Open Letter To The Talented Chairman Bernanke

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 |  Includes: SPY, UPRO
by: Macro Investor

Dear Professor Bernanke,

I never had a chance to take a class with you. I never even attended any of the academic institutions that you have taught at. However, I have read all your essays on the Great Depression. I cannot tell you how grateful I am to you for saving us from a repeat of the Great Depression.

However, I think you can and should do more.

Don't get me wrong here. I understand that the Fed is a democratic institution, and not as independent as one would like it to be. I understand the challenges. Yet, I urge you, Professor Bernanke, please do not remain inactive in the face of the inevitable spending cut that the Tea Party is going to force on the U.S.A. in a few weeks. Reports National Public Radio:

The White House and congressional Democrats are sounding the alarm bells over the consequences of the sequester, the across-the-board cuts to the budget that are scheduled to go into effect in March. Speaking on the same program, Rep. Paul Ryan, R-Wis., chairman of the House Budget Committee, was pessimistic about a deal to avert the cuts. As NPR's Brian Naylor is reporting for our Newscast unit, the cuts will mean federal spending will be reduced by $85 billion between March 1 and the end of September.

Professor Bernanke, you know this very well and I am likely preaching to the choir here, but the U.S.A. cannot afford a $85 billion spending cut this year. This on top of the tax rate changes from the fiscal cliff, will take out about 1.5% out of GDP growth according to the Congressional Budget Office. Reports CNN:

The CBO estimates that the U.S. economy will grow at a slow, inflation-adjusted rate of 1.4% this year.

Without this year's fiscal tightening (spending cuts and tax increases combined) growth could have been 1.5 percentage points higher. Among the policies slowing growth are the sequester, the expiration of the payroll tax cut and the higher rates on wealthy households.

I know you and the Fed anticipated this. That is why you have been expanding the money supply through QEternity. But is buying $85 billion per month enough to counter the 1.5% lost growth?

The U.S. monetary base stands at around $10 trillion now. Adding another trillion through QEternity will raise it by about 10%. However, Money Velocity is dropping, and fast, which counteracts the increase in the money supply. Hence, I believe you need to do much, much more to lower unemployment and increase GDP growth, especially given the spending cut gift that the Tea Party is giving to the country soon after Valentine's Day.

I am not being a scaremonger here. The Congressional Budget Office is with me on this. Reports CNN again:

The CBO expects the unemployment rate will fall from 7.9% this year to 5.3% by 2023. But it won't dip below 7.5% until 2015. "If that happens, 2014 would be the sixth consecutive year with unemployment exceeding 7.5% -- the longest such period in the past 70 years," the CBO report said.

This is already taking into account the $85 billion that you are pumping into the market every month.

I know your unemployment target is 6.5%, Professor Bernanke. You have promised to keep QEternity alive till that target is met. But it does no good if it takes us many years to reach that target. We need to lower unemployment right now. In a few years, we will have a new Federal Reserve Chairman, who may not be a keen student of the Great Depression like you, and may adopt a hawkish stance. We cannot leave the fragile recovery to chance. We need to gut unemployment while you are still in office.

We need you to increase the money supply enough to counteract the lost 1.5% in GDP growth. Given that the velocity of money is dropping by about 1% each year, this means we need a money supply growth (incremental to the $85 billion per month) of about 2.5% for the year, or 0.2% each month. That translates to another $20 billion increase in the monthly purchases.

In other words, increase the monthly purchases from $85 billion to $105 billion, Chairman Bernanke, to counter the downside from the spending cuts. I know this is asking a lot from you and the Federal Reserve. You are not supposed to be alone in the fight against unemployment. Congress is supposed to help you. But given the current make up of Congress, that is unlikely.

If Congress won't act to help the American people, then they will be dealt with harshly in the next election. The American people are not stupid. They know who is on their side, and who is interested in inflicting more pain on them. History will judge the hawks in the Congress harshly, as it has the hawks during the Great Depression.

But we cannot wait for that. We cannot keep having an unemployment rate higher than 7.5%, when the solution is more stimulus. If Congress won't act, the Fed must.

Help us, Helicopter Ben. You are our only hope.

With sincere regards,

-Macro Investor

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Dear Reader,

I personally believe that the chances of a full sequester are slim to none. As it is, $85 billion in nominal spending cuts will only amount to about $45 billion in actual spending cuts, per JPMorgan. Also, as had happened during the fiscal cliff crisis, I believe that the Republicans will negotiate at the end and agree to a compromise. This is just as I had predicted when there was a big worry over the debt ceiling negotiations.

However, the market being the drama queen that it is will likely start to drop pretty soon, which will be the time to sell, and then buy back the week of the final negotiations, to get positioned for the relief rally. I personally plan to do just that.

So, what is the best way for investors to profit from this situation? I like high beta ETFs that are based on market indices. The high beta provides lots of leverage as the market has its mood swings and goes up and down, and the index provides a broad exposure so that investors do not have to worry about getting the punt wrong on a specific stock.

For trading purposes, I recommend the ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO). I plan to buy this ETF about 1 week before the debt ceiling crisis due date, and close the position right after the relief rally. For those less comfortable with volatility, a safer bet may be to use the core SPDR S&P 500 Trust ETF (NYSEARCA:SPY). This strategy yielded about 5% returns in a week during the fiscal cliff crisis.

This, however, has a lot of risk. If Congress truly cannot come to an agreement, investors employing this strategy will be in for a lot of hurt. But as Democratic Representative Alcee Hastings said about the House Republicans during the fiscal cliff debate, I believe that

"They're crazy, but they're not that bats**t crazy."

In the mean time, let's hope that the Feds increase the amount of QEternity. That will for sure help the market a lot over this and the coming years.

Disclosure: I am long UPRO. 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.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice.