Fed Up with The Federal Reserve

Everyone thinks the US Federal Reserve controls the market. But really, the market controls the Fed. That’s certainly the impression we got after reading New York Fed President Bill Dudley’s speech, given at the Japan Society in New York last night.

If Dudley’s thoughts are anything to go by, then the Federal Reserve is terrified of normalising interest rates and upsetting the market…the market being the hoard of speculators who have grown very fat and comfortable from the Fed’s monetary largesse.

Trying to distance themselves from talk of monetary tightening over recent months, the Federal Reserve is now set on telling the market — in a roundabout, qualified sort of way — that tightening is a long way off.

Because the economic recovery they have been expecting just hasn’t materialised, the Federal Reserve are now playing the ‘we could go either way with stimulus card’. Said Dudley last night:

Because the outlook is uncertain, I cannot be sure which way—up or down—the next change will be.

In other words, ‘We are mere mortals. We really have no idea what’s going on but with overwhelming hubris we will continue to play around with the nation’s money in the expectation that we can engineer the outcome we desire…at some point.

‘But don’t worry,’ they say. ‘Do not fear that we will remove the punchbowl anytime soon. We may ‘talk’ about exit strategies, but due to the uncertain outlook we will never have to commit to carrying out those aforementioned strategies…we will simply ‘update our thinking’.

Here’s Dudley’s nice little about turn on the previously communicated exit strategy.

We are also learning about how best to prepare for the eventual normalization of monetary policy. For example, we may need to update our thinking with respect to the so-called exit principles that we published in June 2011 in order to bring them up to date with developments since then, and ensure they do not unnecessarily constrain our ability to conduct policy in the most effective way today.

That’s a convoluted way of saying that the Federal Reserve must lay out exit strategies in order to maintain credibility, but that developments will continually overrun those exit strategies so as to make them absolutely worthless.

And in a clear sign the Federal Reserve is terrified of upsetting the hedge funds and freezing the vast amounts of Fed created liquidity in the process of monetary policy normalisation, Dudley does his best to assuage the markets’ fears…(my emphasis)

An important challenge for us will be to think carefully about what combination of actions and communications will best ensure that when we do eventually judge that it is appropriate to begin normalizing policy, the initial tightening of financial market conditions is commensurate to what we desire.

‘There is a risk in that market participants could overreact to any move in the process of normalization. Indeed, there is some risk that market participants could overreact even before normalization begins, when the pace of purchases is adjusted but the level of accommodation is still increasing month by month.

‘Not only could such responses threaten financial stability, but also they might make it harder to calibrate monetary policy appropriately to the economic situation.

You might not agree, but Dudley is right to worry about the threat to financial stability should any sniff of normalisation of monetary policy get underway. That’s because the Federal Reserve, via its incredibly and historically loose monetary policy, has created an ocean of liquidity that could evaporate quickly should a tantrum-prone market lose confidence and just stop buying.

The Federal Reserve has basically dug a hole for itself. Now, it can either keep digging, or get buried.

When the Federal Reserve engages in quantitative easing, which is a process of debt monetisation, it creates short term digital ‘money’ by purchasing longer term assets such as mortgage bonds and Treasuries. We’re told it’s a process that ‘creates liquidity’, and this is certainty true.

But the Fed also removes liquidity by buying US Treasury and mortgage debt. How? Because the shadow banking system monetises this debt via the repo market. If you own a US Treasury bond you can turn it into ‘money’ in the repo market. And via the process of hypothecation, one treasury bond can create multiple amounts of ‘money’.

So there’s really no need for the Federal Reserve to monetise it to create extra liquidity. The shadow banking system already creates this liquidity quite well.

Our theory, which could well be wrong, is that the Federal Reserve creates liquidity not so much through its purchase of assets as through what those purchases do to sentiment. That is, they create confidence amongst the speculators. And confidence creates liquidity.

Right now, confidence in the Federal Reserve is at an all-time high. It’s not a confidence that the Fed will improve the economy…it’s a confidence that the Fed will support financial market speculation and the equity markets at all costs. It’s an all reward and no risk policy.

One of the biggest results of this confidence inspiring policy is to squeeze the short sellers out of the market. That is, those players betting on falling prices continually get taken out of their positions, until there is almost no incentive to short stocks.

This has major ramifications, because it means the liquidity in the market is purely a confidence-based form of liquidity. And when that goes, liquidity will evaporate faster than you can say ‘quantitative easing’.

It will open up a trapdoor under prices, because the absence of short sellers means there is no one in the market to buy back shares after hefty price falls. There is no ‘natural’ liquidity. So what one day looked like an abundance of liquidity the next day becomes a frozen lake. That is the unstable financial world the Federal Reserves unconventional policy has led us into.

And it’s why Dudley is so worried about even communicating an exit strategy. Not that there can ever really be one. The Federal Reserve will have to keep digging until the walls cave in.

And digging they are. St Louis Fed Chief James Bullard tag-teamed Dudley with a speech in Frankfurt overnight. Reuters reports:

“Inflation is pretty low in the U.S.,” Bullard told reporters after delivering a lecture in Frankfurt. “I can’t envision a good case to be made for tapering unless the inflation situation turns around and we are more confident than we are today that inflation is going to move back toward target,” he said.

Inflation is pretty low? He’s obviously not referring to asset price inflation. But in the Fed’s lexicon, asset price inflation means good, wealth-creating inflation.

So it’s no wonder that US markets make new highs almost daily. Dan Denning must be loving it!   The speculators know that the Fed has their backs.

This all makes Bernanke’s comments tomorrow of great interest. Will he be as soothing as Dudley and Bullard, or will he have one eye on his legacy and start to worry about the heightened risk taking going on in the markets? Or both?!

We’ll get back to you on it tomorrow…

Greg Canavan
for Markets and Money

Join me on Google+
From the Archives…

Multinationals vs. the Nation State
17-05-13 – Sam Volkering

The Federal Reserve Will Panic and Climb Even Higher
16-05-13 – Bill Bonner

Survival of the Most Capital Efficient
15-05-13 ­– Dan Denning

New Australian Home Buyers Aren’t Convinced
14-05-13 – Dan Denning

What Happens When Everyone in the World has Zero Interest Rates?
13-05-13 – Dan Denning

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money