of latent inflation already building in the economy. Food and fuel are already leading the list thanks to QE1 and QE2.

When QE2 was hinted at Jackson Hole in September 2010 gold was $1250 per ounce, silver $19 and oil $71. While the European debt crisis and China's fall from grace has kept oil constrained it finally pushed back to $100 on Friday.

QE1 was for $600 billion in securities. QE2 was $600 billion plus $30 billion a month in 2-10 year treasuries designed to replace maturing securities already in the portfolio. QE3 is $40 billion a month with no limit for mortgage backed securities to keep mortgage rates low. BofA expects the $45 billion in Twist treasury purchases to expire in December and then be replaced by a similar program for all of 2013 to keep treasury rates low. Call it $80 billion a month in 2013 plus the $85 billion for Sept, Oct, Nov, Dec 2012. That is about $1.3 trillion through December 2013 and BofA expects it to continue through 2014.

Any reasonable person looking at those numbers should be afraid, very afraid.

I don't fear the buildup as much as I do the aftermath. Let's say the Fed ends the program in December 2013 with their balance sheet at roughly $4 trillion. The economy is in recovery mode and thanks to the ZIRP for four years it is finally accelerating. That means the Fed not only has to end the QE and ZIRP but it has to also remove that stimulus from the market. That means they sell securities and that raises interest rates by a large amount. Selling $4 trillion in securities even over a couple of years is going to be VERY tricky.

The hangover is always a serious problem. In this case it will be the equivalent of an alcoholic heroin addict being put in jail where he can't get access to the drugs and booze. It is going to mean a serious challenge to businesses, consumers and the economy.

By embarking on the largest stimulus program in human history the Fed has put us on a collision course with the largest stimulus bust in human history. The Fed has NEVER been able to withdraw stimulus from the economy without a market crash. Why is this time any different considering the size of the injection?

In the short term we should see oil prices rise unless the administration can talk the IEA into a strategic petroleum reserve release. If oil moves over $100 I think that is the only political alternative for the president facing reelection. Gasoline prices are already at $4 and we know what happens when prices go over $4. The economy contracts.

I am sorry I spent so much time on this today but it is really heavy on my heart. I really believe that every investor should be planning on how they are going to handle the next several years and what they are going to do to ease the pain when the collapse comes. We are on a roller coaster just starting up the first hill. When we crest the top it will be a panic filled ride and nobody knows when it will end.

The obvious solution is to remain invested in oil, equities and commodities for the next year. Once we see the warning signs we will reverse course and setup for the painful withdrawal of stimulus.

Jim Brown

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