Chairman Bernanke has placed
himself in a box. It is not a box of his choosing, but rather the result of
his misguided economic beliefs, use of flawed statistical data, geo-political
events occurring during his watch, poor decisions and a penchant for
political pandering. Some of these may be requirements for academia success
but not for leading global financial markets during turbulent times.
It is time for Professor
Bernanke to return to the collegial setting of Princeton University while the
world still has time to correct the path he has mistakenly set us on.
I was angry during most of
former Chairman Greenspan's tenure because of his persistent use of liquidity
pumping to solve every problem from Y2K to the Peso crisis. Greenspan's
inability to see a bubble two inches from his nose and yet still pontificate
about irrational exuberance, rather than taking the punch bowl away from the
party, incited me. Bernanke does not affect me that way. He simply
disappoints and leaves a taste like eating dry shredded wheat, with the hope
of a child, to eventually get the prize at the bottom of the box.
Character flaws show during times
of stress. Honesty, integrity, value systems and beliefs are put to test and
are highlighted under the public media microscope. I'm sure Chairman Bernanke
is a nice guy, loved by his family but he is missing a backbone. On April
27th, 2011, that will become obvious to all.
SIGNAL MEETING
On April 27th, 2011 the
Federal Open Market Committee (FOMC) issues its next decision and statement
regarding the future of Quantitative Easing (QE) II. Though previously
announced to officially end June 30th, 2011 there are serious questions if
this is still a viable option.
This particular meeting is the
'signal' meeting that the financial community will be looking for to assess
risk and strategy. Many (including myself) have already concluded what the
outcome will be and are preparing accordingly.
On this date Bernanke will
hold the first ever press briefing by the Federal Reserve, in addition to
releasing forward forecasts which are usually held another 3 weeks. It is
going to be an exciting event.
Unfortunately, Chairman Bernanke
is going to disappoint!
THE BERNANKE BOX
Let's summarize the box
Bernanke presently finds himself in.
REAL RATES
Interest rates have been
artificially suppressed for such a long time that no matter what Bernanke
does come June, interest rates will likely begin rising. Therein lies the
problem for the Fed. Any further debt monetization by the central bank is now
becoming counterproductive. If Bernanke enacts another iteration of
Quantitative Easing, the Fed may find itself the only player in the bond
market. According to my analysis this is nearly the case already.
The truth is that only a
central banker can afford to own bonds that are yielding rates well below
inflation, and growing even more so. The lower real interest rates become,
the less participation there will be in the bond market from private sources.
If you don't believe me, ask PIMCO, the world's largest Bond fund who is not
only out of US Treasuries but selling short. China has been a net seller of
US Treasuries since October. Besides the Fed, who is willing to buy the $1.65
Trillion in fresh new US debt paper?
So if Bernanke extends QEII we
have a collapse in the US$ and a complete lockout of auction buyers. If they
stop QE II, interest rates go through the roof immediately and the US
government with short duration paper has an immediate and serious fiscal
funding gap.
Bernanke is in a Box!
EVENT RISK &
GEO-POLITCAL SHOCK
Event Shocks were unleashed on
the global economy in a historic manner in Q1 2011. Whether Geo-Political
issues throughout North Africa and the Middle East or Physical Natural
Disasters like the earthquakes in Japan, a Tsunami, or a nuclear crisis at
the Japanese Fukushima Nuclear reactors, they have impacted the global
economic recovery.
These shocks are hitting an
already unstable economic and financial situation. Whether Europe's worsening
debt crisis as evident in Ireland, Portugal and Greece or China's aggressive
policy to slow the world's largest economic engine to contain mounting
inflationary pressures, we have tenets of instability.
If you couple this with
corporate margin compressions due to cost push price pressures and increasing
interest rates, it does not bode well for central bank monetary policy
planners. It is definitely not a good recipe for an already over-extended,
over-valued and over-bought stock market.
Typically bad things happen
when this occurs.
What we need to appreciate is
that though Mr. Bernanke is Chairman of the Federal Reserve, his night job is
as Board of Director member of the Bank of International Settlements (BIS) in
Basel Switzerland. Along with the other major central bankers he meets
bi-monthly with them to oversee policy direction for this mysterious institution
which is considered the central bank to the central bankers.
They no doubt have been
meeting to discuss 'coordinated' policy - coordinated policy efforts to
address such global issues as event shock risks.
They have been meeting to
synchronize stopping the Yen from rising and plunging the Yen Carry Trade
into an unwinding spiral. They are highly likely to be meeting to consider
policies that address global inflation which is now running rampant, thanks
to US Quantitative Easing.
This is a busy group with some
'heady' problems - problems that Chairman Bernanke must additionally address
and secede to.
The box Bernanke was in had
little wiggle room prior to the crushing disaster in Japan and the historical
geo-political events in North Africa and the Middle East. The pressures to
increase the value of the US dollar by reducing the money printing operations
of Quantitative Easing II is a decision being shoved in Chairman Bernanke's
face by other central bankers.
I fully understand that the US
dollar is considered the purview of the US Treasury, but there can be little
disputing the fact that the US Dollar, as the world's Reserve Currency, has
become a central policy lever for the US Federal Reserve's Monetary Policy.
The direction of the US dollar is a major consideration for Chairman
Bernanke.
- The
potential of forced unwinding of the Yen Carry Trade has trapped the G-7
into having to stop the YEN rising through repatriation pressures to
finance reconstruction and recovery. To do this means pressures to
increase the US-Yen cross.
- North Africa
and the Middle East geo-political event means the potential of an oil
shock hitting America. This additionally puts pressure on the US dollar
to be stronger to alleviate some of the pressures on the trepid US
recovery or it will be quickly stalled and reversed.
- The crisis
in the EU as seen in Ireland and Portugal tells us the EU issues are
unresolved. If Spain and potentially Italy are next, we have major
global instability and fallout. Before this happens the Euro needs to be
weakened to improve competitiveness. The rising Euro since QE II started
must be reversed. This means the US dollar must be strengthened by
slowing or stopping QEII.
- China is
clearly slowing in response to public policy. A strengthening US dollar
would lighten China's inflation pressures. Some would argue that QE II
is at the root of China's inflation pressures and forced money printing
to combat the US' premeditated Monetary Policy attack.
Bernanke is in a Box!
BANK CAPITAL RATIOS
A weakening US dollar has
allowed US equity prices to rise and thereby assist in fixing the near
terminally ill banking sector with their capital ratios and potential
write-offs. The correlation between the increase in the Fed's balance sheet,
the rise in the market, the rise in profits and the weakness in the US dollar
is unmistakable. The "R2" fit suggests as close a fit and proof as
this writer needs.
US financial institutions
still have close to $3 Trillion of Commercial Real Estate not yet reflecting
current market valuations, which must be written down. Bank capital ratios
are inadequate for this, since the US recovery has not brought back
commercial and residential real estate values to anywhere near their still
elevated book values.
Bernanke is in a Box!
Whether he continues QE II or
stops it, the situation is dire. This is what happens to those who
"Extend & Pretend" and "Kick the Can Down the Road".
GLOBAL INFLATION
Inflation in food, energy and
consumer staples is now a major issue that Bernanke must be seen to be
addressing. This week's headlines says it all:
CHINA
acts after inflation rises to 5.4%
Fresh price controls introduced and renminbi appreciation expected
EUROZONE
inflation jumps to 2.7%
Revision to March figure strengthens expectations of rates increase
EMERGING
MARKETS inflation surges
Inflation
across the G20
WHAT IS TO BE DONE?
So what is Chairman Bernanke
to do?
I believe he will resort to
his old tools. Academic tools like Game Theory is likely being applied and is
no doubt a good starting point for his decision making.
He needs to manage both
perceptions and expectations. He needs to manage the reaction to the message
he will deliver. Deciding on the reaction and degree of reaction is critical.
MANAGEMENT OF PERCEPTIONS
& EXPECTATIONS (MOPE) BOX
In the above game board, I
have labeled the ordinate "Y" axis to reflect a decision and
communications message that would foster increased interest rates. The
abscissa "X" axis reflects the same but for a potential increasing
value of the US dollar.
The problem for Bernanke is
that an either or decision is not optimum to balance the many diverse needs
of the decision. Additionally either decision is prone to an exaggerated and
dangerous reactionary move. He cannot allow the communiqué to be potentially
destabilizing.
Gradualism dictates trying to
move towards a midpoint on the decision game board.
DECISION
DECSION: DON'T GIVE ANY
DIRECTION!
- The optimum
message is one that does not confirm the ending of QE II, nor a message
saying QE II it is being extended.
- The
communiqué should leave the existing June termination date stand without
annotation.
RESULT: LEAVE OPTIONS OPEN
- By sending
no message the market will migrate towards an 'ending decision' but will
be constrained because of the lack of finality.
- By not being
specific the options are left open in case the expected result is
unsatisfactory. May and June can be used for further adjustments.
STRATEGY: BUY TIME BEFORE
QEX
- It is my
opinion that the Fed has no choice but to continue the dramatic
expansion of its balance sheet to offset the collapse of the Shadow
Banking System.
- Money supply
as measured by M3 is still dramatically shrinking.
- The Fed
needs to take some pressures off financial markets by allowing a
corrective/ consolidation to occur via a period of 'risk-off'
adjustment.
- The negative
impact of a 'risk-off' event will give the Fed the political cover to
resume its QEX policy, in due course.
AN INSOLVENCY PROBLEM, NOT A
LIQUIDITY PROBLEM!
The reason Central Banks are
called upon to 'pump' money into an economy with policies like Quantitative
Easing is because an ongoing crisis is draining liquidity in the markets and
the Central Bank is the 'lender of last resort'.
We seem to have forgotten this
over the last few years. There can be little doubt that the issues we are
facing today are not liquidity problems despite the central banks issuing
accelerating amounts of money.
What we have is a solvency
problem that is presently being hidden by inflating assets or collateral
values. Without this occurring, many major financial institutions are legally
insolvent from mal-investment and speculative investments gone bad.
The Federal Reserve is now the
'Buyer of First Resort'. This is a completely new dynamic and shift in the
structure of the country.
The game that is being played
is beyond "Extend & Pretend" and "Kick the Can Down the
Road". It is a game that does not allow the capitalist game to work its
magic powers. It is a game that protects crony capitalism at the expense of
the capitalist system.
Consider the central issue of
"too big to fail'. We have laws that specifically address 'too big'.
They are called anti-trust or monopoly laws. They are in place to stop unfair
competitive advantage of companies using their size, to stop predatory
practices from those too big to be effectively legislated and to protect the
consumer from being taken advantage of. If we had used the antitrust laws
that were outlined in the Sherman Act we would never have got into the
predicament in the first place. We have additionally completely ignored the
tenets of Control Fraud prosecution.
The second part is "....
to fail". We have bankruptcy laws specifically for the problem of
corporate failure. By using government sponsored DIP (Debtor-in-Possession),
break-ups, sell-offs, restructured, debt holder haircuts and debt for equity
we could have addressed much of our current issues without having plunged the
country into near bankruptcy so that less than two years later the banks are
making historic profits and the bank owners and debt holders are completely
whole and richer off. This is the epitome of crony capitalism.
The government, as represented
by the US Treasury if held to the same standards as the private sector, would
be criminal on many fronts. The renowned Kenneth Rogoff in a Financial Times
Op-Ed referred to the US government as effectively operating a full blown
Ponzi Scheme. Bernie Madoff went to prison for 150 years for this. The
government calls it PAYGO. Pay as you go and go free.
We do not have a liquidity
crisis. We have an Insolvency Crisis as a result of debt saturation built
upon mal-investment. The government and Federal Reserve are doing everything
in their powers both ethical and other to keep the whole house of cards from
coming down on our heads.
Bernanke is in a box.
Unfortunately it is a box of cards, cards that when played out will show it
was a bad hand even though t was dealt from the bottom!
Do you really believe the Fed will end QE II in the spring?
NO it won't - BUT
The market will react differently this time no matter what the Fed does
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