Sunday, March 10, 2013

Eating the Fed for Lunch

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)
            The lack of interest regarding just how the Federal Reserve will extricate itself and the rest of us may be a matter of self-preservation. There is no way out from its loony, money hypothesis.

            It is not ironic that the man responsible for extrication is in a trance. Only such a fuzzy-headed, tweedy thinker would have created the greatest moral hazard in the history of the world.

            In review: To attack the debt-induced, financial misdeeds of 2008, the Federal Reserve decided to bloat the clogged channels of badly spent and poorly invested money with more of the same. From a balance sheet of roughly $800 billion in 2007, it is passing $3.2 trillion on its way to $4 trillion by the end of 2013. If there is a change in plans, odds laid here are that we will pass $6 trillion before $3 trillion.

            It was on this last point that several senators quizzed Federal Reserve Chairman Ben S. Bernanke (see also: "Crony Bureaucrat") at a February 26, 2013, hearing of the Senate Committee on Banking, Housing, and Urban Affairs. The means by which the Fed will extract the world's economies from such a burst of academic theorizing falls under the heading of the Fed's "exit strategy."

            Under questioning from Senator Pat Toomey, we learned - as did the startled Senator Toomey - the Fed does not even have an exit strategy:

SENATOR TOOMEY (R-PA): "To what extent are you concerned about asset bubbles...How do you know when there is a bubble and how concerned are you that this absolutely unprecedented monetary policy could manifest itself in inappropriate asset appreciation?"

"CHAIRMAN BERNANKE: "It is a concern as I said in my remarks. We are approaching it two ways. First we are putting a lot of effort into measuring, monitoring, assessing asset prices and financial activities. Secondly, we are trying to make sure that, to the extent there may be some frothiness [unfortunate choice of words - see: Greenspan, Alan; September 26, 2005 - FJS]... in a particular asset class, that the holders of those assets are prepared to deal with those losses...."

SENATOR TOOMEY: "What would the impact be of actually having to liquidate a big portion of your holdings on the bond market, on the equity markets?

CHAIRMAN BERNANKE: "We don't anticipate having to do that."

SENATOR TOOMEY: "Not ever?!?!"

CHAIRMAN BERNANKE: "We could exit without ever having to sell and by letting it run off. ["Run off": Fed balance sheet assets reduced to a level that will not produce inflation. For instance, from $4 trillion, the Fed could sell $3 trillion of Treasury securities. "Who would buy them without bond rates fleeing to double-digits?", some may ask. Thus, the questions raised by the senators, and the fantasy of exiting "without ever having to sell." - FJS] And we could tighten policy by raising rates that we pay on reserves. That would be one strategy, for example. [Bernanke offered no second strategy. - FJS] In any case, we have said that we will sell slowly with lots of notice and we will, of course, also be offering our forward guidance about rates so that there will be a shift in rates expectations on the part of the market. We've given a lot of thought to these issues.

The Fed chairman offered a reflection on investing:

CHAIRMAN BERNANKE: "Senator, if I can make one very quick point. There's no risk-free approach to this situation. The risk of not doing anything is severe as well. So we're trying to balance these things as best we can."

            To discuss each contradiction and betrayal of common sense in the above (and the below) would fill more space than the prosecutor's rebuttal to the O.J. Simpson defense.

            Just a couple of points. First, notice the "first": "measuring, monitoring, assessing..." The process itself is the accomplishment. After the deluge, I assure you, Simple Ben or whomever sits in the witness stand will state: "Senator, we put a lot of effort into measuring, monitoring, assessing asset prices and financial activities." Ben (let's say) will - quite sincerely - consider that a complete and satisfactory summary: an "A" answer, from the A student.

            Second, re-quoting His Simpleness: "in a particular asset class, that the holders of those assets are prepared to deal with those losses...." Bernanke and his chums (New York Fed President Dudley is particularly lucid) have satisfied speculators that low interest rates motivate savers to stop saving and to, instead, speculate.

            Third: Stan Druckenmiller was interviewed after Bernanke's measurement and assessment delirium. He cut right through this "running off" business. As background to Druckenmiller's comments, the Federal Reserve is now buying 80% of all Treasury issues. At last glance, the Treasury refunds $4 trillion of its Treasury issues each year, as they mature. The Fed may soon be buying 100% of Treasuries issued. The $85 billion a month in purchases may need to rise.

            When Druckenmiller managed the Quantum Fund, he gave an annual investment view to clients. The clients joked that his annual view was really a "three-day view" since he might, in an instant, change his mind, then sell and buy in truckloads. (Bold is from Zero Hedge website transcription.)

            Regarding Bernanke's dainty plan: "The chairman testified that [he] will give the market plenty of warning. Do you know what guys like me are going to do when [the Fed] sells the first bond out of 4 trillion?And don't think that letting the bonds run off isn't selling. That debt has to be refinanced. If you do not - if you just let all the bonds run off, that is still 4 trillion in selling. And it's not till they actually sell the first one, it's till you get the whiff - what do you think - what do you think the markets are going to do when they figure out the exit?.... [W]e know that it's not a real market-driven number. And we know the longer you keep it there, the greater the misallocation, and the greater the pain."

Druckenmiller also said: "The Fed is printing a lot of money. They are forcing people into markets.You shouldn't be buying securities because you're forced to buy them by zero rates. You should buy them because you think they're great value. They're great value only relative to zero interest rates. They're not great value on an absolute basis."

"I don't know when it's going to end, but my guess is, it's going to end very badly; and it's going to end very badly because, again, when you get the biggest price in the world, interest rates, being manipulated you get a misallocation of resources and this is going to end in one of two ways - with a malinvestment bust which we got in '07-'08 (we didn't get inflation). We got a malinvestment bust because of the bubble that was created in housing. Or it could end with just monetizing the debt and off we go in inflation. So that's a very binary outcome. [T]hey're both bad."

            Senator Shelby also wanted to understand how the Fed is going to get us out of this:

SENATOR SHELBY (R- AL): Does it concern you... how you might have to deleverage [the balance sheet]? Will that be a challenge to the Fed, or could it be?

CHAIRMAN BERNANKE: ".... In terms of exiting from our balance sheet, we, uh, have put out a couple of years ago, we put out a plan, we have a set of tools, I think we have belts, suspenders, two pairs of suspenders, we have different ways that we can do it, um, so, ah, I'm not, I think we have the technical means to, unwind it at the appropriate time. Of course, picking the exact moment to do it, of course, is always difficult, you know. You want to, you want to withdraw, um, the support at the right time, not too early, not to late, that's always a judgment call. But, in terms of the ability to get out and to normalize our balance sheet, um, we have, again, a set of tools which I'd be happy to go into if you'd like, but which will allow us to normalize policy either by selling assets or by retaining assets [When Sen. Toomey asked, this "couple of year old" plan did not include selling. - FJS] and doing other things like raising the interest rate we pay on reserves."

Separately, Bernanke ducked Senator Shelby's specific question and his answer left us wondering how he has managed - legally - to deal through so many windows:
SENATOR SHELBY: "Is your portfolio public?"


SENATOR SHELBY: "It's public. In other words, the $3 trillion in value of your portfolio, it's public as to what securities you have, and what they're doing, performing and non-performing?"

CHAIRMAN BERNANKE: "They're all performing. Every single one. I mean, they're all Treasuries and Treasury-guaranteed agency securities."

SENATOR SHELBY: "Just about all of them are Treasury or Treasury-Related?"

CHAIRMAN BERNANKE: "By law, we can only buy Treasuries and Agencies."

SENATOR SHELBY: "And they're all performing now?"

CHAIRMAN BERNANKE: "One hundred percent."

Again, separately, and MAYBE NOT QUITE LONG ENOUGH:

SENATOR SHELBY: You studied the Fed a long time before you came to the Fed. Has there ever been a [Federal Reserve] balance sheet close to [$3 trillion]?"

CHAIMRAN BERNANKE: "I don't think so"



Separately, the Fed Chairman asserted: "My inflation record is the best of any post-war Fed chairman." Thanks to Paul Brodsky at QB Partners for the observation: "And he was right! Look at this! He blew 'em all away!"



            It's out there now. As Stan Druckenmiller explains: it will hit us in one form or the other. The Fed will continue with its ad lib pontificating, but when it loses control of the markets, the Fed and investors in "particular asset classes who... are prepared to deal with those losses...." - the vast majority - will get eaten for lunch.