What Is Quantitative Easing? What Quantitative Easing Means for Your Portfolio and The Economy
Tired of Fed speak, yeah me too. Quantitative easing is the most popular phrase on Wall Street right now. Its a pretty word for not so much of a pretty thing – inflation. This is how quantitative easing works and what it means to you.
Let’s break down the phrase “quantitative easing” into two individual words. First, quantitative, it means a certain amount of currency. Second, easing, it makes lending easier for banks. Understanding what it means is almost as easy as understanding how it works.
Goal #1 – Free Up Capital to Lend
The goal is to get enough money out there so that banks have no reason not to lend and borrowers no reason not to borrow. Banks operate on a system called fractional-reserve banking whereby the banks can lend up to 90% of all capital infused into the bank. For instance, if you deposit $1,000,000 into a bank account, $100,000 is put on reserve at the FED and $900,000 can be lent out.
In the most recent case, the Federal Reserve created $950 Billion to buy $750 Billion of mortgage-backed securities from Fannie Mae and Freddie Mac and invest $200 Billion in Freddie Mac bonds.
Goal #2 – Lower Government Borrowing Costs
The FED can also opt to buy government debt. Now the FED cannot buy government debt on the open market, instead it has to buy treasuries from a primary dealer. A primary dealer is basically a bank with access to Treasury auctions that can sell some of its Treasury holdings to make a hefty commission. Basically its a nifty little process that helps the banks further shaft the American people, but what else is new?
So in essence, the Federal Reserve makes a whole bunch of cash, and then gives it to a primary dealer in exchange for Treasuries. Obviously this also creates a lot of demand for Treasuries, increasing the price of the bond and effectively dropping the yield of the bond. (price and yield trade inversely)
Goal #3 – 1+2=3 (Add the first two goals together)
Banks have three ways to make money. Banks can lend to consumers, banks can lend to banks or they can lend to the government. The rate at which one bank makes a loan to another bank is called the LIBOR, and essentially its the rates at which banks do business. Banks can borrow at the LIBOR rate and lend at a higher rate, thus generating a profit.
Currently the 6-month LIBOR rate is 1.74% and the same timeframe on treasuries generates about a .6% return. The difference in the two rates is known as the TED spread, and shows how willing banks are to lend to eachother. Normally TED spreads are thin, meaning banks view other banks at the same risk level they do the US government however right now the TED spreads are huge, meaning banks don’t have much faith in other banks. (And why should they?)
By adding more cash to the system, the FED hopes to create an abundance of money that banks will have to use to make money. By creating so much cash, banks will want to lend to eachother, at least that’s the plan.
That is quantitative easing in a nutshell. I’ll be updating this in the next few days with a FAQ and more information regarding what quantitative easing means for your portfolio. Stay tuned!