Nic Lenoir Interprets The Oracle's Words
From Nic Lenoir of ICAP
Yesterday was yet another sad day for capitalism and the United States. Rewind the clocks a little bit. When the Fed started moving rates towards 0% some observers criticized the policy warning of a repeat of earlier in the decade when low rates fueled the housing bubble. The fed's response at the time: it is not the level of rate that is dangerous, it is when expectations build that they will stay low for an extended period of times which leads to excessively low volatility and credit spreads. What was that again??? Yesterday's statement and the monetary largesse it announced were crafted ONLY to best suit the expectations that had been built in the market. The Federal Reserve has engaged in a positive feedback loop process where it builds up expectations via speeches and leaks and then delivers them to the markets in order to smooth out volatility and encourage excessive lending that can only lead to excessive compression of credit spreads. In fact before this round of QE the Fed asked bank executives what they deemed an acceptable amount of money to best achieve their goal which we discuss below. I don't think anybody really thought banks would encourage the Fed to deliver less liquidity than expected given that just like in every other sewer, you need water to keep the crap floating. In that aim, I suppose yesterday's delivery was an astounding success: most people expected $500Bn to $1Tr so the Fed delivered $600Bn, and since that could have been a slight disappointment, they quickly added that interest re-investment would amount to another $250 to $300Bn which is closer to the upper range, but not so much as to upset too much the inflation hawks. More and more, the Fed is wishy washy trying to kill volatility and ramp the market up quietly, not too fast and avoiding pullbacks. Talk up the economy when people are worried, talk it down when it's good to justify further printing, and most all keep printing... I congratulate the Fed. Not because I agree one bit with their policies, but because they plan and executed their plan to perfection to smoothly achieve their goal. That certainly required a lot of clever orchestrating. Sadly the same great minds planning all this are incapable of understanding the most obvious flaws in the policies they are implementing. Dogma is dangerous because it replaces rational thinking, and in this case the Keynesian theory being implemented is almost a religion for Fed officials who have lost any form of critical thinking ability.
Someone actually pointed out recently [ZH: see here "Niall Ferguson Explains Why Keynesian Policies Are Dooming The World Economy To Round After Round Of Asset Bubbles"] that Keynes himself understood that his theory worked mostly in a "closed economic system". With politicians having pushed free trade for the past 40 years it is hardly the case for the US economy. In fact our economy has pretty much never been more open. No amount of money will solve the structural imbalances, and in my opinion propping up asset prices on a very fragile underlying economic tissue is the best way to inflate a bubble which when it bursts will make 2008 look like a fun afternoon at the pony ranch. Sadly the goal seems hardly to improve the economy here, but rather prop up prices. The Fed chairman makes it clear in his op-ed in the Washington post today:
Alan Greenspan did get a little heat for admitting that higher stocks is the best way to drive economic growth, though in my opinion not nearly enough, but he was retired when he said it. That is in my opinion the one mistake made by Bernanke in the implementation of his evil plan. Coming out and making that unnecessary statement will draw political backlash from all those who criticize his policies precisely for their very direct consequence: boosting asset prices while having little impact on the economy. Doctor Bernanke goes to extrapolate that higher stock prices will lead to second hand spending... so as I said the other day high-end hair salons will offer free manicures while you get your hair done so you can drop a nice $20 tip to your hand-massage therapist on your way out. Meanwhile the next sign of trouble in the economy all those jobs disappear and we will revert to the structural unemployment rate which keeps getting higher by the minute. Amusingly the Fed Chairman does mention that the Fed alone cannot control the economy. I can't wait for the tea-party fanatics to put a bounty on him slapshot-style.
More technically, the one surprise in the announcement yesterday was the fact the average maturity of the purchases will be between 5 and 6 years. A lot of observers including myself had come to expect more buying in the long end. The Fed removed the 35% limit of ownership it can have of any given Treasury issue, which in theory opens the door for them to buy longer dated bonds since they are the one in more limited supply and that the Fed owns a solid share already. However it does not seem they will make that much use of this additional freedom they gave themselves. I felt that was a bit of a curveball, and as a result the 10s30s curve has gone vertical. The bear conditional flatteners we had recommended and that were in the money quite a bit last week are now under-water, but if you did not take profit, you will probably end up flat since both puts will likely expire out of the money and no premium was paid to enter the trade (that was one of the major drivers behind our rational for the trade).
So what does QE 2.0 means for financial markets? Well short term it's simple: higher stock prices, lower volatility, lower USD, and higher commodity prices, while bonds keep going up (hard to sell for now if you have an $850Bn buyer in the open and positionning had been trimmed). Swap spreads in the US are being paid aggressively today as Libor is floored but Treasury yields keep dwindling. The only viable strategy is to trade around the government's flows at this point. That is all there is left. Front-run P.O.M.O. and collect pennies while you can. All that will last until something perturbs this unsustainable dynamic. That can happen next week, or next spring... most likely it will happen when there is no one left long volatility and the market will implode as the first "sell market" order of more than 500 mini S&P futures leads to a flash crash that will slam all the circuit breakers out there. Here is the list of the most likely culprits that will end our monetary teenage dream:
1) Trade wars and protectionism as the rest of the world throws the towel and cannot accept anymore liquidity from the Fed flooding their markets. This is a trend that we have long warned about and is in its infancy but could rather rapidly gather steam
2) Europe accidentally withdraws a bit more liquidity than they should have from their system and it leads to some failures which forces the market to acknowledge what is currently happening out in the open without being priced in at all: bankrupt governments, sovereign spreads making new highs, riots in the streets... Note that it would not take much for it so snowball into a disaster. The ECB knows it and that's why they are buying PIIGS bonds while withdrawing liquidity (which is rather schizophrenic)
3) Inflation chokes the recovery. The Fed has pretty much committed to buying bonds until CPI hits 2% (or rather PCE which they prefer) or unemployment hits 6%. However CPI is useless and its definition has been changed and abused so much over the years that we can have flat readings when health care costs rise 9% a year, same for education costs, oil is up 100% YoY, and every other commodity is through the roof as well. So what is more likely is that we will run into an inflationary wall while the CPI is still showing a happy +0.6% reading YoY. Prices at the pump is something that will strike a public nerve and has always led to recessions. I have contended for a while that all that liquidity is going to find its way abroad and ramp up commodity prices more than anything. That will happen, guarantied, the only question is when does it become too much?
4) Domestic political backlash: I guess we will soon know what the recent tea-party candidates put in office are made of. Showdown between Bernanke and Paul anyone?
I left out the mortgage mess since at this point the market has decided to fully ignore this and you can count on Washington to push whatever law/accounting measure/magic spell required to make it disappear... at least on paper! The one thing that becomes obvious is that when the party ends, the next sell-off will most likely be a systemic rejection of the current policies in place, and it will be a lot more violent than people expect. Until then, expect volatility to trade very low while most markets have 2/3% intraday gyrations, setting up for the more and more inevitable 40% down day. Good job Ben, good job...
Good luck trading,
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