Yesterday we left you with the thought that the Federal Reserve may become the buyer of last resort of US Treasuries. Why? Because foreign creditors are rapidly scaling back their purchases of US assets. As we’ve pointed out previously, this is a big deal because the US absolutely needs foreign creditors to finance their trade deficit, which over the past 12 months was around $500 billion.
If foreigners don’t plug the gap, then the gap shrinks, which means the US consumes a lot less, which means the US economy goes into recession. And from there we’re sure you can join the dots.
The only other alternative is for the Federal Reserve to fill the gap by continuing its policy of QE. But that’s long term dollar bearish. As we pointed out in the Weekend Markets and Money, creating more and more dollar denominated assets (Treasury bonds) paid for by creating more and more dollars (fed funds) is not terribly smart economic policy.
In fact it’s complete lunacy. Which is why the noise coming out of the annual central banker symposium (whatever that’s meant to mean) at Jackson Hole is pretty interesting. In case you weren’t aware, the whole thing has come and gone.
It didn’t get the headlines it normally does because the usual star of the show, US Federal Reserve Chief Ben Bernanke, wasn’t there. But the whole vibe of the gathering this year was very different. There was criticism of QE…claims that it didn’t really help the economy and that continuing down that path would be a mistake.
By the way, we just looked up the meaning of symposium. In Ancient Greece, a symposium referred to a drinking party! We suppose you could say that all the participants at Jackson Hole are drinking from the fountain of easy money. Debate centres around how much or how little to ‘ease’ monetary policy. It’s never a question of whether to do anything at all. It’s always how much.
But the papers presented this year and the discussions they elicited represent a definite questioning of the effectiveness of QE. While policymakers were quick to point out that they were not about to turn off the monetary tap in a hurry, they sent a pretty clear signal to the market that the QE experiment is not going very well.
In short, the Federal Reserve is in retreat mode. They’ll bunker down for a while, a new boss will come in early next year, and they’ll have another crack at an inflationary response then.
It reminds us of the tactics of the German Army in the First World War. After the Battle of the Somme, the Germans retreated to the Hindenburg line. This was a shorter and better constructed front line than the Germans previously occupied and required less manpower to hold it.
On seeing the deserted German trenches, some of the allied soldiers believed the Germans had retreated and gone home. But they were just consolidating and assuming a defensive position before attacking again.
So will the Federal Reserve now assume a defensive position until January when the new Fed Chief arrives and starts giving orders for a new offensive? Maybe. And if the new Chief does turn out to be the ‘brilliant’ Larry Summers, a critic of QE, what will be the gameplan?
It’s been years since the market has been so confused over the Fed’s monetary policy. We think this is why you’re seeing speculative capital flowing out of emerging markets and heading back to the source — the US. When in doubt, reduce leveraged bets.
But it’s also tied up with the lack of foreign financing of US deficits. For years, emerging markets have benefitted from financing US deficits by accumulating US dollar reserve assets — that is, Treasury bonds. As these bonds piled up, foreign central banks would print their own currency to maintain a cheap exchange rate against the US dollar. It had the effect of expanding their domestic credit systems and generating economic growth. This in turn brought in more speculative capital hoping to make quick and easy money from the one way flow of liquidity.
But now foreigners have stopped buying Treasuries. They are no longer recycling their trade surpluses (the other side of the coin of US deficits) back into the US. Which means they are no longer ‘creating liquidity’ for the global economy.
Speculators saw this coming a while ago. As you can see in the chart below, emerging markets peaked right at the end of 2012 and start of 2013. Panic selling hit during May and June, before a relief rally unfolded in July. But you’ve seen renewed selling in August as confusion over the Federal Reserve’s actions continues.
This wouldn’t be a big deal if there wasn’t so much leverage built into the financial system. The leverage factor is not always apparent, and no one really knows what it is.
Our guess is that it’s huge. The constant flow of QE encouraged an enormous amount of leveraged risk taking. As dollars flowed from the US to emerging markets (EM), borrowing (in dollars to buy EM currencies) was an easy money-making trade. But right now, you’re seeing speculators sell EM currencies to unwind previously bullish leveraged bets on EM growth.
That’s why the US dollar is strong right now. It’s a similar dynamic to how the 2008 crisis played out. Back then, leverage centred on the US housing market. And cracks in US housing appeared long before the stock market rout.
Perhaps the cracks in the emerging markets portend a similar outcome. If that is true, then the storm is yet to hit. We’ve been making a similar case to our subscribers for a few months now. And our newest recruit, Vern Gowdie, also thinks the financial system is a house of cards.
Which makes the Federal Reserve’s next steps crucial. Our guess is that they’ll continue with their current policy, all the while ‘communicating’ to the market that they will wind things up as soon as they can. They are simply trying to rein in excessive risk taking without bringing the economy down. But judging from the recent sharp increase in government bond yields, they’re not making a very good fist of it.
Time to get the brilliant Larry Summers in to save the day. More on that tomorrow…
for Markets and Money
From the Archives…
Richard Fisher’s ‘Super Easy’ Fed
23-08-2013 – Nick Hubble
US Stocks and the Timeless Wisdom of Izzy Stone
22-08-2013 – Chris Mayer
Bankers Profit at the Expense of the Broader Community
21-08-2013 – Vern Gowdie
A Bond Market Tantrum
20-08-2013 – Nick Hubble
Australia’s Economy: Complex, Fragile or Centralised?
19-08-2013 – Nick Hubble