Don't Fight The Fed -- The Continuing Saga

Includes: DIA, SPY
by: John M. Mason

Bloomberg has just released the results of a survey of economists concerning the current activities of the Fed. The conclusion:

"Federal Reserve Chairman Ben S. Bernanke's latest round of bond buying will reach $1.14 trillion before he ends the program in the first quarter of 2014, according to median estimates in a Bloomberg survey of economists.

Bernanke will push on with purchases of $40 billion a month of mortgage bonds and $45 billion a month of Treasuries, according to the survey of 44 economists

In the current round, the Fed's total purchases will be split between $600 billion of mortgage-backed securities and $540 billion of Treasuries, according to the median estimates of economists in the survey."

The economy is not growing as fast as Mr. Bernanke would like. The unemployment rate is not dropping as rapidly as Mr. Bernanke would like. So, full steam ahead!

A question remains about what this monetary effort is accomplishing. The Stanford economist John Taylor lays out the concerns very clearly in the Tuesday Wall Street Journal, "Fed Policy is a Drag on the Economy."

Forecasts for the economy in 2013 still put real GDP growth around 2.0 percent. And, very few analysts are seeing the unemployment rate drop much below current levels.

Why, then, is Mr. Bernanke and crew being so persistent in sticking to another round of quantitative easing? Conventional analysis, like that of Mr. Taylor, examines the environment using the fundamental economic analysis of the pre-financial crisis methodology. There are some, like Yale's Gary Gorton, who are saying that this methodology is behind the times when it comes to an understanding of the financial institutions of the 21st century.

This approach argues that the financial innovation that took place in the latter half of the 20th century resulted in substantial changes in the underlying structure of the financial institutions and financial instruments that made it very hard for analysts to identify exactly what was going on in the financial community and the risks that were being assumed.

As a consequence, the financial crisis was not readily anticipated and the reactions to the collapse were unprecedented. No one conceived of the importance of the repo market, the money market funds, the asset-backed securities, and the role that the commercial paper market had taken when the first liquidity crisis hit the financial markets in the fall of 2007. No one really understood the breadth and depth of the "shadow banking" sector. Great wonder arose at the actions of the Federal Reserve to protect market makers and brokers and investment banks and insurance companies. The Fed's balance sheet became cluttered with an incredible collection of institutions that needed help.

Given this view of the financial industry of the 21st century another question remains. What do Mr. Bernanke and the officials of the Federal Reserve know that is not readily obvious to the rest of us? What is the condition of the commercial banking system? The largest 25 banks seem to be doing OK, but what about the other 6,140 or so banks? What about the money market funds that played such a substantial role in the 2007 collapse? According to the statistics of the Federal Reserve, funds in retail money market funds and institutional money market funds finally stopped declining late in 2013. This is just over six years of decline since the initial disruptions to the financial markets. What about the commercial paper market? What about the repo market? What about the "shadow banks"? What does the Fed know?

The financial markets seem to be moving more and more into a "risk on" position suggesting that investors are feeling better about riskier credits. World wide, capital markets seem to be strengthening as investors move back into riskier investments. The 10-year Treasury note topped 2.00 percent yesterday, the first time this level has been hit since April of 2012. The German 10-year bond hit 1.70 yesterday, the first time it had been this high since early last year.

And credit-based spreads are remarkably low. The spread between 10-year Greek bonds and the 10-year German bond was below 850 basis points yesterday. Incredible. And, Spain's bonds are trading to yield about 350 basis points above the German yield; Portuguese bonds are about 450 basis points above. It has been quite a while since these spreads have been so narrow.

Is this the kind of thing that the Fed is really waiting for? Does financial stability have to be re-established within the financial community before more robust real economic growth can be achieved?

We are not able to observe all that is going on within the banking system … within the "shadow banking" system. We are not able to observe what is going on in the private sector as information technology becomes more and more a part of everyday banking and as more and more financial institutions, particularly the big ones and the ones in the shadow, innovate their way into the new era.

The thing is, "Don't Fight the Mission of the Fed." Apparently, Mr. Bernanke and the Fed see something that is not readily apparent to us. Maybe the only way that they can really explain the complexity of the situation is to focus on their ultimate goal, higher real economic growth and lower unemployment. Maybe that is as clear as they can be at this time.

Even if we cannot fully understand it at this time, it would be foolhardy to try and work against the Fed until there is some evidence that Mr. Bernanke is going to be less persistent pursuing further quantitative easing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.