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Dispelling the Myth of the Bernanke Put's Perceived Permanence
Whether or not the Federal Reserve has the ability or willingness to plug in deleveraging-induced black holes in the financial sector's balance sheets with printed money is a foregone conclusion at this point. But the real question is whether or not this is priced in. Or rather, whether or not current asset marks are a reflection of that perception of permanent backstopping.
As we enter 2010, the 30yr Tsy bond yields more than 4.5%, the 2s30s curve is at 367bps (up 55% YoY and at thirty-year wides), the United States public debt has surpassed 94% of GDP, and 13% of tax revenues are for servicing debt interest alone. Roll risk is clearly a significant issue at the Treasury, as diminishing tax receipts and weakened foreign reserves drastically damage potential capital inflows, exacerbating decades of fiscal imbalances.
The basis to the structural global imbalances is the American consumer. With freely available credit (thanks to the Federal Reserve) and inflating asset values producing a "wealth effect," the American consumer levers up household balance sheets by debt-financed consumption. As emerging economies enter international capital and labor markets, American consumption shifts to goods produced for low costs in these emerging economies. This capital flows from the United States to trade surplus nations' reserves. The emerging economies invest these reserves in dollars and dollar-denominated debt, as the dollar is the most liquid and international reserve currency in the world (with most commodities priced in the currency) and supporting the United States is vital to their exports, their main engine of growth.
However, without the American consumer, these creditor nations are forced to make a secular policy shift and domesticize growth. This implies reserve diversification and lack of net demand for Treasury securities (and possibly a shift to net supply offered). Though the global liquidity & reserve status of the dollar and political & economic leverage held by the United States prevent an all-out creditor nation hyperinflationary exodus from the USD and spiking Tsy yields, a disappearing American consumer prevents creditor nations from continuing the status quo of sovereign consumption financed by foreign capital inflows. Especially when deficit spending is skyrocketing, monetary supply and debts are surging, and both foreign inflows and domestic tax receipts are dwindling.
And the American consumer has hit the debt wall and can no longer lever up to capacitate further foreign capital inflows into Tsys, after experiencing two asset crashes within a decade. The most recent consumer credit figure, a $17.5 decline reported for November 2009, is the largest recorded and represents an 18.5% annualized dropoff in revolving consumer credit. Household deleveraging has come and is here to stay, especially with the spiking unemployment rate.
With the foundation to the creditor nation-financed suppression of bond yields suddenly gone, the Treasury has to look elsewhere for demand, especially down the curve. Thus far it has found a suitable substitute in the Federal Reserve, but monetization causes a bearish reflexive response in the Tsy market, as investors offer supply because of inflationary concerns. Indeed, since Bernanke announced the QE program back in March 2009, the 30yr yield has risen 753bps, or 20%, dramatically increasing funding costs.
Because of the roll risk and the ever-shortening average duration of marketable Tsys, Bernanke's Fed cannot print money and inject liquidity into perpetuity, ceteris paribus. With the complacency present in the market, and signified by the surge in bond yields since March 2009, increased liquidity will appear unwarranted and will be met with an even greater increase in Tsy rates, and consequently funding costs for the United States.
The market is discounting the credit crisis as a liquidity crisis rather than a solvency crisis. The Fed cannot inject more liquidity into an environment characterized by surging bond yields without causing a positive-feedback creditor exodus hyperinflationary and/or debt default scenario. Any further substantive marginal liquidity will have to be reactionary.
This is a similar dilemma as the Fed faced in mid 2008, when inflationary pressures from rising commodities prices forced hawkish policy, even as a credit crisis stemming from a bursting housing bubble brewed underneath. Eventually, the hawkish actions helped catalyze the bursting of the commodity bubble and inflationary pressures, but at the expense of catalyzing a mean reversion and consequent credit crisis.
Now, the Fed can't continue or suggest continuing its liquidity injections into perpetuity, as basically every market is discounting a recovery. But if it doesn't, a massive hidden second wave of deleveraging and market volatility will be unmasked.
Aside from the economic implications of a permanent Bernanke put, there is insufficient political capital for continued injections. Obama's popularity has dwindled with the dollar's value, as taxpayers feel the effect of classic CC-PP game theory. Allegations of bank-government collusion and populist anger directed at bankers and politicians are forcing deliberation over exit strategies already.
In addition, further QE (by which I mean another trillion or so, not just a couple more hundred billion in Agency debt purchases) would suggest to the market that the Fed doesn't believe we are out of this mess yet. That would have drastic effects on bond yields and the USD, and though equities may remain stagnant or even rally, their returns wouldn't come close to offsetting the dollar's decline.
The Fed is caught in a trap where it must have its attempts at liquidity injection proven insufficient, to which there will be a massive influx of capital into Treasuries, suppressing rates, as well as a rush to liquidity and asset selloff that will replenish the political capital needed for the Federal Reserve, Treasury, & Obama administration to institute new bailout and QE programs.
Only when the imbalances in financial markets, hidden by excess liquidity, finally come to light with a sharp wave of deleveraging and credit crunch, will the reactionary policy that will catalyze a perception of backstop permanence priced in to the market.
Until then, the underlying deleveraging gorilla can and will reclaim hold over price fluctuations, but only when the offsetting QE liquidity dries up. Once the true state of affairs is uncovered, the Fed's reactionary policy will become a permanent trump card, but only then. At that point, individual sovereign credit risk idiosyncrasies will dictate future market behavior, rather than individual financial sector risks and ability/willingness of respective central banks to backstop losses.
Keep in mind that the already growing perception of globally coordinated debasement and a "race to 0" may cause a "higher low" in risk assets during the next wave of deleveraging.
Deflation first, inflation second. (In the United States.)
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Absolutely....
Why ?
The "plug the black hole number" is how big ?
$30 Trillion ????
What is your best guess ?
Which means that any paultry $1 to 5$ Trillion effort is insufficient ....this is already a known....
Furthermore ...All of these Fed moves are not SUSTAINABLE.
Why ? The SOURCE OF FUNDS IS NOT SUSTAINABLE....
It will not be until that the source of funds are sustainable....that any Fed move could possibly not be viewed as an excessive cost to the US....The way to make this happen ? Simple....business friendly tax structure change.....eliminate corporate and individual taxes....replace with a 15% consumption tax only.....and lever dolars by revamping a worldwide defragmented RETAIL exchange into a more efficient and reliable RETAIL opportunity for wealth sharing....and by separating banks from the securities business....
..............................................
What would have been the most sure way out ?
Let every entity fail that failed....
Only then ....could a true recovery happen....
Furthermore this has not changed....
The Fed is just stacking in higher costs....
These are the "non-sustainability costs".....or rather "fake economics"....being employed by "fake poly-populists-economists"....
A very reasoned analysis.
Unfortunately the Fed is not driven by reason, but by political motivation (note that Bernanke has not been reconfirmed yet).
Fed, White House, banks, do not want deleveraging. They will do everything they can to prevent it, short of nothing. The fred/fan takeover and all the other bailouts would be for naught if real deleveraging occurs and political costs of admitting complete failure would be catastrophic.
QE has no end, only different names.
+1
By no means do I suggest there won't be a second (or third or fourth etc) iteration of quantitative easing. I simply think that a (significant) re-deployment is not priced into markets, and that there will need to be an endogenous deflationary deleveraging event for which the Fed & Treasury can enact reactionary policy that will continue their USD debasement brigade.
Every dollar the S&P falls is equitable to the political capital sufficient for the creation fo ten dollars. With QE 1.0 winding down and the Treasury portion completely done, the Fed & Treasury need something to react to.
That makes perfect sense, and fits well with successive waves down in equities like Japan is still experiencing.
If I read you right, you are saying the FRB is not perceived as being ready to launch QE2, because if it was, we'd be seeing different market activity. I hear you. But wasn't it 2 weeks ago on a Sunday night speech that Ben said (a) the Fed is not responsible for any bubbles, and (b) we will continue to do everything we need to do. I thought that a pretty clear statement that QE is here to stay. What I suppose you mean is that there has been no overt announcement of QE2, and due to that, the markets think Ben is done, is that right? And that Ben needs an "event" to occur to provide political cover for QE 2?
The Fed uses its interest rate policies to affect elections---no coincidence that the financial crisis, precipitated by the Fed's hiking of interest rates, resulted in Obama's election;
To the victor go the spoils: under Obama the Fed and their bankster friends have looted the Treasury as their just reward.
Right now Fed policy dangles like the Sword of Damocles over the heads of the Democratic Party---it would be a snap for the Fed to turn hawkish this summer and create a mid-term landslide for the Republicans.
The Fed and banksters have Obama checkmated.
THAT is an interesting take, pros.
I do agree with the author that deflation first then inflation later is the most likely scenario.
In our fiat money system, the money supply MUST grow, else all the rents and bond covenants and mutual expectations come crashing down.
New cash is the fuel that keeps the engine running. Without it, the system shuts down.
*
There's no way of avoiding the deflationary collapse. Prepare for 20 years of down - with lawsuits, special investigations, congressional hearings, financial industry claw-backs, debt repudiation, and lots and lots of personal, corporate, institutional and public bankruptcy.
Really, its already happened. We're well past the event horizon. Now its a question of mathematical adjustment. How does it work? Does the numerator come way down (what is happening now on steroids) - or does the denominator come up (what they want, but just can't seem to manage without willing borrowers in the private sector)?
This looks to me like a set up for "hyper-Deflation"
Spot on analysis; my thoughts precisely. Ben and Co. are walking a tight rope with populist outrage on one side and economic reality on the other. While they can bob and weave for a while, the moment that populist outrage forces TPTB into facing economic reality, sparks will fly.
"loaf of bread, stick of butter, carton of milk"
See, even as a kid Seasame St. taught you about inflation....
It's not a matter of 'if'... it's 'when' and 'how much how far' these things are going to go. Inflation seems to be a boiling pot right now but the lid is still on it. Do NOT touch it- it's scalding hot and ready to blow.
but when?
Inflation is like a colonoscopy sans drugs.
There is no exit strategy. Any time you think there is an exit strategy, remember the following: There is no exit strategy.
Certainly not now. So much has been commited to the current disastrous course that it would be equally disastrous to try to undo it all, which would be necessary before correcting to a rational and responsible strategy.
We are in the position of a man who has walked halfway across a vast desert, then discovered his canteen is empty.
This market is going to crash - bullishness at highs not seen since April 1987.
REF: "massive influx of capital into U.S Treasuries as well as a rush to liquidity and asset selloff that will replenish the political capital needed for the Federal Reserve"
Really? I know that happened in '08, but who in their right mind would want to run and invest in historic U.S govt debt which has a contracting economy that is 70% dependant on its bankrupt consumers? I am just a simple factory worker from Ohio and let me tell you , even when equities and commodities are spiralling downward, the last thing on earth I will want to own is more historic U.S debt.
We still have factories in Ohio!?
REF: "We still have factories in Ohio!?"
LOL! Yeah, It's Japanese owned.
Another problem Heli Ben is facing is the low velocity of funds the Fed is pouring in. This is bad and not getting better it appears.
And then the Fed blinked, and they quickly backed off that policy, which destroyed the illusion of incrementalism that Greenspan created. Higher rates would solve just about everything, as the cost of credit and the availability of credit are separate issues, but the bear market in credit has resulted in credit dumping, (Japan may dump steel, the US dumps credit). Quite simply credit demand would improve if buyers saw rates increasing and they started borrowing money to lock in the rates.
If the Fed is in a trap, there are gold bars on the windows. The rush into Treasuries suppresses rates, which is an assumption about Fed policy which deserves an asterisk. Bernanke came to power on a platform of targeted inflation. Now he has lost a bit of time, and the economy has lost steam, so when inflation picks up he will probably let inflation run a bit longer than would make Wall Street comfortable. Remember Greenspan raised rates and expanded credit. At least when the credit bubble was feeding the housing market there was a beneficial effect to the domestic economy. Construction is the primary engine of US industrial growth. Ironic that it maybe while that we have a gross oversupply and the third world lives in shacks. Look for housing to become a moveable feast, as most of the world is grossly lacking in that regard. Mexico and Central America should benefit first, but we could sell housing to the Chinese.
If you want housing to comeback the Fed has to prick the commodity bubble, oil is already there, and that requires some rate hikes, which is not synomous with a credit crunch, which is what the Bejing politburo is engineering at this moment.
2010 prediction, housing rebounds, cross border lending takes off, and Fannie and Freddie go global. The Bernanke put is a myth, one perpretrated by the trade deficits, the financial oligarchy, and their political whores.
But all good things come to an end.
" Look for housing to become a moveable feast, as most of the world is grossly lacking in that regard. Mexico and Central America should benefit first, but we could sell housing to the Chinese."
Like my mom's version of what to do with my unfinished dinner, we could pack up all these foreclosed homes and send 'em over on a slowboat to China. Problem solved.
i have no idea what the housing subsector of the shanghai stock market looks like, i am guessing there isn't any, but Mexico and Estados Unidos will get together in your lifetime anyway.
It would be great if someone out there, can do a graph as per below:
I saw a graph somewhere, that when the trend of the debt and the relationship of servicing the debt along with some other parameters, you can actually estimate the time scale of the burst.
At least the USA has China as its partner in this unending debt. China has tied its currency to the dollar, needs the USA markets to keep its factories running and holds at least $800 billion in Treasuries. If China allows the Treasury auctions to weaken, they lose just as the USA loses. In some ways, the USA/China partnership forces all the other Asian economies to buy the dollar and Treasuries or they lose exports. The real losers are the UK and the EU whose currencies will increase and exports decline.