Gary Tanashian's  Instablog

Here Rex Nutting argues that the Fed will not taper QE any time soon because their targets are further away now than when QE3 began.

He argues that bond yields are not normal and are reflective of a struggling economy.

"A normal economy would mean normal bond yields of around 4% to 5% for the benchmark 10-year Treasury, instead of the current 2.2%, or last month's 1.7%."

He seems to think the market can simply decide when higher rates are in order but that its current expectation of rising rates is somehow wrong. But what is QE? Bond buying is what it is. What does bond buying do? It drops rates. What does a lack of buying do? It raises rates. Simple supply and demand.

"But the market's expectations for much higher rates ignore just how far the economy is away from normal. In fact, right now the Fed is even further away from its dual goals of full employment and stable inflation than it was last September when it announced the QE3 bond buying program."

And just maybe Rex, the Fed is smart enough to know that pure bond buying is not the ultimate answer to getting the inflation to take. I mean, do you see the lunacy of your statement when juxtaposed against the premise of the entire article and indeed the point you are trying to make?

QE is obviously not working, so the Fed has to keep on promoting QE.

Ah, WTF? Just maybe the game is in transition and the next phase will feature that free money that the banks have ingested being marked up (by higher long term interest rates) and finally sent out into the economy. At least that makes some sort of sense. 'Keep doing what you are doing because it isn't working' makes no sense whatsoever.

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The following is the opening segment to this week's premium letter, NFTRH 242. The balance of #242 went on to discuss the technical status of US and global stock markets, key commodities, the current status of 'inflation expectations', precious metals and currencies; all in detail.

Taper to Carry

Last week we introduced the theoretical 'taper to carry' scenario whereby the Federal Reserve would indeed 'have the balls' to begin the end of traditional QE and transition the inflation via a new set of mechanics. Mind you, we still get inflation under this scenario, but it would be less stealth and more honest and obvious to the public. Here are the theoretical components of the play…

• Simultaneous ZIRP & QE have served to liquefy banks and maintain tepid economic growth while capping inflationary pressure, as banks hold significant reserves 'in house' until conditions are 'right' (read: profitable).

• There would be much public hand wringing about rising interest rates, which could undo the debt-leveraged economy. There would be a lot of noise in the perma-bear and gold bug camps that the Fed would not dare to taper QE.

• Yet taper they do, with the knowledge that the next 'fix' is already in. The rising long-term interest rates that would result from such action (tapering of bond purchase program, AKA QE) would immediately benefit the banks as they 'carry' the free money received from the Fed on the short end and roll it into profits by lending at higher interest rates on the long end.

• This process can be regulated as policy makers see fit. It is a "taper" after all!

All of the above imagines what could be an actual plan being promoted behind the scenes by entities far removed from this simple newsletter writer and his thoughts about what they will or maybe even should do. But I have yet to come up with (or be advised about) reasons why this scenario should be disqualified as a valid and rational 'next step' in the ongoing and systematic inflation attempt currently in progress.

I think that the last bullet point above is very important. Think about it; the smart man running the Federal Reserve has even introduced a word (taper) [edit: whether Ben Bernanke has actually used this word is irrelevant; its implication is front and center] that implies the process of transitioning the inflation from one form to another would be regulated as needed. He may be attempting control the pace of transition so things do not get too hot or too cold at any given time. Genius! If it works.

I think there may be recognition on the part of officials that the game of printing money out of old, bloated and un-payable debt while hammering gold (the early warning inflation barometer) is getting long in the tooth. Of course, this is not out of any sympathy for the gold bugs but rather a realization that a 'lukewarm and rudderless' economy against a systematic backdrop of debt monetization and money creation is not going remain politically expedient.

Enter our friends the Pigs (AKA the main players in the last doomed inflation and subsequent liquidation, the banks). This is simply the Greenspan playbook warmed over. Greenspan used different mechanics to create his credit bubble but the play was to get the banks to profitably 'carry' the spread and lend out into the economy. There is nothing new under the sun today if our 'taper and carry' thesis is viable and likely.

BKX-SPX Ratio (candlesticks) w/ TNX (blue line)

Last week the BKX ratio to the S&P 500 (candlesticks) took a hit but remained above the breakout line and this should remain a barometer to a confirmation of our would-be 'carry' play or a negation of it. So far so good. Long-term interest rates (blue line) also got through another week in breakout territory.

Against this backdrop let's remember that the Fed is only jawboning a QE taper, not an end to inflationary ZIRP. This looks like a well-scripted plan by intellectual inflators that are much more sophisticated than the great Maestro of the previous inflationary era. But then they have to be sophisticated because things are so much more leveraged in rising debt with the cost of failure a likely unwinding of the current system.

Bottom Line

'All or nothing' is the play and these players are winning (duh). Gold bugs and their quaint notions of honest money are losing (for now). Stock market bears - outside of an expected summer correction (which could play well into the script outlined above as inflation is best promoted against a worried public) may lose as well, at least for however long a new inflation cycle lasts.

If and when the banks become incentivized to get the inflated funds 'out there', asset prices are going to go up. This is what being bullish means in the current era, basically taking advantage policy designed to prop asset prices; i.e. inflationary policy.

Bear in mind that all the above is where a letter writer's logical thought process has taken him. But here is the thing, I sit down each weekend to write a letter, not make policy. I observe financial markets with an attitude of trying to find the honest answers as to what is going on in a very complex macro financial world. But I do not have the answers. I only have my own logic, which could prove to be wrong.

But for another week at least, the theory lives on. What would be even better for the theory is if in the days or weeks ahead the Fed jawbones continue to promote a 'taper' to QE, T bonds continue to drop (rates up) financial markets correct on this noise and the banks out perform the S&P 500, indicating the next inflationary solution. It's a tall order, but I'd rather have a game plan that can be revised or discredited than to be flying blind.

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I read a piece this morning by Josh Brown, the Reformed Broker, in which he destroys the 1999 comparison for the stock market. He makes some excellent points about why the stock market is not only not over valued compared to 1999, but is actually a bargain. You should read it because we should all be considerate of rational views.

I also read The Fed is NOT Printing Money by Jesse's Cafe', which offers a view into a money creation process that is more geared toward the gaming of the financial markets through intermediary banks than it is the normal inflation of old. I mean seriously, I do not call Ben Bernanke an evil genius for nothing; it seems that he and his associates have taken monetary policy to the Nth degree and figured out how to paint inflation as non-inflationary. Our hero.

The point is that I think Josh Brown is 100% right. There is no mania in stocks. In fact, stocks' worst offense right now is that they are strenuously over bought and sponsored by 'dumb money' aggregates that are equal and opposite to one year ago, when the same dumb money was exactly as bearish as it is bullish today. As he notes, the mainstream public may no longer be interested in the markets, but whoever that dumb money is, they proved a good indicator on an imminent bull phase last May. Again, we present the proof compliments of Sentimentrader.com:

Smart-Dumb money sentiment 1 year ago

Smart-Dumb money sentiment today

I have absolutely no problem being bullish on the stock market because it is made up of companies both bad and good; very good. After Memorial Day, my wife will re-start her career at a currently non-public technology company about which we are very excited. Its technology began as the founder's MIT thesis and is now rolling out into major markets and outlets. One brilliant kid, an idea, a market and voila.

I totally believe in human progress and what great companies like Microsoft, Intel and later Google and Apple have brought us. I believe in the software systems that are making the burdensome healthcare system more manageable and great companies the world over that fill a need, improve lives and win out in the markets of public opinion and financial transaction.

But the point I think the Reformed Broker is missing is what underpins the market of stocks in these corporations. Looking at the stock market as a stand-alone, I tend to agree with his viewpoint. But when policy makers are woven into the fabric of the market to this degree, they must be factored. Questions must be asked like "why on earth, with this excellent and healthy stock market and sufficiently functioning economy are they continuing to repress interest rates by buying $85 billion in bonds per month?"

Aren't those bonds debt? Where did that debt come from? Does bloated debt not imply that the economy in which the stock market's components ply their trade is a leveraged thing, as opposed to an organically thriving thing? Why can't we just let the debt float on the open market and let it get resolved by the market if things are so good beneath the surface?

I think you know the answers to those questions. That is the main point of bears questioning the stock market's fundamentals. Not the old PE Ratio canard. We are now in the post-PE world. What matters is policy because it is policy that has created the seemingly healthy stock market. So which side are you on; the side that sees the stock market and the stock market only, or the side that sees the stock market within the context of the universe in which it exists?

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