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Bernanke’s speech at the Jackson
Hole meeting of central bankers last weekend was met with the full range of
responses between the severest criticisms and complete apathy. The apathetic
are in the majority, but the critics are becoming more focused and vocal,
because they can now with certainty point to the failure of monetary policies
to achieve anything, in spite of a doubling of the monetary base. This
failure is becoming more obvious because the prospects for economic recovery
are diminishing. The Fed must be loosing confidence in its own policies, and
this is reflected in the mood at the Fed.
That
the results of Fed policy are disappointing is no surprise to those of us who
see the shortcomings of modern economic theories, but what might surprise
some of our small unhappy band is the extent of the failure. The Fed and the
government between them planned firstly to rescue the financial system from
collapse, and secondly to rescue the economy from further recession by a
policy of deficit spending and money printing. The damage to the financial
system is barely concealed in its balance sheets for the moment, but anyone
who knows half the truth about the insolvency of the banks fears that a
second financial crisis is still likely. The rescue of the economy has
failed, and is making a second financial crisis almost certain and more
immediate.
The
failure of Keynesian policies has trapped the Fed in a cul-de-sac, from which
there is no obvious escape. So far, it has fortunately managed to keep the
economy financed on the back of a bond market bubble.
We
must now consider the consequences for the bond market of the failure of
these Keynesian policies. The primary result will be a dramatic
widening of the Federal deficit and a matching increase in the issuance of
treasury debt. The Fed will almost certainly accelerate its QE programme,
buying Treasuries; but the tsunami of new government debt seems certain to
pop the treasury bubble. Quite simply, Treasuries will no longer be regarded
as risk-free, but instead poisoned with risk. Fed buying of treasury debt
will be understood for what it is: an extremely dangerous gamble with the
value of paper dollars. The Fed will have lost control of the markets, and
the markets will have emasculated the Fed.
The
gamble is made even more dangerous by the presence of the banks, which have a
total exposure of $4.5 trillion dollars to the government and the Fed. This is made up of $2.4
trillion in Treasuries, $1.1 trillion of GSE securities (Fannie Mae, Freddie
Mac and Ginnie Mae), and $1 trillion in reserves at the Fed. And banks are
fickle investors at the best of times.
There
is no sign yet that the Fed is worried about these market dynamics. So
far, it has been able to print money with impunity, because the markets have
given it the benefit of the doubt. But if QE did not work first time round,
the markets are unlikely to accept it a second time after the treasury
bubble has popped, without considering the inflationary consequences.
And there is now a significant danger that the bubble will burst sooner
rather than later, because of the deteriorating economy.
The
lesson of bursting bubbles is that they are violent, hurtful events that
catch the unwary, suggesting the yields on Treasuries have the potential to
rise rapidly to unimagined levels. This would be entirely consistent with a
swing in banking and investor sentiment, from regarding Treasuries as a safe
haven to being laced with risk.
The
dangers for the Fed are acute, and it even risks loosing control over
short-term rates. The penalty of borrowing at far higher interest rates is an
uncosted burden on government finances, and any attempt by the Fed to shore
up bond prices by buying Treasuries would be viewed with the deepest
cynicism.
For
the rest of us investment strategy will have to be rethought. With sharply
rising yields in a slumping economy, bond and equity markets will crash,
along with commercial and residential property values. All developed
economies face similar problems, so are also vulnerable. Emerging markets
have attractions, but portfolio exposure to them is already at record levels,
and a knock-on effect can be expected from sharply rising
dollar/sterling/euro yields. Furthermore, US investors have another
problem to contend with: the effect of the end of the bond market bubble on
the currency.
Faced
with rising yields, foreign investors can be expected to sell both dollars
and dollar investments as quickly as possible to limit their losses, adding a
potential dollar slide to a bond market crash. So the question for investors
becomes, with stocks, bonds and property all turning sour, where do they
invest their money? The answer by a process of elimination is likely to be
key commodities.
Meanwhile,
as I wrote last week, there is likely to be accelerating
demand for the same commodities from China and other Asian nations, partly to
secure resources for their own future needs and partly to reduce their dollar
exposure. So we face the prospect of both portfolio and strategic buyers
bidding for commodities at the same time. The effect, given fixed supply,
could be dramatic, with the cost of food and energy in particular spiralling
out of control. How high will the price of wheat rise? Five or ten times? How
high does the price of oil go as winter approaches? $300? Or higher?
It
would be no exaggeration to describe such an eventuality as a
hyperinflationary slump.
As
proxy for this mess and perhaps in anticipation of it, both gold and silver
are showing worrying signs of strength, defying all attempts by both central
and bullion banks to suppress their prices. If these proxies for money are
leading the way, the omens are not good. We have arrived at the moment when
central banks have lost control of bullion prices to growing private sector
hoarding, which so far has hardly started. When the dust settles, we will
look back at the systemic shortages of these two metals in disbelief, and
wonder how it could have happened.
There
is therefore forward-looking evidence that the US economy is entering a
second recession, the reflationary moves to date having failed. The
catastrophic deterioration in government finances this implies will change
investment perceptions of Treasuries, collapsing the bond market. By a
process of elimination, these flows can only go to key commodities with
dramatic consequences. The argument is to strong to ignore, and deserves full
consideration, rather than dismissed.
Alasdair McLeod
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