Chairman Bernanke, the engineer of the most manipulated and contrived market rally in history has informed us he won't be making an appearance at the Jackson Hole Economic Symposium this year. The reason - a scheduling conflict.
Could there be something significant here? He didn't tell us what he sees as more important than one of the biggest events of the year for a central banker. In my opinion it must be a pretty big deal. Here's what I think - by August the market will have imploded once again and world economic leaders will be "circling the wagons" to offer up an epic solution to our global economic dilemma.
The solution - Bretton Woods II. You won't find too much on this subject in the media but there has been a lot of work going on behind the scenes. Our current system is in total shambles and in fact it isn't even a system at all. The truth is when we abandoned the original Bretton Woods system nothing was agreed to as a replacement.
In recent days it has occurred to me that Bernanke's plan all along might not be what almost all of us thought it was. This is admittedly just conjecture but isn't that what market forecasting is all about anyway? I have offered this up for consideration in previous articles and think the events of recent weeks and particularly the stunning announcement that Bernanke will skip Jackson Hole is sufficient justification for revisiting the issue of a new and improved global monetary system.
I think the Fed's plan since the onset of QE has been much different than we've all assumed. I have asked myself this question time and again - why would the Fed persist with a policy that makes no sense? In other words, why would the Fed continue to build excess reserves with more and more QE when it is obvious QE isn't working to stimulate the economy? Look at the chart and tell me you think this makes sense.
Keep in mind excess reserves are bank cash as are required reserves. When the Fed buys a bond the cash in the banking system expands and the bank's bond account contracts. That is all the Fed does with QE. QE doesn't expand M2 as many believe. That is a function of private-sector banks making loans. Here is how that works. The bank makes a loan and in so doing increases deposits (M2) and also increases assets - i.e., the bank's loans account.
When the bank hoards cash as it has done since the onset of QE there is no significant expansion in M2 and therefore no impact to the economy. That is what has happened since the beginning of QE so why would Bernanke and the Fed keep doing it when the money just keeps building to higher and higher levels in the bank's reserve account?
Bernanke's speech last Friday provides a few clues. You've got to read between the lines to get the point and I will get to that in a moment but for now let me lay out my thesis. Here is what I think may be going on. As early as 2008-09 there was a renewed interest in a plan to usher in a new global monetary system. It is my opinion that Bernanke saw the merit in such a plan and may have been resolved to the idea of orchestrating events in such a way that the ultimate outcome would be a relatively painless transition to a new global monetary system.
My thesis here is that everything that has taken place since then has been orchestrated to accomplish that end - at least that is what I think - and if that is in fact the case then everything that seems to make no sense suddenly does make sense. Bear with me as I develop my thesis as the subject matter is a little complicated and highly interconnected.
At the onset of the recession the stock market fell as did GDP but the real concern of the Fed was to avert a systemic collapse and avoid a deflationary spiral. A deflationary spiral puts downward pressure on M2 growth and that in turn results in a strong dollar. A pretty simple concept that most should be able to understand but there are other implications in a fear driven, tight credit economy from a global perspective.
In other words just as companies, banks and consumers went into a dollar hoarding mode so did sovereigns. To get a grasp of the thesis I am presenting here you need to understand how the global monetary system works and the cornerstone of the system is the reserve currency.
There is a abundance of analytical, research and opinion papers on the subject but this one prepared by the IMF entitled Reserve Accumulation and International Monetary Stability [pdf] seems well suited as a primer on the subject. I suggest you take the time to read it as the scope of my article is necessarily limited and fails to fully address the complexity or the serious implications of the impact of emerging markets on the global economy. The take away is this - the U.S. is incapable of continuing to supply sufficient levels of reserve assets and a change is imminent.
The paper referenced above was written in 2010 and therefore the data reflected isn't current but the gist of the argument is well presented in the excerpt below:
Here is a blow-up of the chart above on reserves as a percent of US GDP:
Here is another excerpt that tends to put the matter in context as it relates to the chart above:
Ratchet effects. In addition to self-insurance, and to the extent international investors
consider high reserves indicative of lower risk for them, individual countries may feel
compelled to acquire reserves not only sufficient to cover their own needs in a "sudden stop" event (e.g. all of their short-term external debt), but also enough to compare favorably with other emerging markets in competition for international capital or facing similar risks.5 A ratchet effect may be observable as countries effectively set new benchmarks for each other.
Similarly, if a given fall in reserves provokes further capital outflows because it is seen as
increasing the chance of outright crisis, a substantially larger initial stock than suggested by commonly used measures may be required.6 Such effects are hard to quantify but would imply that self-insurance policies would require ever greater cost and effort to maintain similar protections.
This next excerpt forms the basis for my thesis that a change is imminent:
As long as reserve issuing countries are willing to incur debt to purchase imports, an export-led growth strategy leading to persistent current account surpluses will be a feasible policy choice. As economies relying on undervalued exchange rates and demand from reserve issuers grow relatively large, the difficulties for the reserve issuers in achieving adjustment through domestic means alone increases.
Here is the key phrase - "As long as reserve issuing countries are willing to incur debt to purchase imports, an export-led growth strategy leading to persistent current account surpluses will be a feasible policy choice." So far the U.S. has been willing to do just that and here is my point - the fiscal and monetary policy that was implemented at the onset of the financial crisis was of such an immense magnitude that the United States and its central bank necessarily were required to meet the increase in the demand for reserve currency assets.
It was at the point where I finally got a grasp of this subject that I arrived at the conclusion that Fed QE and massive deficit spending were necessary even if the outcomes to the domestic economy were not significant. The real question - and one that Bernanke has made time and again is what would have happened if the Fed hadn't moved to inject liquidity into the system. Take a look at the GDP and CPI charts with particular attention to the period at the onset of recession:
What happened at the onset of the financial collapse - instant deflation and a collapse in GDP. The response by all - both domestically and on a global scale - was a rush to cash and dollar denominated assets - i.e., U.S. Treasuries. The demand for the dollar was instant and significant as the chart below reflects. The dollar appreciated by 25% before finally moving lower at the beginning of QE1.
As you can see from the charts above the rapid increase in demand for the U.S. dollar and U.S. Treasuries created a very rapid imbalance between supply and demand that drove the dollar substantially higher. Domestically speaking this is deflationary as the CPI chart shows. And of course deflation is the worst of all possible scenarios and produced an instant collapse in GDP and a broad based sell-off in stocks.
The Fed and the U.S. Treasury needed to move and do so rapidly to diffuse the impacts and to address the need for reserve assets - i.e., U.S. Treasuries. There can be no doubt that we did that as the massive increase in debt as reflected in the next chart brought U.S. debt as a % of GDP to post WWI levels - a period in time where a new global monetary system was essential and ushered in the Bretton Woods system.
The boxed in area on the chart shows the Fed and the U.S. Treasuries response to the need to supply a substantial quantity of reserve assets. So, the question again - where would we be had the U.S. government not fulfilled its role as the provider of reserve currency? The answer is that we would be in a global depression the likes of which we have never seen before.
Additionally, one should keep in mind this process was not really so much a function of the Fed as it was the massive increase in U.S. debt. It was the willingness on the part of the U.S. to expand the supply of Treasuries to meet the global demand for reserve assets that produced the much needed counter cyclical effects precipitated by the crisis.
Although everyone gives credit to the Fed the truth is the Fed's role was more of a facilitator than anything else in this context. It was Congress that passed much needed legislation and provided the authority to finance stimulus through deficit financing.
The Fed became a buyer of U.S. Treasuries and in so doing prevented what could have been an altogether different problem - rapid acceleration in inflation and a loss in confidence in the dollar as a reserve asset. The Fed apparently recognized the risk of inflation and decided to pay interest on excess reserves to incentivize banks not to take high risks by making loans - a situation that could have produced serious hyper inflation.
Hopefully this is starting to make sense to you. I have vacillated between being an avid supporter of Bernanke and one of his biggest critics. At this point I am solidly in the supporter camp but only on the basis that his purpose was in part to orchestrate a partial recovery of the global and domestic economies and to stabilize the system and get it prepared to withstand another shock and another trip to the bottom of the secular bear market trading range - a prerequisite to the end game that will result in a new international monetary system.
Although I admit my thesis is based on conjecture I think there are a lot of signs emerging - and at a rather rapid rate - that suggests the Fed and Congress are about to pull the rug out from under the markets. The Fed with a slow down in QE and Congress with deficit reduction. There is a reason for this though and it could have some very good long-term benefits. The truth is we need a new monetary system that will correct the inherent flaws of the present system. At Bretton Woods Keynes told us the system as configured would fail.
It did fail so Keynes was right. Keynes believed that a global central bank and a global non-sovereign currency was the preferred solution. Keynes proposed the bancor and his proposal became Britain's official position on the matter at Bretton Woods. Here is a brief overview on the idea Keynes floated at Bretton Woods:
The bancor was a supranational currency that John Maynard Keynes and E. F. Schumacher conceptualised in the years 1940-42 and which the United Kingdom proposed to introduce after the Second World War. This newly created supranational currency would then be used in international trade as a unit of account within a multilateral clearing system - the International Clearing Union - which would also have to be founded.
John Maynard Keynes proposed an explanation for the ineffectiveness of monetary policy to stem the depression, as well as a nonmonetary interpretation of the depression, and finally an alternative to a monetary policy for meeting the depression. Keynes believed that in times of heavy unemployment, interest rates could not be lowered by monetary policies. The ability for wealth to move between countries seeking the highest interest rate frustrated Keynesian policies. By closer government control of international trade and the movement of wealth, Keynesian policy would be more effective in stimulating individual economies.
My guess is something similar to what Keynes proposed is currently in place and waiting in the wings to be ushered in at the right time. The plan will set the IMF's Special Drawing Rights as the reserve asset of choice and the IMF will take on the role as Keynes' International Clearing Union.
The problem will be one of politics in spite of the merits of a non-sovereign system. Here is an excerpt from the paper referenced above on the subject of political resistance:
Additional hurdles to the development of an SDR-based system include potential resistance from reserve issuers who have no direct use for SDRs
There are certain benefits derived by being a reserve currency nation but the fact remains the global playing field is changing and in rapid fashion. The old system no longer works and it is doubtful you will find a credible reason offered for continuing with the present arrangement. That said, change is not so easy to accomplish and the political class in Washington must be convinced. Churchill said it this way and I think he was right:
"We can always count on the Americans to do the right thing, after they have exhausted all the other possibilities."
That takes us to the markets and what we might expect going forward. Here is what I think will happen going forward. In my opinion the markets have been manipulated, prodded and pushed to all-time nominal highs. I can't imagine anyone suggesting that the Fed hasn't provided the impetus for this push higher and a look at the correlation between the Fed's balance sheet and the Dow should dispel any doubts:
So can we count on Bernanke and the Fed to continue with the Bernanke put? As I said at the first of this article Bernanke s speech last Friday offers clues. Here's an excerpt from the text of that speech:
Ongoing monitoring of the financial system is vital to the macroprudential approach to regulation. Systemic risks can only be defused if they are first identified. That said, it is reasonable to ask whether systemic risks can in fact be reliably identified in advance; after all, neither the Federal Reserve nor economists in general predicted the past crisis. To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities.2 The triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will. For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages. In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks. Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system. Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises; the collapse of the relatively small market for subprime mortgages, for example, would not have been nearly as consequential without preexisting fragilities in securitization practices and short-term funding markets which greatly increased its impact. Of course, monitoring can and does attempt to identify potential triggers--indications of an asset bubble, for example--but shocks of one kind or another are inevitable, so identifying and addressing vulnerabilities is key to ensuring that the financial system overall is robust. Moreover, attempts to address specific vulnerabilities can be supplemented by broader measures--such as requiring banks to hold more capital and liquidity--that make the system more resilient to a range of shocks
Here is what Bernanke said with the Fed speak removed. We can't identify in advance when a systemic collapse of markets might occur. We know that high levels of leverage and a disconnect between the markets and reality can magnify the shocks and that requiring banks to hold more capital and liquidity can work to mitigate the shocks. In other words we aren't guaranteeing that the markets won't move to irrational levels but we have done our job to mitigate the consequence to the system the next time the markets move to irrational levels and subsequently crash in that we have addressed capital and liquidity issues.
Bernanke's comments tend to be a CYA statement but they are true and very informative if one cares to be informed. The truth is liquidity levels today are off the charts as the excess reserves chart above shows. Here is the math. Total M2 as of March 2013, was $10.447 trillion. That means that required reserves are approximately 10% or $1 trillion and excess reserves per the chart above are approximately $1.7 trillion for a total of $2.7 trillion in reserves or about 27% of total M2. That is simply unprecedented and suggests that United States banks can withstand a massive onslaught of depositor demands and still remain solvent.
In other words if we do have another market crash and it precipitates a run on the banks the banks will remain solvent and confidence in the system will be re-established rapidly. Consider the magnitude of the reserves and do so within the context of Bernanke's remarks and ask yourself this question - could Bernanke have been preparing the banks for another crash - one he knew would be coming all along?
For my money that makes a whole lot more sense than continuing to flood a system with utterly useless excess reserves. The only logical motive for doing this is to brace the system for another crash and to make sure the banking system would not be threatened with collapse. If that was his motive he gets an A+ as he has certainly done that and in that context an otherwise irrational policy suddenly appears almost prophetic and completely rational.
Here is another excerpt from Bernanke's speech:
In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.
From a financial stability perspective, however, the assessment of asset valuations is only the first step of the analysis. Also to be considered are factors such as the leverage and degree of maturity mismatch being used by the holders of the asset, the liquidity of the asset, and the sensitivity of the asset's value to changes in broad financial conditions. Differences in these factors help explain why the correction in equity markets in 2000 and 2001 did not induce widespread systemic disruptions, while the collapse in house prices and in the quality of mortgage credit during the 2007-09 crisis had much more far-reaching effects: The losses from the stock market declines in 2000 and 2001 were widely diffused, while mortgage losses were concentrated--and, through various financial instruments, amplified--in critical parts of the financial system, resulting ultimately in panic, asset fire sales, and the collapse of credit markets.
Here is what he said. Investors are getting carried away and are reaching for yield and that bothers us a little. We are also concerned about the amount of leverage currently being employed. Even so, we are not to worried at this point as the crash that is about to come will not have a systemic impact this time and not induce "widespread systemic disruptions"
You can ignore his warning if you want and continue to over leverage and chase yield but you sure can't blame Bernanke when you once again lose a substantial part of your portfolio. After all he has warned you.
As a side note there are a few pretty well respected investors who have heard the warnings and see the handwriting on the wall. Check out this excerpt from Richard Russell's Billionaires Selling Consumer Stocks: Red Flag or Profit Taking?
What do billionaires Warren Buffett, John Paulson, and George Soros know that you and I don't know? I don't have the answer, but I do know what these billionaires are DOING. They, all three, are selling consumer-oriented stocks. Buffett has been a cheerleader for US stocks all along. But in the latest filing, Buffett has been drastically cutting back on his exposure to consumer stocks. Berkshire sold roughly 19 million shares of Johnson and Johnson (JNJ). Berkshire has reduced his overall stake in consumer product stocks by 21%, including Kraft (KRFT)and Procter and Gamble (PG). He has also cleared out his entire position in Intel. He has sold 10,000 shares of GM (GM)and 597,000 shares of IBM (IBM).
I concede that my thesis is conjecture at this point but it makes sense to me. Here is what I see happening. The Fed withdraws market support, the market crashes in a shocking and rapid descent back to the 2009 lows, the eurozone recession worsens, China's slowdown worsens, Japan's last ditch effort back fires and the world plunges into recession.
In short order a solution is offered - a new monetary system that promises to resolve our problems. The system has the added benefit of a partially gold backed re-set of all sovereign currencies - in effect monetizing the debts of troubled nations once and for all and allowing debt-to-GDP ratios to move back in line with historic norms.
Thereafter, economies start to improve as confidence is restored and the perception of value is evident in all asset classes. Excess reserves rapidly shrink as money lending resumes and investments increase - again based in part on the perception of real value and also the confidence in the new monetary system. In other words, the next secular bull market begins.
As banks lend M2 will expand rapidly and inflation will be the short-term consequence. And yes, the gold bugs will be proven right as inflation will push gold sharply higher and that will also be of benefit to sovereigns who now hold gold as a partial backing of their own currencies. Bonds will fall and yields will rise once again rewarding the prudent amongst us who will benefit from normalized rates. In fact, higher interest rates will be necessary to keep inflation in check.
What might be the most surprising aspect of this whole scenario is the incredibly rapid pace of the events. Here too we may have a clue on timing. Consider that Bernanke has announced he won't be in attendance at Jackson Hole this year due to a scheduling conflict. One wonders what that conflict might be that would pre-empt the single biggest event of the year for a central bank head. It certainly can't be an emergency as he announced that he wouldn't attend several months before the event.
What possible reason would he have for announcing he would not attend? Maybe he plans to be pre-occupied selling Congress on the need to adopt the new system or maybe he simply plans to take the lead in introducing and selling the system to the world and the timing for this event has already been set and conflicts with Jackson Hole. I do think the stage is set and now is the time to begin the final chapter in the process of orchestrating an epic and positive shift that I see as resolving many issues that have held us captive in a secular bear market that is well into its second decade.