From Jeff Snider of Atlantic Capital Management
Bernanke In A Box
His statement spoke volumes without saying anything. Yes, he disappointed the hardcore debasement enthusiasts called stock investors, but only at first. In between the lines of what he did say, it was crystal clear: Chairman Bernanke wants to do more QE. “Want” is not really the right word because it doesn’t really go far enough into Bernanke’s canon. I think it is abundantly clear he believes the Fed needs to do it as soon as operationally possible.
His concern on the economic issues is expected – anyone with rudimentary economic knowledge knows long-term unemployment can have lasting productive and social impacts or “scars”. He still seems confused about those headwinds, but at least has resigned himself and monetary policy to the fact that they are very real.
Rather, his attention to “financial uncertainty” and his view of the damage to “expectations” that comes with it is what really stands out now. Because the Fed is wedded to the rational expectations theory, financial uncertainty can become ingrained into investor psychology, flowing through to consumers and businesses. If consumers believe banks will be in trouble in the near future, they will act on those fears today. It is a mortal threat to the carefully cultivated, though utterly useless, appearance that everything is normal and good. The Fed has created trillions of dollars so that stocks will signal a robust future – and consumers and businesses will act today in the expectation of validity to that rosy, rainbow vision.
The beginning stages of another financial crisis or credit crunch change those expectations radically. This has to be nipped now, long before it permeates too far into the consciousness of the populace (not just in the US, but globally).
“We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including, of course, economic and financial developments, at our meeting in September.”
He said QE 3.0, without really saying it. The markets, seeing the enlarged schedule for the September meeting and interpreting the likelihood of heavy discussions, have gotten the message. Stocks threw off the daily mortal struggle that is life as Bank of America and bid for the QE future that is now September (good riddance to August apparently). Gold prices followed on those expectations of a resumption to the willful and wanton dollar destruction that QE purely represents.
If the Chairman can influence a major market rally without ever having to face the growing dissent within the FOMC ranks, then his speech has proven to be a stroke of genius. That is the essence of rational expectations, making others believe you have magical powers so that they do your bidding without any actual work or direct engagement on your part.
But there is a huge downside to waiting, and Bernanke knows it. The financial crisis grows while the economy is sliding further into contraction. Time is not on his side.
So why does he wait?
Simple, Bernanke and QE is in a box – conditions currently in the wholesale money markets, especially the repo market, will not suffer more QE. As the unsecured Fed funds and eurodollar markets have effectively frozen for banks outside the primary dealer network, wholesale funding has been left to repos. However, there is already a shortage of treasury bills, the prime, vital collateral of nearly all post-2008 repo funding arrangements.
QE is nothing more than an extraction of those bills (and notes), creating that shortage in the first place. So while the primary dealers are loaded up with Fed-created bank reserves, they are not forwarding them to the wider marketplace out of well-founded fears of PIIGS exposures and currency mismatches between assets and liabilities. Despite an ocean of liquidity at the center, the wider system is now a desert. The Fed is held hostage by the operational realities of the design of the Federal Reserve system.
Should the Fed embark on a new QE program today, it would simply extract more of that vital collateral, exacerbating the shortage to the point of significant voluntary capital destruction – banks would be forced to take on t-bills at greater and greater negative rates. This kind of situation is purely deflationary, and nothing scares Bernanke more than that dreaded d-word.
As long as the unsecured markets remain in limbo, and they will as long as the global banking system is hiding its problems, the Fed CANNOT launch another round of QE, no matter how much Bernanke might want to. In the calculus of monetary primacy, the banking system will win every time, even at the potential expense of stocks and rational expectations.
So the Chairman is forced to jawbone stock investors into believing QE is not yet appropriate (they are constantly monitoring the economic situation), but is still imminent. Meanwhile, the Fed is actively engaged in expanding the reverse repo program to help alleviate the bill shortage. While no one was looking, it has taken its aggregate of reverse repo transactions to nearly $100 billion, from only $65 billion at the beginning of August.
Reverse repos are an exit strategy, not monetary accommodation. But, in the context of the wider wholesale market freeze, reverse repos expand the amount of treasuries, especially bills, available to be used as collateral by financial institutions outside the primary dealer network. As much as the Fed adheres to flawed ideology and oft-times inconsistent theoretical constructions, it is not likely to engage in monetary programs that are directly contradictory. Reverse repos and QE would cancel each other out.
The cue for more QE, then, is t-bill rates. If the shortage resolves itself at some point in the coming weeks, then the green light is on. There is no doubt that given that green light, Bernanke will take it – he has to if for no other reason than monetizing the debt (which may not be a problem right now, but it will be at some point). The question for September is, among other pressing concerns, whether or not the unsecured markets thaw enough to remove the squeeze in repo collateral. If that does not happen, stocks are certainly not positioned for a second consecutive episode of crushed QE expectations.
It may not matter anyway. The selling we saw in early to mid-August was precipitated by the banking squeeze to begin with. Should that intensify, the expectations of stock investors outside the general banking system will be the least of our problems. For now, Bernanke’s mystique will be tested in the coming weeks. Moral suasion is good for the textbooks, but it usually has little use during a real crisis.