Wednesday, 29 December 2010

Inception - Bernanke's QE2 experiment

Like in the movie Inception, the Fed is trying to plant an idea into people's mind. Bernanke idea's with QE2 is to create a wealth impression which would increase consumption and economic growth, with the help of rising assets prices. We had the Greenspan put and the Bernanke put, we also now have to contend with the same bubble creation plan which was initially followed by Alan Greenspan.
We all know now the results of creating asset bubbles and the consequences.
It is a very dangerous game.

I agree with Cullen Roche from the excellent site Pragmatic Capitalist, that QE1 was not money printing and was necessary in order to alleviate the massive burden of toxic assets sitting on banks balance sheet.

"Over the last 15 years the Federal Reserve has essentially become a price fixing mechanism for an economy that has long struggled with severe structural problems. When problems have arisen in the economy the U.S. central bank has intervened to lessen the blow to the economy. In theory, this was intended to reduce the volatility of the business cycle. Unfortunately, many of their policies have simply exacerbated the problems or helped to generate even greater imbalances.

This all started well before the housing bubble or the Nasdaq bubble. After the 1987 crash Alan Greenspan was quick to reassure investors that the Fed was there to bolster markets. This “Greenspan put” was mastered with the bailout of LTCM as the Fed intervened in markets to make sure that losers didn’t have to become losers. LTCM was the epitome of failed economic theory at work in markets. A group of brilliant economists believed they had discovered the path to minting money in financial markets. On paper their equations appeared flawless. In reality, they were a disaster waiting to happen. In one fell swoop this collection of geniuses proved that EMH was flawed. And not two years later the Greenspan Put helped contribute to a market bubble like the United States had never seen. In the words of David Tepper, it was a “win win” market – or so they believed."

What if we had let LTCM fail in 1998? Would we have had a Lehman demise in 2008?

In his excellent post Cullen adds: "the modern day Fed has taken its role to an entirely new level. They are no longer just the lender of last resort – they have become the bailout mechanism of the capitalist system and ultimately a plaque build-up in a system that is increasingly unhealthy"

The outrage and the condemnation stem from the moral hazard of the situation of QE1, where Main Street had to step in to bail out Wall Street.

Cullen concludes his excellent post with the following comment:

"What these men haven’t stopped to ponder is whether any of this intervention was actually healthy for the markets. Perhaps the market crashed in 1987 because an irrational 40% climb in 8 months had created instability? Perhaps the Nasdaq never should have approached 5,000? Perhaps LTCM needed to fail? Perhaps housing was never intended to be a speculative asset? Perhaps these assets needed to be allowed to decline? The result has been a slow deterioration in the foundation of the system with each and every bailout."

Should the role of the Fed and its Central bankers be extended to preventing bubbles? Clearly some Central Bankers in other part of the world, think so. At least this is what the Central Bank of Canada has been following which meant that went the crisis occurred, they were in a better situation to face the financial carnage we witnessed. The Canadian Central Bank approach is highligthed in my previous post. Mark Carney, Governor of the Bank of Canada is right : "selected use of macro-prudential measures" are needed as a third line of defense in Central Banks policies, meaning deploying counter-cyclical capital buffers to lean against excess credit creation.

In the case of QE2, fear is justified, Bernanke has crossed the Rubicon.
When the Fed is starting to lend money to the US government, meaning no sterilization of the purchase of US treasuries, it is in fact money printing, let's be very clear about that. QE2 was not necessary and is very dangerous.

Paul Mortimer-Lee of BNP Paribas, in an article called "The night they killed Santa", commented in this article following Bernanke's television appearance that
"Until Tuesday, I believed QE2 was a monetary policy play designed to facilitate lower yields and avoid the threat of disinflation. Now it looks like the nice man with the white beard was just there to fund a fiscal expansion."

This is the greatest of moral hazard, when the central bank starts lending money to the US government. Is that what QE2 is all about?

Mortimer-Lee adds:
"Belief in the US as a pillar of stability has gone. We have written before about how the Fed's ultra-lax monetary policy is threatening the US dollar's role in the international monetary system. This week we saw any pretence of fiscal probity dumped."

He concluded his note with the following comment:
"Tuesday night was when I stopped believing in Ben Bernanke. I feel a bit foolish for having been gullible for so long, but a bit sad too."

"The night they killed Santa"

"One myth that's out there is that what we're doing is printing money. We're not printing money. The amount of currency in circulation is not changing." Federal Reserve chairman Ben Bernanke, December 5, 2010.

In relation to Ben Bernanke's public intervention, the excellent Doug Noland commented in Asia Times in his weekly Credit Market Bulletin following Ben's intervention on television in December:

Bernanke was pilloried last week for his "we're not printing" comment from Sunday evening's 60 Minutes interview. I'll pile on, but from a different angle. It seems strange to me - perhaps disingenuous - for our Fed chairman to suddenly take such a narrow view of "money".

At US$917 billion, outstanding currency comprises just over 10% of the "M2" monetary aggregate (savings deposits are the largest component at $5.343 trillion). And I have argued over the years that "M2" is a much too narrow definition of "money" to provide a useful barometer of overall credit and liquidity conditions. Certainly, the expansion of paper currency has been inconsequential to the grand scheme of Washington stimulus.

In the "old days", the banking system dominated system credit creation. Bank lending was integral to credit growth, with new bank deposits created through the process of expanding bank loans. "M2" provided a good indication of bank lending - that was a decent indicator of overall credit conditions. As such, the Fed reigned supreme over the credit mechanism through its careful regulation of bank reserves. Rather mechanically, our central bank would add reserves - the fodder for new bank loans - when it sought a boost in lending. It would extract reserves when it preferred to lean against the wind. Bank deposits were the critical component of "money" supply, and our central bank judiciously monitored their expansion.

The financial world - certainly including monetary management - was turned upside down with the unleashing of (unconstrained) non-bank credit instruments. No longer did the banks dominate system credit creation. In a process that gained fateful momentum throughout the 1990s, the bank loan was relegated to second-class citizen in the age of the booming Wall Street securitization marketplace. Meanwhile, the Fed's entire process of manipulating bank reserves became moot. Fed policy immediately gravitated toward manipulating the securities markets, and Bernanke's predecessor at the Fed, Alan Greenspan - "The Maestro" - absolutely relished his new "activist" role.

I have defined contemporary "money" as the most precious of credit instruments. "Money" is as "money" does. The great Austrian economist Ludwig von Mises recognized the crucial monetary role played by "fiduciary media" that had the economic functionality of a more narrowly defined stock of money. Especially with the advent of non-bank credit, the definition of what might operate as "money" in the markets and real economy had to be broadened significantly. The greater the boom in marketable debt instruments the more paramount the role of market perceptions in determining the stability of our financial markets and real economy.

Over the years, I have explored the concept of the "moneyness of credit." Moneyness is driven by the marketplace's perception of safety and liquidity. Generally speaking, "money" is a debt instrument perceived as a highly liquid store of nominal value. Money has always enjoyed a special role and, hence, unique demand characteristics: folks simply can't get enough of it, which nurtures a propensity to create it in overabundance. Money operates with its own problematic supply and demand dynamics, and never has moneyness enjoyed such capacity to wreak global havoc as it does today. With all their good intentions, central bankers are nonetheless at the root of the problem.

The Fed may not be running the currency printing press around the clock, but Fed policies have certainly been instrumental to the unending expansion of Treasury borrowings. And, clearly, any meaningful definition of contemporary "money" must include government debt instruments. Indeed, with bank (and, more generally, private-sector) credit suffering from post-housing mania stagnation, never before has government debt so dominated system "money" and credit creation.

Importantly, the Federal Reserve's zero-rate policy and massive monetization program have been instrumental in maintaining the perception of "moneyness" in the face of unprecedented Treasury debt issuance. I can't envisage a more powerful bubble dynamic: the Fed intervenes and manipulates the Treasury market - the predominant debt market underpinning fixed income and securities markets more generally. Enormous fiscal stimulus then works to stabilize system incomes, corporate cash flows, state & local tax receipts, and asset prices more generally. In the final analysis, trillions of dollars of government-created purchasing power ensure that a structurally maladjusted US economy has, at the minimum, the appearance of viability - and the stock market booms.

The Fed may not be "printing", but its operations as "backstop bid" are fundamental to the US and global government finance bubbles. In a replay of how "backstop bid" of mortgage guarantors Fannie Mae and Freddie Mac, the Fed and the US Treasury created the "moneyness of credit" for mortgages and related securitizations, the Fed's quantitative easing program distorts market perceptions of various risks (credit, interest rate, liquidity and systemic) and promotes over-issuance. From this perspective, our central bank's operations are more dangerous than the traditional printing press.

"Moneyness" was fundamental to the doubling of mortgage debt in just about six years during the mortgage finance bubble. Over time, the expanding gulf between market perceptions of moneyness and the true underlying state of mortgage credit ensured a crisis of confidence. Moreover, the trillions of additional mortgage credit had played havoc with spending and investing patterns and, increasingly over time, the underlying economic structure. These days, the attribute of "moneyness" in Treasury debt is on track to ensure the doubling of federal borrowings in the neighborhood of four years. For this round, the "expanding gulf" is much more pernicious and the consequences of a crisis of confidence potentially more devastating.

Money has throughout history demonstrated its dangerous side. Abuse money and "moneyness" at your own peril - although this fundamental lesson is invariably unlearned given enough time (and the seductiveness of monetary booms). The fiascos are always a little different, inevitably created by clever new wrinkles in the many faces of "money" and credit.

We are in the midst of another sordid episode. John Law's experimentation with paper "money" in France ended with the spectacular bursting of the Mississippi Bubble in 1720. Today's backdrop is much more complex: the Fed and global central bankers are working diligently to control an experiment in electronic "money" and credit gone terribly awry.

If it were only the printing press, it would be easier to appreciate what was developing and how to administer some restraint. Instead, the Fed has banked everything on its capacity to inflate marketplace liquidity, sustain massive government debt issuance, and maintain market perceptions of moneyness."

Where Doug makes his point is the role played by the Fed in maintaining what he calls "moneyness". The Fed acts as a backstop bid as well as maintaining perception of value. In fact, what he means I think is that the game of the Fed is to maintain perception of value by inflating assets prices through QE, moneyness being the perception of safety.

The point he makes and we all know that, the Fed is great at creating bubbles after bubble and QE is already creating the seeds for another one. It will end up in tears.

Gold will therefore continue its meteoric rise, supported by the misguided QE2 policy. Oil got my attention when it was recently trading at 75 USD in October. I am not surprised we are getting closer again to the 100 USD level. I think we will reach 100 USD in early 2011.

Oil in 2010:

Also at the current level of VIX, buying insurance for a market correction is once again cheap, and as in April, before the May sell-off, I wrote it was the right time to buy some protection. Again this time around, I think it is a good time to start buying some protection for some downside risk in early 2011.

Facts on current vols levels:
-EuroStoxx 50 is at the lowest level in the last four years. One month Implicit Vol was on the 15th of December at 17.3%, the lowest point was 6th of April 2010 at 15.5%, we know what happened in May... Implicit Vol 1 year was at 22.8% on the 15th of December.
-V2X has never drop as fast as it did between the 5th and the 15th of December since 2004. 19.7% as of the 15th of December, lowest point in 2010 was 19.8% on the 26th of March 2010. This is the lowest point since 30th of May 2008. V2X was at 31.1% on the 30th of November 2010 as a reminder.

Merry Christmas to all!

Martin T.

PS: Happy Birthday to my blog, it has been more than a year now and it is well alive and kicking. I would like to thank all my friends who have provided me with reports and some Bloomberg specific graphs which have helped me to illustrate my point of view. Please don't hesitate to comment on the posts to make this blog more interactive.

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