I've spent the last week or so in discussions regarding the Fed's statement on Wednesday. As the out-of-the-box thinker in these discussions I have a lot of interesting theories on the issue. We'll get to those theories in a minute but first I want to set the stage by providing the backdrop the Fed must take into account when considering monetary policy going forward.
In a recent article I wrote that the current bull market has been a policy driven bull and not supported by economic growth. I noted that it is one of the most impressive bull markets in history in that it has managed such an impressive run in terms of point gains and percentage gains in spite of a lack of participation and on declining volume. I used the following chart of the S&P (NYSEARCA:SPY) to establish that this bull market was indeed a policy driven bull and not supported by broad based investor participation or high volume:
This is particularly important to investors as it implies that fiscal and monetary policy has been the driving force that has pushed the markets to all time highs. Many tend to assign full responsibility to the Fed and in particular to Ben Bernanke and his aggressive monetary policy for the impressive bull run but there are two parts to consider - fiscal and monetary policy.
On the fiscal policy front we've had massive stimulus funded by debt and deficit spending. The chart below shows the magnitude of fiscal stimulus dating from the start of the recession through the 1st quarter of 2013:
The focal point here is the contribution debt and deficit spending made to GDP. The average GDP for the period reflected above was $14.794 trillion. The average deficit over the same time frame was $1.380 trillion and represents 9.32% of GDP.
Those who credit the Fed's aggressive monetary policy to the dramatic bull run in stocks are quite simply ill informed as it was fiscal stimulus that drove GDP which drove corporate profits - not the Fed's QE. But here is the problem going forward - Congress has elected to fight the deficit with spending cuts and tax hikes.
Consider that over the period beginning at the start of the recession through the 1st quarter of 2013 the average annual deficit was $1.380 trillion (this doesn't correlate with reported deficits but is the mathematical calculation based on debt increase average) or 9.32% of GDP. This year per the Congressional Budget Office the deficit is projected to be $642 billion. If that deficit holds GDP will contract - perhaps by 1.5% - in 2013.
That's not the really big problem though - what really matters is whether or not the Fed can maintain control of the bond market at this point and my guess is they can't do it. Consider what's happened since talk of QE tapering began. Those who follow me may be getting a little tired of this chart but it is important and crucial to the discussion:
The question one must ask is how and why bonds are falling in the face of the Fed's massive QE. Here is my thesis - the fall was precipitated by talk of tapering and the high level of foreign sales of US treasuries in recent weeks and perpetuated by the unwinding of the dollar (NYSEARCA:UUP) carry trade. Here is a run down on what's occurred as far as foreign sales are concerned:
WASHINGTON--Foreign investors sold out of long-term U.S. Treasurys in record amounts in April amid signs that the American economy would continue to recover despite automatic budget cuts, and as Federal Reserve officials talked about tapering its bond-buying operations.
Private foreign investors sold a net $30.8 billion in long term Treasury bond and notes, the largest selloff on record, the U.S. Treasury said Friday in its monthly report on cross-border capital flows.
They were not alone. Foreign official holders of long-term U.S. debt sold out of $23.7 billion, the highest outflow since November 2008 at the height of the financial crisis.
Foreign official investors also exited out of short-term dollar debt, selling a net $30.1 billion in Treasury bills and other liabilities.
Despite large automatic federal budget cuts that kicked in, crimping output potential for the U.S. economy, data showed signs of a steady recovery.
That precipitated a robust discussion among Fed officials about when the central bank should begin to gradually reduce the amounts of monthly purchases of Treasury debt and mortgage backed securities
Whether the sale of treasuries by foreign holders precipitated the sell-off in bonds or the Fed's talk of tapering was the cause of the sell-off the fact remains bonds have sold off. The question one must ask then is what happens to the dollar carry trade in this situation?
Here's how the carry trade might work. Investors borrow (leverage) short-term dollars at super low rates and invest in the longer end of the yield curve. Things are fine as long as the yield curve is stable but what happens when the long end of the curve begins to climb and drives the purchased assets down in value? The answer is pretty straightforward - investors exit the trade by selling assets at the long end of the curve putting pressure on bonds and pushing yields higher and bonds lower still.
As the chart above reflects (NASDAQ:TLT) is off the highs by about 8% in recent weeks. A loss of 8% on the asset on a carry trade expecting to yield interest of around 3% is not a good deal. As the exit accelerates the yield is pushed higher and bonds lower creating a feedback loop that ends up rapidly collapsing the bond market and spiking yields.
We've seen this scenario play out already with gold (NYSEARCA:GLD):
So that is the backdrop for the discussion regarding what we might expect from Bernanke today. I am a little inclined - no, a lot inclined actually - to seek out significance in events that others might not consider so significant. The truth is I see a lot of events that signal a change in course that could be reflected in the Fed's statement and policy decision at this point. Here is a list of some of them:
- Obama's interview with Charlie Rose where he made it clear Bernanke would not serve another term.
- Bernanke's announcement that he would not be attending Jackson Hole.
- Joe Biden's speech in April on the need for a new world order.
- The Fed's telegraphing of possible tapering in recent weeks.
- Obama's support for a new global reserve currency.
- Timothy Geithner's admission that the SDR as a new global currency was acceptable.
Let's start with Bernanke's announcement in April that he would not attend Jackson Hole. That is akin to the President announcing he has a scheduling conflict that won't allow him to attend the State of the Union Address. Let that simmer for a minute while we move on to Obama's statement about Bernanke serving another term in an interview with Charlie Rose this week. Here is what Obama had to say on the matter as reported by Jon Hilsenrath:
In an interview with television host Charlie Rose conducted Sunday and aired Monday, Mr. Obama said that Mr. Bernanke "has already stayed a lot longer than he wanted or he was supposed to."
Why would Obama go on Charlie Rose a few days before the FOMC meeting and make that statement? Clearly Obama had a desire to do some damage control on a number of issues but Bernanke's exit wasn't one of them. Just business as usual - I don't think so. Hilsenrath noted that Bernanke had spoken with the President in February about his future:
Mr. Obama met with Mr. Bernanke on February 5, according to Mr. Bernanke's calendar, which was made public through a freedom of information request. At his last news conference, Mr. Bernanke said he had spoken "a bit" about his future with the president.
Clearly Bernanke doesn't have a future with the Fed. More relevant though is the fact that he knew that at the time he announced he would not be in attendance at Jackson Hole this year. Obama's comments about Bernanke were not particularly offensive on the surface but they were highly dismissive - kind of an "I have a plan and Ben Bernanke doesn't fit into my plans" kind of a statement.
So, what might Obama's plan be then? Maybe Joe Biden gave us a clue back in April. Here is an excerpt from Biden's speech to the Export-Import Bank:
The task we have now is to actually create a new world order. Because the global order is changing again, and the institutions that have worked so well in the post-World War II era for decades, they need to be strengthened, and some have to be changed. So we have to do what we do best, we have to lead. We have to lead. We have to update the global rules of the road. We have to do it in a way that maximize benefits for everyone, because obviously, it's overwhelmingly in our interest, this is not a zero sum game, it's overwhelmingly in our interest that China prosper, that Mongolia prosper, that nations big and large, east and west, in Latin America and in Africa, prosper, because you know that old expression, they asked Willie Sutton why he robbed banks, he said 'that's where the money is.' We want everybody to have a little money to make sure they can buy American products. So the paradox - so we don't view, the President and I and Fred [Hochberg, President of the Export-Import Bank], we don't view economic growth as a zero sum game here, that somehow we grow and it's not in our interests if other powers grow as well. That's the paradox of this new global order. So much of our success depends on the success of those with whom we compete.
So the President does in fact have an agenda as Biden notes. But what exactly is that agenda and who is on board with the plan. Well, Ben Bernanke is apparently not on board but it would appear Tim Geithner is on board. Consider this excerpt from an article entitled US backing for world currency stuns markets:
US Treasury Secretary Tim Geithner shocked global markets by revealing that Washington is "quite open" to Chinese proposals for the gradual development of a global reserve currency run by the International Monetary Fund.
Jon Hilsenrath notes that Geithner is in the mix as a possible successor to Bernanke in this excerpt from his Obama May Be Ready to Let Bernanke Go article:
Several other contenders could get close consideration by Mr. Obama, including former economic advisers, Timothy Geithner, Lawrence Summers and Christina Romer
Any bets on who it might be out of the possible contenders? My money is on Geithner. In the article referenced above - US backing for world currency stuns markets - the agenda referred to by Geithner and Biden is explained here:
China's proposal is to activate the IMF's power to issue Special Drawing Rights (SDRs). The IMF would be groomed as de facto central bank for the planet. The SDRs would gradually become an "accepted means of payment."
The statement above was from an article written back in 2009 but Biden brought a degree of freshness to the subject in his speech in April of this year. Equally important is the recent agreements by a number of nations to circumvent the US dollar as a reserve currency. Here is an excerpt from an article in Businessweek as recent as March of this year - BRICS Nations Plan New Bank to Bypass World Bank, IMF - on the rapid pace of events moving toward a new reserve currency regime:
"We need to change the way business is conducted in the international financial institutions," South African International Relations Minister Maite Nkoana-Mashabane said in a March 15 speech in Johannesburg. "They need to be reformed."
The U.S. has failed to ratify a 2010 agreement to give more sway to emerging markets at the IMF, while it secured Jim Yong Kim, an American, as head of the World Bank last year over candidates from Nigeria and Colombia.
Finance ministers and central bank governors from the BRICS nations, who met in Durban today, agreed to set up currency crisis fund of about $100 billion, Brazilian Finance Minister Guido Mantega told reporters today. He didn't give details of proposed funding for the new bank, which Brazil wants established by 2014. The nation's leaders are due to sign a final accord tomorrow.
Here's another excerpt on the issue - BRICS Regimes Forge New World Bank, Call for Global Currency:
As The New American has been reporting for years, the push for a planetary fiat currency is gaining traction as the privately owned Federal Reserve continues to destroy the dollar. Unsurprisingly, the BRICS regimes agreed with the Socialist International and other powerful forces seeking to build a global central bank with a new world currency. In the final BRICS Durban declaration, signed by all five rulers on March 27, the totalitarian-minded alliance openly called for expanding the role of the International Monetary Fund's proto-global currency known as Special Drawing Rights.
"We support the reform and improvement of the international monetary system, with a broad based international reserve currency system providing stability and certainty," the five regimes said in the declaration, calling for Third World dictators to have a greater say in the IMF and the emerging global monetary regime. "We welcome the discussion about the role of the [IMF's] SDR in the existing international monetary system including the composition of SDR's basket of currencies."
So here is where we find ourselves today - on the outside looking in - as the BRICS simply choose to sidestep us. Lest anyone think the political will exists at the present that would allow Obama and company to sell the idea of joining the move to Congress I would suggest that is not likely. That said, I wouldn't underestimate Obama's talents nor the extremes he will go to in order to impose his will.
Some may ask what this has to do with the Fed's decision to initiate tapering of QE. Well it is exactly the Fed's concerted effort to devalue the dollar through QE that has the BRICS upset in the first place and what is different today compared to times past is the determination of the Fed to devalue is receiving pro-active and determined push back from the BRICS.
This is no longer an issue that is to be considered at some point in the future - it is an issue that is being acted on in the here and now and the US is on the outside looking in and is simply being excluded due to a refusal to endorse the plan. Quite literally we are being blindsided and we aren't winning the battle.
My goal is to connect the dots in order to determine what the Fed may announce today. Clearly this FOMC meeting is significant in many respects. For one Obama was dismissive regarding his statements relating to Bernanke in his Charlie Rose interview this week and I find the whole line of questions on Bernanke as odd unless there was a point to make.
I also find it extremely odd that Bernanke announced he wouldn't be in attendance at Jackson Hole this year. It seems obvious to me that the Chairman and the President may be at odds on policy and the President is bringing as much pressure to bear as possible on Bernanke to alter course with QE.
I also think the recent decision by the BRICS to move forward regardless of a US endorsement is putting a lot of pressure on the Fed and the President. The recent trend to divesting of foreign held US treasuries is more than a little disconcerting. Consider the magnitude of US treasuries held by China alone. Have no doubt on this - if China dumped all their treasuries on the market the US bond market would literally implode. Are we being blackmailed into submission here?
How all this plays out today is yet to be seen. Bernanke may very well follow the same course he has in times past - a simple "we're staying the course but will monitor things closely and change policy as needed." On the other hand the prospects of a major shift have been well telegraphed this time and that has been the Fed's mode of operation for some time now. For the most part we've been able to predict what Bernanke would do based on the rumors. This may well be a business as usual event but the signs suggest something different. Maybe a little exposure in the VIX (BATS:VXX) would be advised.
Disclosure: I am long FAZ, TZA, TECS, UVXY, VXX. 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.