The Changing Game Of Ben Bernanke

by: Shubhendu Pathak

Credit is losing its potency

QE1 was announced by the Fed on November 25, 2008 and QE2 about two years later on November 03, 2010. On September 21, 2011, the S&P 500 opened at 1,203. The market was expecting another QE announcement that day but the Fed announced Operation Twist instead. The index closed at 1,129 on September 22, 2011, a drop of more than 6% within 48 hours of the announcement. The market has not only come to expect QEs but is also surviving on this unprecedented financing of fiscal deficit. QE3 was announced a little less than one year later on September 13, 2012.

The U.S. is a net importer and a sizeable portion of the new money pumped into the economy is spent by people to buy goods produced outside of the U.S., partially defeating one of the objects of pump priming - that the money be spent to buy goods produced in the U.S. and employ people who produce those goods.

The other object i.e. cheap credit is available either to the government to spend to create "jobs" or to the consumers to buy homes and cars. It is also available to corporations, yet they deferred $175 billion in capital expenditures between 2009 and 2011.

Clearly credit is losing its potency. PIMCO chief Bill Gross in his article titled Credit Supernova points out that in 1980 it took $4 of new credit to generate $1 of GDP, it now takes about $20. He predicts - "The countdown [to credit supernova] begins when investable assets pose too much risk for too little return". I will discuss this quote later in my article.

The carnage in waiting

Trade deficit is $40 billion a month, fiscal deficit is $90 billion a month and the Fed is expanding its balance sheet by $85 billion a month. History has never seen the current levels of excess reserves of depository institutions at the Fed.

The CPI does not suggest easing, and if you trust the hedonic adjustments, perhaps rightly so. Inflation is not in goods right now. Repeat: right now. The dollars that cross the U.S. borders due to continuing trade deficit are circulated back into the U.S. treasuries inflating their price. Foreigners now hold more than $5.5 trillion of the U.S. treasuries and are running out of reasons to buy more, or even to continue to hold them.

Why do Japan and China use notes printed in the U.S. to trade goods between themselves? Back in 1944 the U.S. dollar was accepted as the reserve currency for a reason; the whole world wanted goods that carried the words 'Made in U.S.A' and needed dollars to buy those goods from the U.S.

The balance of trade has made a radical shift since then. The U.S. now sells treasuries to finance its deficits. Treasuries are claims on goods and services produced in the future. Savers in Japan and China, who effectively hold these claims, will at some point exercise them and bid up the price of goods and services produced in the U.S.

Even if that does not happen, all it will take for inflation to show in goods and services is a no from China, Japan and other creditors to more of the U.S. treasuries. Once that happens, the Fed, with its balance sheet loaded with toxic assets, will have no other option but to increase the interest it pays on more than $1.5 trillion of excess reserves. Or a change in the liquidity preferences of people will do the job.

More than 30% of the $9 trillion marketable interest bearing public debt held by private investors matures within one year and about 75% matures within five years. 70% of the U.S. GDP is consumption and the engine is running on more than $500 billion of mortgage purchase originations, $250 billion of auto loan originations and $100 billion of student loan originations every year. Repeat: originations. Repeat: every year. Revolving debt stands at $850 billion. All these debts are vulnerable to rising interest rates.

Again, despite the artificially propped up spending and historically low cost of borrowing, the GDP growth is sluggish, investment is being deferred by corporations, U-6 unemployment is above 14%, student loan 90 day delinquency rate is in double digits, default rate of corporations is inching higher and more than 46 million Americans are living on food stamps. It is not hard to imagine the carnage rising interest rates will bring.

Ben Bernanke's changing game

Ben Bernanke scored 1,590/1,600 on SAT and it is difficult believe that he is oblivious to the situation we have on our hands. The Fed Chairman has been at times very vocal about his concerns and raised them in surprisingly strong words in his June 14, 2011 speech at the Annual Conference of the Committee for a Responsible Federal Budget. Then why does he advocate QEs? Is it only the FOMC consensus that he is allowed to speak during the hearings? I don't think so. I think he is playing a game.

Game in game theory has a precise meaning. I discussed the content of this article with Prof. Ray Hill, PhD Economics, MIT and former CFO of Mirant Corporation; he expressed his concern over calling what the Fed Chairman is doing a game. Game has to have two players he says and we cannot treat the market as a single player. I am going to call it a game nevertheless. It sounds sexy.

In a conventional set up the market is not certain about the moves of the Fed. Due to this uncertainty around whether and when the Fed will loosen, an anticipating investor would fear exposing himself to a downside if he holds on to his assets and might prefer liquidating his position(s). This is what happened after September 21, 2011 when the Fed announced Operation Twist. Had the market been confident that QE3 will be announced later, it could have been a non-event. What happened that day was not a game, not even close to it.

The game is played between the QE announcements. It begins when the effects of the previous easing starts to fade. When payroll numbers come out as disappointing and consumer spending takes a dip, it is then that Ben Bernanke comes out, blows into his hands, and rolls the dice. He takes a position that effectively translates into "The moment the S&P 500 goes below 1,200, I will de-tether my helicopters the next day". He does not use the S&P 500 breaching 1,200 as a contingency, that I am using for the sake of simplicity, but this is essentially what he means when he says that he will do what it takes to stop deflation and that he will not hesitate to drop wads of federal reserve notes from his helicopter if that is what it takes to "kick start" the economy.

An investor, especially a speculative investor, tries to anticipate the timing and amount of investments the other player i.e. the market makes or liquidates. This anticipation and Ben Bernanke's effective position creates a game.

If the investor sells and the S&P 500 plunges below 1,200 at a point in time when he is all in cash, his game is over. QE will be announced, nobody will sell and the index will bounce back without much volume exchanging hands.

On the other hand if the investor holds on to his assets, there is a chance that the S&P 500 gets very close to 1,200 but never breaches the mark because at that point both the investor and the market, knowing that they might be very close to a QE announcement, are too afraid to sell. The index will never go below 1,200. So what is the PIMCO chief talking about because Ben Bernanke seems to have it all under control?

At some point when the creditors start raising eyebrows or when inflation starts showing in goods and services the Fed will be forced to stop easing. This will lead to lower corporate earnings and high P/E ratios if the market continues to hold/buy. Perhaps the conventional wisdom that does not see the bubble in bonds right now, will then see the irrational exuberance of the market. P/E is what the wise man watches out for. This I believe is what Bill Gross means when he says - "The countdown begins when investable assets pose too much risk for too little return". Ben Bernanke is only buying some time.

The current stance of the Fed of "indefinite QE", which the Fed Chairman most recently confirmed in his press conference on March 20, 2013, does not change the game. In fact it brings us closer to the countdown. Credit it seems has become so week that Ben Bernanke could not afford to postpone a QE any longer. His effective position that he will do whatever it takes still stands. So the game is on, it has only changed from No-QE-to-QE to QE-to-more-QE.

Investment strategy

Buy something you can hold or touch, something that has intrinsic value and cannot be printed by the central banks. Gold and silver are two good options; they have intrinsic value and low storage costs. Gold was money before 1971. You can actually see deflation, as one should observe in a depression, if you price goods and services in gold. The S&P 500 priced in gold has fallen dramatically since the dot com bubble burst in 2001.

If a breakdown of the financial system is not one of your concerns, you can buy commodity ETFs. SPDR Gold Shares (NYSEARCA:GLD) and iShares Silver Trust Fund (NYSEARCA:SLV) are two ETFs you can consider. If you don't trust the financial system you can either buy physical gold or buy title to gold held by Perth Mint. A reasonable company that offers both is Euro Pacific Capital.

The currently unfolding banking crisis in Cyprus and possibly other similar debacles in the future can be good for physical gold as people losing trust in bank deposits might return to the old money. FDIC "insurance" in the U.S. only protects the nominal value of the deposits. The haircut Cypriots are likely to take might be dwarfed by the real value inflation takes away from the dollar deposits once the countdown begins.

Agriculture could also be a good investment. RICI Agriculture ETN (NYSEARCA:RJA) and PowerShares DB Agriculture Fund (NYSEARCA:DBA) are two decent ETFs.

Before going long a currency other than the U.S. dollar, you need to consider what the central bank issuing that currency is doing. I have discussed the case of Yen and ETNs PowerShares DB Inverse JGB Futures (NYSEARCA:JGBS) and PowerShares DB 3x Inverse JGB Futures (NYSEARCA:JGBD) in my article The Time To Short Japanese Government Bonds Is Now.

Lastly, if you trust that the U.S. government will report the correct CPI going forward, you can consider investing in TIPs.

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.

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