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Tuesday, November 9, 2010

The New Alchemists

A continuation of yesterday's (11/8/2010) Post "Something for Nothing"

Alchemy is the practice of altering base metals into gold and dates back as far as the Ancient Egyptians. Many cultures throughout history have dabbled in alchemy including: Mesopotamia (current day Iraq), India, Persia (current day Iran), China, Japan, Korea, the Greeks, the Romans, the medieval Islamic world, and then medieval Europe and up to the present day. Alchemy training and practice was and probably is still carried out in a covert and complex network of schools and philosophical systems that have spanned at least the last 2,500 years or so. Even famous individuals like Isaac Newton dabbled in Alchemy and was affiliated with another famous alchemist named Robert Boyle, who Newton urged to keep their experiments in “high silence” not discussing it publically. Today we still don’t have any real methods of converting base metals in to gold although we can convert paper in to gold.

All the talk about QE and its impact prompted me to think deeper about the subject. Last year on July 21st 2009 “B52 Ben” defended his QE strategy by laying out the “The FED’s Exit Strategy” in a Wall Street Journal Op-Ed piece. In the article “Benny” makes the case that the FED has given considerable thought to how they would withdraw all the monetary and policy accommodations. He goes further by indicating that the exit strategy is closely linked to the FED’s balance sheet. It is the belief of the FED that as the economy improved, banks would begin lending out their reserves much of which were parked at the FED. Loaning out of bank reserves would stoke inflation and the FED would implement countervailing policy to curb the inflationary pressures. Also as the environment improved reserves held by the banks would contract automatically due to a reduction in the need for short term lending facilities. Well dear reader hindsight is always 20/20 and we know today that the reduction in reserves has not played out the way “Benny” envisioned.

Bernanke then goes on to add a caveat that even if the “balance sheet stays large for a while” they still have two broad means of tightening at the appropriate time.  The FED could pay interest on reserves to coax banks to deposit more with the FED for riskless income pulling money out of the available pool or taking various unspecified actions that would reduce the stock of reserves; this would be done as if by magic I guess.

This is all wonderful stuff don’t you agree dear reader but let’s skip down to the all important exit strategy as laid out by the “smartest people in banking”. Option one is to drain bank reserves and reduce excess liquidity via large scale repurchase agreements; which is a fancy way of saying the FED will sell some of their portfolio bonds to get cash out of the system. Second, in coordination with the FED the US Treasury run by “Turbo Timmy” could go out in to the market and sell Treasuries, you know more debt, and then take the proceeds and deposit them at the FED for safe keeping to drain money out of the system. The third brilliant strategy is for the FED to offer banks interest on deposits at the FED which they are already doing but they can raise the rates to further entice those greedy banks. The fourth genius idea is that the FED could simply sell a portion of the holdings of long term securities in to the open market.

So I am not sure about you dear reader but it sure seems to me that assuming the FED is still standing by these strategies to remove liquidity from the market they are in for a potential world of hurt. The thinking regarding the exit strategy is very linear and does not appear to be very deep to me. To break it down they have a couple tools that worked in the past and they plan to use them again assuming they can identify the appropriate time to implement them. The FED (or the Treasury) is either going to sell bonds to suck dollars out or bribe the banks to suck dollars out; I don’t know about you dear reader but this appears to short sighted and simplistic a solution. I know from my days as a computer programming consultant that many times the simple elegant solution is best as in K.I.S.S. or keep it simple stupid, however that is true of linear problems not compound or exponential problems. The current ordeal we face requires thinking that goes beyond the traditional means.

Under “Mr. Magoo” Greenspan, the FED was a master of cryptic speech to hide their intentions; where as the “B52 Ben” Bernanke FED is less cryptic in its pronouncements. The market participants can definitely read between the lines of what “Benny” is conveying better than Greenspan, which is a good thing but leaves the FED exposed in some areas.

The FED tries to extol confidence in its economic prowess with regards to its ability to manage the economy and maintain its mandate of low inflation, price stability and full employment. Of course it appears to me dear reader that they have not done a good job on any of these fronts basically since the inception of the FED especially if you look at the dollar having lost over 95% of its value since the creature arose from Jekyll Island.

So in the exit plan that “B52 Ben” has laid out he wants us to believe that the FED can control inflation and the money supply just by selling bonds. I believe that the FED is either deliberately lying about their exit plan or they are truly incompetent. Everyone who knows anything about bonds, and presumably the FED are experts,   understands that inflation has an impact on bonds. What happens to interest rates when inflation rears its ugly head dear reader; of course rates rise to offset the inflation impact which also means the underlying value of the instrument drops.  Under what scenario would the FED want to sell bonds in to the market to drain liquidity, when inflation has risen or at least that is what they tell us. The FED doesn’t want us to worry our pretty little heads about this as they have it under control. Right now “B52 Ben” has been out on the stump talking about setting inflation targets, which as in typical FED fashion I am sure they will exceed by a wide margin. The FED’s track record on controlling the economy is suspect at best. In the past the FED’s philosophy was to raise rates until something breaks and we get a recession; so what makes the market think that they will be any better in this situation.

Once the FED identifies that inflation is present and the economy is supposedly strong enough that they want to remove liquidity and slow down the inflation train. What will happen at the point they decide to pull the trigger on the liquidity sucking apparatus at the FED?

The FED currently has a balance sheet full of 5, 7 and 10 year notes all of which are dramatically more sensitive to inflation in terms of interest rates and capital losses than the short end of the spectrum. If you think about it dear reader when rates are as artificially low as the FED has kept them even small upward moves in rates are larger in terms of their percentage. In other words the interest rate move of one percentage point on a note yielding 1% versus a note yielding 10% is far larger and consequently the underlying principal will take a much more dramatic hit to compensate for the yield fluctuation.

So what does this mean for the FED? At the time they decide that inflation is rising and they want to dump off much of their inflated balance sheet to drain liquidity reality will preclude them from doing so. They don’t want to hold the bonds to maturity even though that would at least on paper keep them from taking massive hits on their balance sheet. The FED holding the bonds would also have the unintended consequence of leaving lots of excess liquidity in the system, which would allow inflation to run amok.

The FED seems to take a don’t worry be happy attitude when it comes to holding the bonds on their balance sheet stating that they can hold the bonds because they don’t have to worry about mark to market, but that doesn’t achieve the goal of containing inflation or meeting their mandate.

The other possibility is that the FED could sell the bonds and take the hits to their balance sheet. The inflation in the system will have taken its toll on how much the FED can sell the bonds for in the market as their value will have dropped significantly because of rising rates from such a low level. The other problem with this scenario is that the FED will not reduce the same amount of liquidity pumped in to the system and their balance sheet would be severely impaired possibly to the point of bankruptcy meaning they would not have a means to mop up the remaining dollars. Of course dear reader there are many that will point out that the FED could simply print more dollars to shore up their balance sheet; while this is true it still does not address the problem as creating more liquidity to reduce liquidity will not work. The FEDs further printing at that time would only serve to further debase not only the Dollar but confidence in the Dollar an even more dangerous problem that inflation.

Of course this game can go on for quite a while before the whole thing implodes as the FED does have other tools at its disposal to cover their tracks. The FED has used both primary auction dealers and other sovereigns in the past to prop things up, especially debt auctions. So if we get to the point where our debt is being called in to question the FED will simply print the money and have the Goldman’s and Morgan’s of the world just buy it as a front for them, which of course would just serve to further fan the inflation flames but at least we would not have an auction failure. Even the sovereigns like the UK got in to the act as discussed in this piece on ZeroHedge.com, “U.K. Holdings of US Treasuries Go Exponential”; whether it was UK money in the middle of their own crisis or FED funny money we will never know. The FED has not hesitated to use POMO or permanent open market operations in the past and will do so going forward, heck they even post a schedule on the New York FED site.

So with the impaired ability of the FED to really respond once they see inflation it makes you wonder how they are going to control it. Just this morning I saw another article that solidified for me that Mr. Obama is going to allow “B52 Ben” to continue on the current path. In an article with which the Chinese take exception to the FED actions Mr. Obama responded “I will say that the Fed's mandate, my mandate, is to grow our economy. And that's not just good for the United States, that's good for the world as a whole," Obama said during a trip to India. "And the worst thing that could happen to the world economy, not just ours, is if we end up being stuck with no growth or very limited growth”. So there you have it one obstacle removed from continuing QE.

In a bit of irony here is the fact that the Chinese are the ones screaming the loudest about the FED proposal to print money and buy the very bonds of which they are the largest holders. In some respects on the surface it appears smart as a way for “B52 Ben” to try and diffuse some of the rhetoric surrounding his QE decisions although that may be giving him too much credit. What better way to shut the Chinese government up then to offer to play in their space, essentially saying you want to get full value for your holdings since you disagree with our policy we will buy your bonds. In turn this would decrease the “hold” that China has over the US and make them less vocal; of course it creates a conundrum for the Chinese as to what to do with the Dollars they don’t really want. This may in fact shoot the FED in the foot as the Chinese may go on a resource buying spree again which could impact raw material prices further boxing in the FED on the inflation front. Oh what a tangled web we weave!

Besides the FED there are other things at home that are concerning and could cause a Dollar and debt crisis if we are not careful. The election of Rand Paul to the US Senate carries some risk as he is a potential filibuster to block the raising of the National Debt Ceiling, which would be one way to control spending; however it could have unintended effects on the Dollar and ability to sustain and finance our debt. Right now the Republicans are posturing with Eric Cantor in the media essentially proclaiming that if there was a showdown on the debt ceiling Obama would be responsible for the government shutdown and whatever comes after.

There is some additional posturing ,by the World Bank’s Robert Zoellick, going on before the upcoming G20 leaders meeting in Seoul. Zoellick who is a former US Treasury official would like to see at least a debate on something a kin to a Bretton Woods II. Basically he wants an agreement that would use gold as kind of a currency anchor. I think it would not necessarily be a bad idea but I think it will unfortunately take an even deeper crisis to convince governments around the world to have anything to do with constraining their currencies with gold. Of course gold is exerting its historical role as a defacto alternative currency in its own right as it is up in all currencies and making new highs against the Dollar. Today as I pen this post gold has risen to $1,417 per ounce and silver is $28.36, partially because of the market digesting Zoellick’s remarks.

I almost forgot to mention the other "B52 Ben" related item. As part of his cheerleading whistle stop tour our illustrious "FED HEAD" has taken to writing another missive as an Op-Ed propaganda piece that may have been ghost written by Goebbels himself titled, "What the Fed did and why: supporting the recovery and sustaining price stability". Benny” tries to illuminate all of us serfs that what he is doing with the continual money pumping is good for the economy because we will get ourselves into what I think he is trying to call a "positive viscous cycle". In other words  by the FED Bible, pumping money from thin air begot higher stock prices which begot more profits which then begot hiring and then  begot even higher stock prices and so on. This is a wonderful plan but I see at least three problems dear reader. The first problem is this policy at best will create an artificial boom not organic growth, the economy which is already in the dumps because it needs its next fix of monetary heroin has developed a tolerance to the injections and just like a real addict will require more and greater doses to achieve the next economic "high"(think back to the French Assignat). The second problem is, will the markets and world continue to play ball with the FED insanity; for the moment it appears that everyone is going along kicking and screaming but that may not last forever. The third problem is "Benny's" linear thought process; did you notice dear reader the only thing missing for his grand defense is what happens if the markets don't react over the longer term to the FED injections and stocks and other assets decline in price, then what? All bets are off at that point as lower stock prices would begat what to fix the economy, yet we would be stuck with high debt and the inflationary over hang from "B52 Ben's" modern day alchemy experiment. The only logical conclusion is that "Benny" and company will not let stocks fall even if they have to divert the world's cotton crop to fabricate new dollar bills in order to maintain a rising market. This opens the door to what I now added to Jim Sinclair's saying "QE to infinity and beyond". At this point the question I have is what is the color of the sky in Bernanke's world?

What will be the end game of all the QE1, QE2 ...3....4...5... Well as a viewer of the program "The Universe" I will explain the out come in a metaphor.  Let's say that Bernanke and the FED are at the core of the sun and they are controlling the monetary policy which is the fuel of this sun. On the outer layers of the sun we have the economy, debt, foreign trade, business lending, banking and all the things that make up our world economically. Just like the real sun as things are in balance the pressures exerted on the core are offset by its ability to burn fuel and maintain the equilibrium. There comes a point in the life cycle of every star, our sun included, where it begins to exhaust its fuel and the outside pressure begins to collapse the core. Once Bernanke and company have exhausted their fuel by debasing the currency and eroding confidence in it the outside pressures of the economy will over take the FED core. At the point the outside pressure in a star over takes the core it collapses and subsequently explodes in a supernova. The problem the FED and government face now is that things are broken and there is tremendous disequilibrium and rather than face up and fix the problems early on they have let the pressures build to a point of limited options. Each day the US gets closer to being that star running out of fuel on the path to financial supernova.

The message of this action in the metals markets is, the world other than those in the media are putting their money where their money where their mouth is and are voting against the continued worldwide debasement of currencies; led here in the US by the FED. I believe the rise in all “things” will continue because of the policies in place and will accelerate in the future.

Currently the world is looking at the Euro zone for their austerity measures, however, I believe it is only a matter of time before they again begin to monetize too. Given the shape of the Euro zone they cannot withstand a prolonged period where their currency is significantly stronger than everyone else’s. Additionally as the conditions in various Euro zone economies begin to deteriorate in earnest and there are more problems politically and financially there will be growing cries to act and that will mean QEuro (Quantatative Euro)!

In conclusion FED is today what I call the “new alchemists” for their ability to take money which used to be a store of value and convert it in to something of diminishing value; ironically the FED is able to take gold and make it in to something even more valuable a store of wealth and the ultimate reserve currency. In fact “Benny” is the ultimate alchemist taking nothing as in monetary policy and converting it in to higher gold prices.

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