On Friday, the Fed planted a story with John Hilsenrath in the WSJ suggesting that interest rates will stay low for a very long time. This was meant to counter-act turmoil in various markets as a result of Ben Bernanke's Congressional testimony on May 22nd.
Today's piece discusses the precarious nature of the world's financial markets, and how the Fed's efforts to assuage the markets is part of their larger mission to promote confidence within the markets, as there is a limit to how much real impact the Fed will have on the economy.
Why the Fed blinked by promoting Friday's WSJ article
While Ben Bernanke will not be able to influence events after he leaves the Fed, I believe his comments about the possibility of QE tapering are meant to signal that the less dovish members of the FED would likely slow down the pace of QE once he is gone from the FED. His innocent comment about possible QE tapering at the Congressional hearings on May 22nd was misconstrued by the market. You might call it a trial balloon which Ben was launching in the hopes to ease the separation anxiety which is sure to follow when he leaves the FED. Just like a child on his first day of Kindergarten, the markets had a tantrum, with risk-off the watch word for many leveraged hedge funds in a variety of asset categories. For its part however, the stock market held within a few percentage points of its recently achieved all time highs. All this notwithstanding, the Fed planted Friday's story in the WSJ which was meant to assuage the markets, just as a parent might spend time with their young child on the first days of a new school.
As I stated on Friday, all the Fed can do is to influence market psychology. To understand why this is so important, you have to understand how unstable the global financial system is. The bulk (85% according to what I have seen quoted) of the world's financial assets are denominated in US dollars, the Euro and Japanese Yen, in that order.
In the US, we have debts equal to 350% of our GDP. We saw what happened in 2008 when a 35% drop in housing prices, supporting 20% of debts in the US did to world financial markets. In short, the markets called into question the financial viability of institutions which were dependent on those asset markets holding value. World leading financial firms such as Citigroup, Bank of America, Fannie Mae, Freddie Mac, AIG, Wachovia Bank, WAMU, Lehman Brothers and Bear Stearns were bankrupt; most were kept alive due to the good graces and self-preservation interests of the government. Throughout the 2008 and 2009 crisis, many firms realized that they need to hold a greater share of their assets in cold cash because they could not count on traditional sources of liquidity. These cash balance earn a zero return, and this demand was met by an alphabet soup concoction of assistance programs by the Fed and many governmental agencies. The Fed's balance sheet more than doubled in short order in 2008, and I would say that the Fed's balance sheet as it stood in 2009 probably represents a new level consistent with the cash demands of various constituents. To accommodate such demands and provide a boost of confidence for the markets, the Fed initiated various QE programs, which started in December, 2008.
Presently, the U.S. economy is on the verge of a major decline. I say this because much of the U.S.' manufacturing and service sectors have been relocated overseas. This represents a permanent loss of employment, and a continuation of the U.S.' current account and trade deficits. The fact that the government has been running persistent deficits in the neighborhood of 7 to 10%; only resulting in economic growth ranging from 1 to 3% highlights what a hole we are in. Unfortunately, the U.S.' debt is now in the range of 100% of GDP, with guarantees of (GSE sponsored) mortgage debt equal to another 40% of GDP. This is not a recipe for economic revival, but a fiscal conundrum, as there are no real drivers for economic growth to counteract the deleterious effects of out-sourcing and a withdrawal of this fiscal stimulus. After four years of convincing the American public that it is OK to be fiscally imprudent, some factions of the Republican Party are having some impact on the government's fiscal irresponsible behavior. While the press and prognosticators are assuming that there appears to no impact due to the beginning of the year tax increases, or the impact of the Q2 sequester, it takes time to implement these changes, and even more time for people to react to the impact on their personal situation, as no one likes to down-size.
Which brings us back to the confidence game the Fed is playing, with increasingly higher costs to achieve the same boost in confidence as time goes on. Consider that the U.S.' monetary system is like a junkie who needs greater quantities of drugs to achieve the same high over time. The bottom line is that with no real model for the economy to improve, the Fed is stuck having to rely on a confidence game. Unfortunately, the confidence game is becoming increasingly expensive to maintain. One could argue that the return to the economy based on the amount of money the Fed has had to inject into the banking system cannot be justified by any rational measures. However, the Fed views their mandate as to control the money supply and influence the economy, so rational measures are not necessary for them to continue in this vein.
Are debt ratios of 350% to GDP for the U.S. too high? Are the assets backing those debts sound, or if the debts are not backed by assets, then do the borrowers have the means to keep up with their debt service? The same set of metrics can be applied to the debtors in Europe and Japan. In Europe, the entire housing market of Spain is suspect, while the balance sheets of the large banks appear to be leveraged and under-capitalized. In the U.K., financial service sector debt is over 500% of the U.K.'s GDP, with a total ratio of debt to GDP in excess of 700%. In Japan, government debt is almost 300% of GDP, and the pricing of this pile of debt has an average interest rate below 1%, clearly not a sustainable situation. In China, there is about $1 trillion of debt held by the nation's banks to municipalities or municipal development companies without a revenue model to repay the debt. The U.S. is the biggest player in this shell game, so it is important for the Fed to keep investors in these debt markets fully confident in these markets. And this is not to mention the $500+ Trillion of derivative contracts within the global banking system, which represents another level of complexity should any player within this system stumble.
We saw what turmoil $18 billion of Cypriot debt did to roil the world markets a couple of months ago. With so much debt outstanding, and the likelihood that the powers that be will not be able to wrap the risks of every player in the system, in my opinion, it is not if the system experiences contagion, but when! In fact, if you were to believe the spirit of the Dodd-Frank legislation, which mandates that debt holders absorb the losses of a failing financial firm, then contagion is assured. When the next crisis occurs, will our leaders let the chips fall where they may?
I am not upset by what the Fed is doing, as they are only doing what a self-serving and self-preserving entity is supposed to do: do anything to reinforce their relevance and power base within the country and world. Many consider the markets a rigged game. I disagree. The Fed just happens to be the largest actor in the game, one which has been relatively quiet in the past and has now asserted its relevance since no other actor has been left with enough fire power to make a difference. The Fed meets tomorrow and Wednesday, and will have some sort of market soothing pronouncement, as well as soothing words to share in the post meeting press conference.
What does this means going forward? I believe the Fed will continue QE for the foreseeable future. Arguments about prudence do not seem to matter unless a hawkish person replaces Bernanke when his term ends in January, 2014. And given the market's skittishness following Bernanke's May 22nd Congressional testimony, I believe that the Fed will be dancing around the market, sensitive to the idea that the market is on pins and needles. If market players were not sitting on nice year to date profits, usually with leverage, it is not certain whether the market would be so sensitive, but alas, that is not the case. In the meantime, the Fed will do what it needs to do, and all it can do: make nice to the markets.