The Fed's Crash Cooking Is Almost Done

Includes: IEF, JNK, OEF, SPY, TBT
by: Harold L. Vogel, CFA

Earlier this year I had expressed the view (in "Cooking Up a Crash" and "The Fed's Twinkie Defense") that the Fed had already locked itself into the "infinity and beyond" stage of quantitative easing - a strategy and policy that did nothing to reverse and at best only slowly impeded the economy's slide into what might be generously described as a "soft patch." This is a soft patch that could easily morph into a deep recession by the second half of 2014.

If anything, the Fed and the other major central banks (ECB, BoJ, BoE) have as well painted themselves into a corner that grows more difficult by the day to exit.

Here are a few things to keep in mind whenever thinking about central banks and their policies, strategies, and public pronouncements:

  • The banks are supposed to be politically independent but none of them really are. The Fed, for example, is a private bank that operates with a unique public/private structure and oversight by the U.S. Congress. The Federal Reserve System (as described here) is designed to be self-funding but it clearly exists as a creation of and at the pleasure of Congress. The subtext is that the Fed must inevitably be sensitive to political considerations of the moment and not necessarily to what's good for the economy over the long term.
  • As non-independent political entities, central banks will always find it much more convenient and expedient to push interest rates down and keep them low and to provide more liquidity than the economy can readily absorb. That means that it's asymmetrically far easier for banks to blow bubbles than to deflate them. And this assumes that central banks are disposed to or able to even recognize in real time the bubbles of their own making.
  • The Fed and other central bank governors and their numerous academic advisors are deeply steeped in Keynesian thinking. The basic accompanying assumption is that there is such a thing as economic equilibrium and that therefore so-called dynamic stochastic general equilibrium (DSGE) models can be built to enable high-probability predictions of what specific policy and strategy changes will do to the economy. As I suggested in "Why Keynesianism Is Headed For Irrelevancy" in 2011, Keynesianism in and of itself is not all that bad a concept and strategy if used to stimulate an economy when debt to GDP levels are relatively low - perhaps under 65%. But it cannot possibly work when government debt is 100% or more of GDP and total debt is more than 300% of GDP as it now stands.

The forgotten part of Keynesianism is always that when the economy begins to recover and grow, you're supposed to dial back a large part of the debt incurred in bootstrapping out of the trough. But this is never done in an entitlement-dependent world, not in the U.S. nor in Europe, Asia, or Latin America. So the debt just continues to pile up even when times are good. Under such circumstances, Keynesian QE-to-infinity approaches become irrelevant. (Dr. Janet Yellen, a student of Yale Keynesian, James Tobin, a Nobel prize winner and direct disciple of Keynes himself, would probably disagree.) Even with $3 trillion of QE soon going to $4 trillion plus, the food stamp enrollments in the U.S. have in five years doubled to nearly 50 million people and the more realistic U6 unemployment indicator which includes workers who are part-time purely for economic reasons still hovers around 13.6%!

  • The Fed, especially, has despite attempts at more "transparency," fumbled in communicating its intentions. The "we're thinking of tapering" in late May, then followed immediately by regional bank presidents saying "we really didn't mean it," then followed by "we're not going to taper" in September has whiplashed investors. The Fed thus showed in a small but important way a failure to understand the markets. Also demonstrated was that the much-vaunted DSGE models apparently didn't predict that the 10-year benchmark treasury bond might rise so rapidly from around 1.6% to 3.0%. Scary is the word that first comes to mind. Moreover, on tapering and other policy decisions, the Fed has continued to emphasize that decisions will be "data-dependent." In the 100-year history of the Fed, has any decision ever not been data-dependent? This statement is pure hokum, smokescreen baloney and the opposite of transparency and clarity.
  • Many of the academics paid by the Fed for being consultants or visiting professors are not about to bite the hand that feeds them. And they are largely cut from the same cloth, as are almost all central bankers around the world. The media is generally respectful and faithful in transmitting their thoughts. But being not of the real world, much of what is uncritically repeated in the media is nonsense. Sure, the headline inflation numbers suggest that inflation (i.e., the CPI) is rising by only 1% or 2% a year. But as in my previously mentioned "Twinkie Defense" article, the true inflation rate that affects what real people pay for everyday items has been much higher.

In fact, it's most astonishing and disturbing that in the October 26, 2013 New York Times article by Binyamin Appelbaum, professional economists who ought to know better, were making a case for more stimulus. This is like dogs chewing on favorite old bones that they won't let go of.

Here's an excerpt that ought to raise the blood pressure and hackles of anyone outside central banking circles: "Some Fed officials cite the slower pace of inflation as a reason, alongside reducing unemployment, to continue the central bank's stimulus campaign…Critics, including Professor Rogoff, say the Fed is being much too meek. He says that inflation should be pushed as high as 6 percent a year for a few years, a rate not seen since the early 1980s. And he compared the Fed's caution to not swinging hard enough at a golf ball in a sand trap."

Much too meek? Six percent annual inflation? Has what happened in the American economy in the 1970s already been forgotten? Germany in the early 1920s? Zimbabwe's hyper- hyperinflation of 2008 with hundred-trillion-dollar notes being readied for circulation? What planet do the academics live on? (Excuse me, good professor, but when it comes to inflation, this time is also not different.)

All of this is akin to the old economics story that if you want to roast a pig for dinner, it's not advisable to accomplish this objective by burning the house down: In so doing, the pig will certainly be well-roasted but there won't anymore be a dining room either. At a six percent inflation rate, within a mere five years, you end up destroying around one-third of the average person's buying power, thereby hollowing out pension savings that took a lifetime of work to accumulate. It is grand larceny of the worst kind because the people who ought to be helped the most are the people most harmed by the silent theft of inflation.

Six percent inflation anywhere, but especially in developed economies, significantly undermines confidence in the ability and credibility of central banks, in the governments with which these banks are affiliated, and in business investment returns. It does this by destroying trust - the bedrock of the value of money, the key stabilizing social factor, and the most precious thing that any democratic and free society can produce.

  • Large and aggressive money managers have in the past two years concluded that central banks in general have their backs and that downside risk is limited as long as quantitative easing policies continue to be implemented. To a large degree, this has fueled the S&P to new heights and bounced the NASDAQ to within shouting distance of its dot-com high in early 2000.

The overriding assumption and presumption of most of the large wealth advisors and pension and hedge fund managers is that central banks actually control interest rates. If the Fed nods and winks that short term interest rates will be held at near zero even through to 2016, it must be so. This anchoring of the short rate ought to then prevent long rates from unexpectedly rising. Right?

Historical evidence ought to give pause to such presumptions because, except over the very short term, the Fed is not an interest rate leader, it is usually a follower (see chart below) and it is surprised as often as not by what happens. Central bankers around the world were greatly surprised by the quick run-up of the 10-year U.S. benchmark rate to 3% - a doubling in about four months. They were also surprised by the rapid ascent of one-month treasury-bill rates from around 0.08% on October 2 to around 0.35% on October 15 - the period directly leading up to a potential US government default on October 17.

The following shows the Fed funds rate almost always following, not leading market interest rates. The message here is that despite many pronouncements and good intentions, the Fed and other central banks in reality don't have a clue as to what short rates will be in 2016, let alone June of 2014. So, not only do the central bankers actually not have your back, they don't even have their own. In my opinion, it will come as an enormous shock to the stock and bond markets when it is realized that short rates might not at all be anchored to near zero till 2015 or 2016: Short rates might instead begin rising notably as early as Q1 2014.

The Fed usually follows: Three-month market Treasury bill rates (lighter irregular line, DTB3) versus FOMC Fed funds rates (thicker line), January 1990 to March 2013. Source: Federal Reserve Open Market Committee.

What the central banks began cooking up over the last three years is almost done cooking. It might need another two or three months on the stove or in the oven, and the stock market might arguably have enough gas left to eke out a small gain of perhaps another 2% to 3%. But in my view the inevitable crash can no longer be cushioned or avoided by more central bank bond buying through QE-infinity programs. QE has already been tried and its potency and effectiveness has been progressively reduced to nil. Central banks and their highly-credentialed advisors do not appear to have any new ideas. Politically, it's nearly impossible to reduce deeply entrenched government transfer-payment/entitlement commitments. And strategically and tactically, the banks have boxed themselves in.

My recommendation is to liquidate bond and stock holdings and to use ETFs. In bonds I like shorting SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK), and iShares 7-10 Year Treasury Bond ETF (IEF). I also like being long the inverted bond, ProShares UltraShort 20+ Year Treasury ETF (TBT). If you can stand the downward pressure for a while more, adding to any number of VIX related issues is still a good idea too. If a crash does indeed occur, volatility ought to spike much higher. It is probably also not too early to begin building or thinking of building short positions in the S&P 500 SPY and the S&P 100 (OEF).

In my view, the biggest surprise will not be that the market experiences a "correction" after having had such a great run up this year. The surprise will be that the down will be so sudden, violent, and broad-based. But then again, that's why such extreme events are known as crashes.

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.