The Unintended Consequences Brewing Thanks to the Federal Reserve

We’re just back from a few days break in sunny NSW with the family. In the time we’ve been gone, the market soared, then waited, then tanked, then retreated again. All this happened despite the Federal Reserve not really doing anything.

Oh wait, it did do something. It communicated. Badly. As our mate Dan Denning likes to point out, communication is the last policy tool of a badly constrained Federal Reserve. And it’s not communicating all that well.

The analogy that comes to mind is such a simple one we don’t know why we haven’t come up with it before. But after more ‘Fedspeak’ overnight, it became blindingly obvious. That is, the Federal Reserve is like a bunch of kids with a garden hose. The hose is easy enough to handle when the pressure is low and the amount of liquid coming out of the hose is manageable.

But when you turn the tap up to full bore (say US$85 billion a month in liquidity flow) then the hose becomes a little harder to hold onto. Ever since Bernanke started the taper talk back in May, it feels like he has lost his grip on the hose. Now it’s flying around everywhere. All the Fed kids are racing around the yard trying to get the hose under control, but it’s flicking around like a cut snake. Water is going everywhere.

The biggest kid, New York Fed President William Dudley, reckons there’s no need to taper. In a speech overnight he said the economy was still too weak to think about turning the liquidity tap down yet. But his Dallas counterpart, Richard Fisher, at the same time said he urged his Fed colleagues to turn the tap down to the tune of about US$10 billion a month.

So there are clearly some divergent views at the world’s biggest central bank about which way to go from here. Or maybe Chairman Bernanke is happy to let the divergent views play out in public. Maybe the communications strategy and Bernanke’s famed policy of ‘transparency’ is intended to be so transparent it confuses the bejesus out of everyone. They probably think confusion acts as a bit of a handbrake on speculation. The Fed’s Holy Grail is clearly to leave the tap turned on while discouraging speculation, but is it working?

No. Like most things that come out of the Federal Reserve, it’s wishful thinking, ignorant of unintended consequences. Our old mate Doug Noland destroyed the notion that confusion over the future direction of QE might lead to less speculation in his latest Credit Bubble Bulletin. Not surprisingly when you get US$85 billion per month of liquidity flow in a non-crisis economy, Noland points out that you get very loose financial conditions, despite what the Fed might try and ‘communicate’:

Stock prices have surged to all-time record highs. The S&P500 has gained 7.7% in three months, with Nasdaq up 12.4%. The small cap Russell 2000 has surged 11.3% in three months. The Nasdaq Biotech index has jumped 24.8%, increasing its 2013 gain to 53.3% (2-yr gain of 116%). Internet stocks enjoy a three-month gain of 12.6%. The average stock (Value Line Arithmetic) is up 11.2% in three months. Stock prices indicate the opposite of tightening.

Last week set an all-time weekly record for corporate debt issuance. The year is on track for record junk bond issuance and on near-record pace for overall corporate debt issuance. At 350 bps, junk bond spreads are near 5-year lows (5-yr avg. 655bps). At about 70 bps, investment grade Credit spreads closed Thursday at the lowest level since 2007 (5-yr avg. 114bps). It’s a huge year for M&A. And with the return of “cov-lite” and abundant cheap finance for leveraged lending generally, U.S. corporate debt markets are screaming the opposite of tightening.

August existing home sales were the strongest since February 2007. National home prices are now rising at double-digit rates. An increasing number of local markets -certainly including many in California – are showing signs of overheating. Prices at the upper-end in many markets are back to all-time highs. And despite a backup in mortgage borrowing costs from record lows, housing markets have yet to indicate a tightening of Financial Conditions. Clearly benefiting from loose lending conditions, August auto sales were the strongest since 2006.

Yes that’s right. There is no tightening of financial conditions in the world’s largest capital market. It’s bubbling away as hot as ever. The policy of ‘jawboning’ is not really working at all.

These monetary experimenters – these modern day John Laws – are just setting us up for a bust that will make the Mississippi Bubble look quaint. And then they’ll retire back to Academia and advise us all on how to clean up the mess.

What about China? Won’t it save us all? Well, the latest gauge of manufacturing activity shows continued improvement, with the index expanding to a 6-month high of 51.2 (above 50 denotes expansion). The China improving story has boosted the Aussie dollar and the resources sector.

But if you look at the performance of the commodities sector, it’s not really buying it. The chart below shows the CRB Commodities index. It bottomed soon after the People’s Bank of China started pumping additional liquidity into the economy following its credit crunch scare in June. But it peaked in late August and has sold off since then. And the index certainty didn’t respond to the ‘good news’ about China’s recovering manufacturing sector.

Commodities – Not Believing the China Recovery Story?

click to enlarge
Source: StockCharts

Perhaps commodities can see the huge amount of overcapacity in the country. This Forbes article tells us that the steel industry ‘has run up $490 billion of debt in building mills that now account for 66% of global production…the country currently has about 300 million metric tons of excess capacity, almost twice the output of the European Union.’

Just have a think about that before you go long Rio or Fortescue. Almost twice the output of the European Union – no slouch when it comes to steel production – is simply ‘excess capacity’ in China. We’re not sure what the definition of excess capacity is, but if there’s excess steel production there’s obviously excess iron ore production.

We’ve been warning about this for a while and still the excess and imbalances remain. Just because the market hasn’t succumbed to the forces of supply and demand yet doesn’t mean it won’t. So if you’re in playing in the casino we suggest thinking about casually taking your chips off the iron ore table and wandering off to see what else is happening.

Right now, with stock prices elevated and speculation still rampant, we’d prefer to sit in the bar, maybe with a Long Island Iced Tea, and observe the action from a distance. ‘Cause it’s going to be good viewing if you’re away from the tables.


Greg Canavan+
for Markets and Money

Join Markets and Money on Google+

From the Archives…

How Long Can the Government Charade Continue?
20-09-2013 – Vern Gowdie

The End of Australia’s Boom Economy
19-09-2013 – Satyajit Das

Super… Who’s Going to Buy Your Shares When You Retire?
18-09-2013 – Nick Hubble

Australian Banks in the Firing Line
17-09-2013 – Nick Hubble

Yellen at Stocks to go Up
16-09-2013 – Nick Hubble

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