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Go on, fight the Fed

Nobody wants to fight the Fed, with its infamously unlimited firepower.

But the reality in this modern world is that the United States Federal Reserve has appointed itself the guardian and protector of bulls, and the enemy of bears. If no one was willing to nut up and fight the Fed, there would be no such thing as bear markets.

If you can’t imagine how bulls can lose with the Fed always on their side, you should be one. To qualify as a bear these days, you must understand that Fed firepower is limited after all. Despite its theoretically infinite arsenal, the Fed is constrained by politics, and its weapons aren’t always effective.

So allow me to restate the old adage, from the bear point of view: Go on, fight the Fed. But try to avoid direct engagement.

Just when the bulls are cornered and losing hope, the Fed is likely to come to their rescue with a “shock and awe” flood of liquidity that knocks bears back into the woods. But the Fed can’t actually do that very often. Most of the time, the Fed is cautious and strategic, taking only occasional potshots at the most aggressive bear blitzes. Often the Fed does nothing more than try to lift bull spirits with inspirational speeches.

Our goal as bears is to predict when the Fed will come out with all guns blazing, and when it will shake its pom-poms and shout some cheers.

The biggest bear-market slaughters happen when bulls get overconfident in the Fed’s willingness or ability to provide them with cover. That is where every bear wants to be. But no one can second-guess the Fed every time. If you want to take maximum advantage of this bear market, you must risk putting yourself in the Fed’s line of fire. If you’re not willing, you’ll be one of those bears who always shows up late and scrums for the scraps. You won’t make much money, if any.

The days ahead are shaping up as a prime opportunity for bears to rip into huge, soft herds of complacent bulls who have left their fattened behinds utterly exposed. Even as most fresh economic data continues to point towards renewed recession, bulls are staging a rally. They’re betting heavily that Ben Bernanke will use his annual speech in Jackson Hole this Friday to launch a major new assault on the bears. Most bears are backpedaling, remembering the beating they took after the Fed chairman’s speech last year.

The feeling of déjà vu as we wait for Bernanke’s speech on Friday is almost irresistible. Then, as now, stock markets were selling off, credit markets were tightening, and economic data was weakening. Then, at Jackson Hole, Bernanke unexpectedly raised the prospect that the Fed could make a big, new injection of liquidity, and implied that he favored doing so. By pre-announcing the plan, dubbed QE2 by the markets, Bernanke gave a boost to stocks and helped loosen up credit markets, even before the plan was formally approved two months later.

But actually, August 2011 is very different from August 2010. A number of crucial changes in the past year make it very unlikely that Bernanke will again use Jackson Hole to pre-announce QE.

First, inflation has accelerated. This is crucial because the ostensible primary purpose of QE is to stop the threat of deflation. I say ostensible because I believe the real purpose of QE is to boost asset prices and bail out the asset-owning classes. The alleged threat of deflation in my opinion is a totally phony cover story. Nonetheless, having used the threat of deflation to justify QE1 and QE2, the lack of any credible threat of deflation today makes it much more difficult for Bernanke to justify QE3.

Second, QE has become politically controversial. A year ago, few Americans knew what QE was, or paid much attention to Fed policy. Since then, QE has become almost a household term as it has come to be widely blamed for higher inflation. A revival in popularity of laissez-faire economics among Republican and independent voters has driven a sharp turn within the Republican party away from the interventionist monetary policy that Bernanke represents. A leading Republican presidential candidate, Rick Perry, has warned Bernanke he would consider further QE “almost treacherous”, and the libertarian Ron Paul, who wants to abolish the Fed, shocked Republicans by nearly winning their Iowa straw poll.

Third, Bernanke’s support within the Fed’s monetary policy committee, the FOMC, has weakened considerably.  Three of the committee’s ten members have begun to publicly criticize his policy after they refused to endorse the FOMC’s recent pledge to keep interest rates near zero till 2013. Although Bernanke still has five like-thinking allies on the committee, it’s not obvious he could get all of them to put their names behind QE in the current economic and political climate.

There are a lot of ideas being floated by professional Fed-watchers for possible alternatives to QE3. These range from petty and irrelevant, such as changing the duration composition of the Fed’s holdings of Treasurys, to weird and wildly unrealistic, such as the Fed becoming a direct lender to business in a sort of Depression-era-style industrial policy. It’s possible Bernanke could mention one or more of the petty and irrelevant ideas in his speech, as a potential option. That would signal that the Fed will probably dither for a while before making up its mind about anything serious.

Personally, I guess that Bernanke probably wants QE3. I figure so because men like him care about their standing in history, and at this point it looks like he’ll be remembered for being the last man on earth to see the Great Recession coming, and for engineering the Great Miserably Slow Semi-Recovery That Fizzled. Having staked his reputation on QE’s success, it seems to me his only hope is to try QE again and pray that this time by some miracle the economy will sustainably recover.

But, assuming I’m right and Bernanke wants QE3, I also figure he knows he would gain absolutely nothing this year by pre-announcing it at Jackson Hole. If he did, he would essentially be putting up QE3 as a proposal for public debate. Many parts of society would support him, but others would lampoon and deride him. Journalists would hound the other FOMC members, trying to peg down where their votes would fall. All the Republican presidential candidates would be obliged to weigh in. Not only would Bernanke face an unpleasant ordeal, his support on the FOMC could peel away under the spotlight.

So I’m sure that, if we do get QE3, it will not be pre-announced. It will be presented after an FOMC meeting as a fait accomplis. It has long been the practice of Fed chairmen to avoid signaling their plans before they are officially decided by the FOMC. Last year’s Jackson Hole speech was a rare exception.

I expect Bernanke to deliver a surprisingly downbeat speech this Friday. Even while trying to talk up the economy, it will be hard for him to avoid saying something that sounds like an admission that recession is likely. After all, the majority of early data on August activity point to the US economy already being in recession. When the bulls put the grim economic picture together with the lack of any important new policy measures, their bull charge will turn into a buffalo panic and run right off a cliff.

I realize there’s a chance my prediction could turn out to be flat out wrong. I could conceivably end up on the receiving end of some heavy Fed shelling. But I’m comfortable with the risk. Because even if we get QE3, markets will realize fairly soon that even the Fed’s heaviest weaponry won’t turn this economy around.

Last year, financial markets understood that by nearly doubling excess liquidity in the banking system, QE2 would re-accelerate a softening credit expansion. It worked, for one quarter. Now, nobody really believes banks would do anything differently with the marginally greater liquidity that QE3 would inject. Credit tightening is being driven by fear of a developing vicious cycle of rising defaults among everyone from European states to American commercial real estate.  The fear of sovereign defaults is in turn is forcing the withdrawal of fiscal stimulus by even the most reluctant governments, including (gasp) the super-Keynesian Obama administration. Western economies have been on so much stimulus for so long, it’s hard for people to imagine what a future without stimulus will look like, and investors are just plain scared. Even if this bet goes wrong on Friday, I still think it will pay off soon.

I’m putting on the puts, and I highly recommend you do the same. But just in case, make sure they’re sufficiently long-dated (mine expire in mid-October) to give them a second chance to pay.

(note: article originally published Aug. 24, 2010 on

UPDATE: The speech has turned out to be more upbeat for bulls than I expected. Without really acknowledging the severity of the economic downturn underway since late July, Bernanke strongly suggested that he is pushing for some kind of additional policy action at the FOMC’s September meeting. The key paragraph from his speech is here:

“In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including of course economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion.”

As I expected, Bernanke is keeping his cards very close to his chest about what policy he is pushing for. He essentially acknowledges that there is strong disagreement within the FOMC about policy and implies that he wants to at least give the FOMC a chance to reach a greater consensus than it did in August, when three FOMC members dissented and spoke out against Bernanke’s move to extend the timeline of zero interest rates. Ben left markets guessing what exactly he is pushing for and whether he might be willing to compromise on less for the sake of consensus. But above all, with the paragraph above, Bernanke has fed bulls hopes that QE is coming.

As a result, my market call has not really been validated … yet. My puts are currently trading with a wide spread of 32 to 36 cents, compared to the 30 cents where I bought the last of them, due mainly to events in Europe. The downward revision of Q2 GDP to 1% also mattered. But the Michigan consumer confidence number, which dropped to a definitively recessionary level, was brushed off as an “as expected”.

If you took profits in the first minutes after Ben’s speech, when markets sold off (and the bids for my puts peaked at 44 cents) before the paragraph I cited got noticed, you should have done pretty well. I’m holding on, as I expect the Greece crisis in Europe to deteriorate, and I expect the economic data that will come out in early September, starting with the PMIs, to be downright awful.

AND ONE MORE AFTERTHOUGHT: Ben’s speech also raised the importance of the minutes of the August 9 FOMC meeting, due out August 30. Given what Ben said about additional stimulus measures having been discussed, markets will be looking very closely at the minutes to see whether QE – in Fed lingo, “Large Scale Asset Purchases” – was specifically discussed. A specific mention of QE in the minutes would further feed bulls’ hopes of it coming soon. But even a lack of any such specific mention wouldn’t rule out that QE was discussed.