Fed Crash Cooking Done: First Course Being Served

by: Harold L. Vogel, CFA

Welcome to your new job, Dr. Yellen.

You and your predecessor, Dr. Bernanke, have done what you were both taught to do according to standard (but in my humble opinion, deeply-flawed) economic-theory prescriptions. It is heresy not to at least try to do whatever seems possible to boost the economy and to thereby relieve chronic unemployment. Your intentions have both been noble and well-intentioned.

But none of the bills for the grand QE experiments - ballooning the Fed's balance sheet into the trillions of dollars and suppressing stock market volatility and short term rates - have as yet been paid. The S&P 500's decline since mid-January is closing in on 10% but the bottom is not yet in sight. A fine mess has been cooked up in the central bank kitchens in Washington, London, Frankfurt, and Tokyo among others. (See, previously, "The Fed's Crash Cooking is Almost Done," and "In Hotel QE, You Can Check In But You Can't Check Out").

Well, the bills are now starting to come due and the first course is already being served. The problems will unfortunately for all of us in retrospect make Dr. Yellen's first days on the job seem the easiest and best of her entire forthcoming tenure.

As history shows, bubbles burst when the credit created is insufficient to service the debts outstanding. Central banks must try to create enough credit to stay ahead of the burgeoning debt obligations, hoping that economic growth will in the nick of time be sufficient to save everyone's hide before the entire experiment goes awry.

Why do such "experiments" so often fail?

There are two basic reasons: The first is that money is really all and only about trust and information. At a certain point, the debt service obligations are so high that even with standard policies of extend, amend, and pretend (as in QE and other euro central bank machinations of recent years) the string runs out - and trust evaporates. The second reason is that central banks are at this stage being forced - kicking and screaming and much against their will - to tighten into economic weakness and/or recession-tinged conditions. That's indeed what's happening now.

Argentina has been skating near the debtors' edge for years. Turkey is, to say the least, currently a financial turkey. Russia has oil, but prices are too low and falling. Brazil has for now run out of Miracle-Gro. Ditto for all of the formerly popular emerging markets that have - to revive an old phrase of the late 1990s - again turned out to be submerging markets.

The Fed's largesse had to end because it was practically consuming the entire Treasury issuances and wasn't doing much anymore to "stimulate" the economy. Discouraged drop-outs from the labor force continue unabated, younger people can't find entry-level jobs, retirees are seeing their saving vanish even as pension funds are gasping for the air of higher returns.

All of this has always historically led to a breakdown of trust - in currencies, in politicians, in governments, and in central banks. Money is providing the information that submerging market countries are encountering great difficulties in trying to earn their way out of distress because the large economies - the U.S., China, and Japan - for their own various reasons, no longer demand as many goods and services and natural resources as had been previously needed. So the economies become cash-constrained. Inflation rates soar, currency exchange rates fall, businesses then can't sustain their credit commitments, and unemployment rises. None of this is ever stabilized and reversed easily or quickly.

As the trust disappears, money and credit begins, naturally, to cost more. Central banks can keep short interest rates down only up to the trust-breakdown threshold. Short-term rates in Turkey and India have already been raised significantly and this will happen almost everywhere else too (including the U.S.). Although flight to quality ought to help keep long term treasury yields relatively low for a while longer, even here there's a sense of growing unease - i.e., a notable reduction of trust and respect in the form of extreme political polarization.

Tightening into weakness is the only alternative to total systemic disintegration and societal upheaval. It's not what central banks want to do, it's what they have no choice in doing. Most of the submerging market banks had anyhow largely gotten a free pass as long as the Fed pursued QE.

Stock market bulls too are hewing quite closely to the historical script. Coming out of 2013, the mantra was that "the market "needs" a 5% to 10% correction" that will be "healthy" and create a buying opportunity. To continue rising, the only thing that markets ever "need" is more net credit creation that is not fully absorbed by actual economic activities.

For investors, as always, when the market is down more than 10%, the previous swagger and confidence dissipates. When the market is down 20%, the buying "opportunity" will be much greater and the bearishness more profound and deep-seated.

Giant bear markets, like the one just starting, take a while to get going and this one will be like others in the past. It will be punctuated by sharp rallies that seem to be for real but are in fact fake-outs because the later downdrafts will be even more violent than the updrafts.

What to do as the contagion spreads? The central banks are pretty much out of ammo - they mostly used it up in the futile efforts that only led to the yield-chasing bubble of 2009-13 and created the surface impression that the global economy was healing. But with interest rates held artificially low for so long and with QE aggressively and widely applied, the resulting distortions, it might be argued, have actually undermined rather than fortified the global economic foundation.

I was too early in being long various volatility-related ETFs but I still - despite recognition of their inherent structural problems - like trading VXX and SDS as they are finally starting to move up. I would also look to short JNK as small companies barely able to stay afloat under QE policies will now enter a much tougher credit environment that will cause spreads to widen. Although treasury yields have declined of late, the 10-year is still 100 basis points or so above its low of 18 months ago and I think it's again headed higher (as somewhat counter-intuitively happened in the deflationary depression of the early 1930s). The TBT seems to be a viable play on this.

In sum, the first crash course is being served but it's not the last course. That last course will be the most panicky, distasteful, and devastating and will likely be served later - after a major rally that starting from lower levels than currently might extend from sometime in the second half of 2014 and into early 2015. Should it occur, this rally would in my opinion be highly unlikely to exceed the market's recent record highs.

Since 2009, cash has been seen as trash. Now and over the next two years at least, in my view, cash will turn out to be king as deflation - the thing that central banks dread the most - takes hold around the world.

Disclosure: I am long VXX, SDS, TBT. 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.