Many investors are struggling to understand the ramifications of the recently announced QE2 plan. Quantitative easing, or more simply known as money printing, is a dilution transaction similar to issuing more shares for a stock. The dilution has two primary affects: a decrease in the value of the initial shares and a redistribution of wealth from the original owners to the new owners.
The most significant difference between stock dilution and currency dilution is of course that publicly traded companies tend to use the funds raised through dilution to add value by investing those funds - whereas governments don't add value by diluting a currency.
In this case, $900 billion will be diluted to purchase US treasuries so the primary benefactor of the quantitative easing will be the US federal government and the financial institutions selling that debt. However, capital flows can rarely be controlled and the newly created money will find its way into other markets and asset classes.
Interestingly, the $100 billion per month figure that has been mentioned as the target rate for QE is almost exactly what is needed to rollover maturing treasuries coming due - so it could be argued that the plan is to effectively finance the US Federal debt which would eventually lead to a complete monetization of the treasury market. Supporting this argument is the recent projection made by ZeroHedge that the Federal Reserve will own more treasuries than China by the end of November.
In an attempt to measure these affects, we can compare the size of the quantitative easing plan to the size of several markets.
| Outstanding | $900B as Percent of Market | Diluted value of $900B entering market | |
| US GDP | $14,500.00 | 6% | $0.94 |
| US Federal Debt | $14,500.00 | 6% | $0.94 |
| M2 | $8,750.00 | 10% | $0.91 |
| M1 | $1,800.00 | 50% | $0.67 |
| Currency | $900.00 | 100% | $0.50 |
| Treasuries | $11,030.00 | 8% | $0.92 |
| Municipal | $2,670.00 | 34% | $0.75 |
| MBS | $8,860.00 | 10% | $0.91 |
| ABS | $2,600.00 | 35% | $0.74 |
| Money Market | $3,900.00 | 23% | $0.81 |
| Corp Bonds | $6,720.00 | 13% | $0.88 |
| Silver | $24.30 | 3703% | $0.03 |
| Gold | $2,475.00 | 36% | $0.73 |
If the QE2 funds went into the currency market, its value would fall in half. However, $900 billion is roughly 6 percent of US Federal Debt. Inflation is defined by the growth in the money supply. If using M2, the QE2 plan would dilute the money supply by 10 percent. $900 billion represents 36% of the world’s gold supply, so an equivalent move upward in price could be seen if the money finds its way into the gold market. QE2 is 37 times the size of the world’s estimated silver supply so a flow of capital into the silver market could be explosive.
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A dollar on November 1st is now worth 92 cents if measured in treasuries or 91 cents if measured with the money supply. It can be seen that inflation as measured by the growth in money supply is projected to increase by 10 to 20 percent on an annualized basis.
The result will be a double digit real negative interest rate and a carry trade opportunity to sell treasuries and other US dollar secured paper at a cost of near 0 percent while accumulating real assets such as precious metals and other resources that cannot be diluted.
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