Rosie On The Fed's Intent To Get Everyone Onboard Its All-In Bet On Stocks
Just in case there is someone living in a cave who still doesn't understand that the Fed's one and only mandate (forget that crap about inflation and jobs) is to give everyone one last shove into the all in ponzi before the diarrhea hits the HVAC, here is David Rosenberg explaining, for the cheap seats, what the Fed's terminal intent is.
The Fed’s intent is not to create consumer inflation, but rather asset inflation — primarily in the equity market. By pulling longer-term bond yields lower, the Fed hopes that this will alter how investors value equities relative to the fixed-income market. Moreover, the Fed will be actively pushing up the value of bonds that exist in investor portfolios, and as such the intent is to induce these investors to rebalance their asset mix towards equities in order to maintain their current allocation. The Fed is also trying to incentivize fund flows into the equity market. This in turn would theoretically boost household wealth and as such make consumers, who now feel richer, to go out and spend more. So the theory goes — we shall see how it works in practice.
The Fed’s intent is also to lower both the debt and equity cost of capital so that companies will, at the margin, compare that to expected returns on newly invested capital and begin to spend more on new plant and equipment. The hope here is that the investment spending multiplier will kick in and that stepped-up job creation would occur in tandem with the renewed capex growth.
In essence, the Fed wants to avoid what happened in Japan over the last two decades — have a look at Japan Goes from Dynamic to Disheartened on the front page of the Sunday NYT. The comment in the article to the effect that back in 1991, the consensus was looking for the Japanese economy to begin surpassing the U.S. economy in size by 2010. Nice call. Instead, Japan’s economy has not expanded at all since that time whereas the U.S. economy, despite all its problems, has grown 65%.
That said, the U.S. has already experienced a lost decade in many respects, especially as it pertains to the labour market, while Japan has lost two decades. Also have a look at How to Erase the Lost Decade on page 5 of the Sunday NYT business section — Bob Farrell’s Rule #1 on mean reversion comes to life, and that is what this cycle is all about. To wit: “…instead of waiting for stock performance to return to the mean, investors would do better to pay attention to whether price-to-earnings ratios are reverting to long-term averages.” It’s not just the markets — it’s also about the economy.
The era of betting big with the mortgage and credit card in the prior decade is over and is giving way towards an era where “getting small” will be the norm. This theme rankles many growth bulls but all you have to do is take the blinders off, grab a copy of the Sunday NYT magazine, and open it up to page 58 and have a read of The Elusive Small-House Utopia. The 6,000 square foot McMansion has become the modern-day version of the 1973 Lincoln Continental — the 1,700 square foot bungalow is far less offensive and has become “the home for a new economy.” A precipitous trajectory of mean reversion and that is the deflationary risk that is keeping Bernanke up at night.
Now back to the Fed and the macro picture. The U.S. economy is caught in a classic liquidity trap. With additional fiscal stimulus no longer a viable political option, even though the government is better equipped to deal with many of the structural hurdles to growth than monetary policy, Mr. Bernanke clearly feels that the Fed is the only game in town. Although, the White House does seem set to push, yet again, for a $250 bonus to the country’s 58 million Social Security recipients. Mr. Bernanke so eloquently outlined the risks associated with QE2 last Friday, but he obviously believes that the cost of doing nothing outweighs the risks. But he also knows that there is a chance that QE2 will only be met with limited success — monetary policy, even in a non-conventional form, is a very blunt tool to use to reverse a secular uptrend in the savings rate, re-dress chronic unemployment or induce people to spend rather than correct their debt-laden balance sheets.
At the same time, the Fed’s actions are also going to have global consequences, and the money printing to the buy the bonds will inevitably trigger more dollar depreciation. But there are a host of other countries that do not want their currencies to become overvalued — especially in emerging markets and in Japan (see Japan Turns Up Currency Rhetoric on page 3 of the weekend FT). Indeed, the weekend FT editorial (page 8) was dedicated to this very topic — global currency tensions (The New Threat to the Global Economy).
Also see What Bernanke Didn't Say on page A16 of the weekend WSJ (hint: in a 4,000-word speech, nada a mention of the dollar, even though it has clearly been a huge casualty). Precious metals would seem to be the best hedger, or perhaps even Canadian bonds, which will trade in lockstep with Treasuries but denominated in a currency that isn’t about to become debased.
Then there is what he did say, and page B1 of the Saturday NYT nailed it on the head (Bernanke Weights Risks of New Action):
“The likely impact would ripple far beyond American shores. The new actions could contribute to the weakening of the dollar and complicate a festering currency dispute that threatens to disrupt global trade relations.” This is happening at a time when globalization is heading into reverse — see the always-reliable Floyd Norris on page B3 of the Saturday NYT —World Trade, Once Rising, Is Starting to Sag Again. The article added “...the Fed hopes that by making credit even cheaper it will encourage businesses and consumers to borrow and spend...” Yikes! This is what got us into trouble to begin with — excessively cheap credit that fuelled an unsustainable spending binge. Also see Japan Turns Up Currency Rhetoric. We have an unstable foreign exchange market backdrop on our hands and history shows that this is where major financial spasms generally get started.
All this begs the question: is a gallon of gas at $3 cheaper than a gallon of gas at $300.
Another question, and this will get much more prominent in a few months, is whether Ben Batmanke be able to save the day and pull out just in time instead of drowning the world in trillion dollar bank notes?
More, as always, at the source.