How I Learned to Stop Worrying and Love the Fed

by: Michael Shulman

This past Sunday evening Bernanke was interviewed on 60 Minutes and said he will expand the Fed’s balance sheet and provide “quantitative easing” for as long as it takes. This made some people condemn Bernanke. They should not – they should love him. And defend him.

I do.

Most of the criticism of Bernanke and the Fed is based on classical monetary theory – which holds that, by keeping interest rates too low and expanding the Fed’s balance sheet, he is debasing the U.S. currency and creating the foundation of inflation. This criticism is totally wrongheaded and based on theories formulated, and working, in an era of fixed-exchange rates and the gold standard. That world no longer exists.

The expansion of the Fed balance sheet and low interest rates have not created new money; the money supply has contracted since the beginnings of the crash, depending on the measure you use. Inflation happens when an increase in the money supply hits a fixed supply of goods, services and assets. Our supply of all three is fairly elastic – some would say too elastic – and as long as we let China run the world’s manufacturing base, there will no inflation in easy-to-manufacture products.

Fed actions have not debased the U.S. dollar. And who's to say what would happen if the four major central banks of the world – the Fed, the ECB, the Bank of England and the Bank of Japan – simultaneously created more money? Whose currency would take a hit? Using the logic of monetarists, none would.

What would happen is the undervalued currencies of post-Third World countries such as China and Brazil would appreciate. It can be argued that the simultaneous creation of new money would allow governments to monetize debts and to promises of re-valuing their currencies to rebuild battered manufacturing bases. The rise in commodity prices -- even oil -- would have a psychological impact, but in the most advanced nations core commodity prices are a very small part of the cost of goods or GDP.

This is all theory in defense of the Fed. Now let me tell you why I love the Fed and what it means for traders and investors.

Lehman Brothers: Bernanke let Lehman (OTC:LEHMQ) fail. Some bank on the ropes had to be allowed to fail, and if you had to pick a bank worth failing it was the one run by Dick Fuld -- someone who makes Albert Haynesworth look like a stand-up guy. Yes, the Fed allowing Lehman to fail crashed the markets. This was going to happen anyway; do you think a $10-an-hour drywall hanger was really going to be able to pay off the mortgage on his $800,000 house? By letting Lehman fail, Bernanke said a.) this is a capitalist country; b.) all you other banks: Get it together, merge, or raise capital; and c.) Congress: Yes, we need money, the banks cannot raise capital. We need it now. A great summary of this maneuvering is in David Wessel’s In Fed We Trust.

What does this mean for traders? Bernanke is not afraid of Wall Street – and in 2011 and 2012 he will demand the banks raise more capital and begin the conversation about a return to 2007 accounting standards. Why 2007 accounting standards? Using those standards, most large banks today are insolvent. This in turn will create some of the great short opportunities of the new decade such as long term puts on the XLF (NYSEARCA:XLF).

The fall of Lehman led to Congress passing the TARP -- the next reason I love Ben Bernanke.

TARP: TARP – the creation of Bernanke, Paulson and Geithner – saved the U.S. and the world's financial system, avoiding a Great Depression II. Ben said as much this past Sunday during the 60 Minutes interview, and I agree.

What does TARP, almost completely repaid, mean for traders today? The American people will not tolerate Congress providing any more bailout money, for reasons both good (the banks are still terribly managed) and bad (Rand Paul and other economically illiterate Tea Party types). This means the banks have to heal themselves -- and that means their profits are going down in 2011 and 2012 as they boost loan-loss reserves. The banks to watch with the greatest downside potential due to “surprise” increases in loan-loss provisions are Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C). Just read their financial documents; no special insight here.

The end of TARP and public bailouts meant there was a need for more liquidity from another source; namely, QE from the Fed -- the next reason I love the Fed.

QE III: The Fed is already well into expanding its balance sheet as part of quantitative easing, round two, known as QE II. Now Bernanke has suggested there could be a QE III. QE II and potentially QE III provide wonderful, predictable trades.

  • The inflation trade: Unfounded fears of inflation drive traders to precious metal, “a flight to gold.” And silver. That means calls on the GLD and SLV. I am not sure why precious metals are still seen as safe havens, but they are; don’t fight this trade.
  • Currency debasement: Unfounded fears of the Fed killing the dollar means more purchases of not just precious metals but also of other commodities. That means calls on the commodity ETFs, notably oil and other commodities used as hard-asset reserves against inflation and currency debasement. Avoid commodities subject to data put out by the Chinese, fiction though they may be.
  • Liquidity: When Uncle Ben expands his balance sheet, this fuels purchases of other assets, pushing up or at a minimum sustaining equity markets.
  • Market Psychology: “Don’t fight the Fed” is a bullish belief when the Fed is creating more liquidity – and when traders trade that belief, there's more support for equity markets.

Why is Bernanke so concerned about equity and other asset prices? A fear of further deflation in assets. And that is the fourth reason why I love Uncle Ben.

Deflation: We have seen a radical reduction in asset prices in the U.S. When you add asset prices to price measures for goods and services, it is obvious the U.S. has been going through deflation for more than two years. There is only one way to fight deflation – push more liquidity into the financial system. Even Milton Friedman would have said so. The reality of deflation means Fed actions to increase liquidity will continue as long as asset prices are under pressure. In my view, and if you have read other columns I have written, national home prices will not truly stabilize until 2013-2014, and commercial real estate prices outside of New York will not rise until 2012-2013. So the danger of deflation will remain Bernanke’s chief concern. This makes more QE almost inevitable.

What does this mean for traders? The fear of deflation means QE and its consequences will be with us for a while.

Independence: The last reason I love Ben Bernanke is the simplest. He is independent. He reports to no one. He listens to -- but does not have to obey -- politicians. Capitalism was born, and with it a crucial component of the modern definition of freedom, when the Bank of England was created independent of the British Crown in the 17th century. Capitalism requires independent central banks so that, when desperate CEOs and politicians lose their minds, independent banks do not.

Nor does Ben Bernanke.