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Tuesday, May 22, 2012

May 22, 2012 Neither the Fed Nor the ECB Will Be Able to Stop What's Coming

Today, we are witnessing the investment world's slow awakening to the fact that the monetary actions taken by the world's Central Banks have not in fact solved the issues leading up to the 2008 Crisis.

In point of fact, the Central Banks' actions have exacerbated pre-existing problems (excessive leverage) while simultaneously creating new problems (inflation).

This slow awakening has taken much longer than I would have expected, but with tens of thousands of careers on the line (financial professionals) as well as tens of trillions of dollars in portfolios at risk, the vast majority of professional market participants were highly incentivized not to realize these issues.

However, at this point, it is becoming clear that not only are financial professionals slowly realizing that 2008 was actually "the warm up," but that Central Banks themselves are aware that they've:

1) Failed to solve the issues leading up to 2008.

2) Created other unforeseen problems.

Indeed, this process of realization first began in the US where we had signs as far back as April 2011 that the Federal Reserve was aware that QE (AKA monetization of US debt) was less "attractive" as a policy (read: not such a good idea).

The vast majority of the media and Wall Street analysts failed to recognize this, though Bernanke himself admitted it in public:

Q. Since both housing and unemployment have not recovered sufficiently, why are you not instantly embarking on QE3? -- Michael A. Kamperman, Waco, Tex.

Mr. Bernanke: "Going forward, we'll have to continue to make judgments about whether additional steps are warranted, but as we do so, we have to keep in mind that we do have a dual mandate, that we do have to worry about both the rate of growth but also the inflation rate...

"The trade-offs are getting -- are getting less attractive at this point. Inflation has gotten higher. Inflation expectations are a bit higher. It's not clear that we can get substantial improvements in payrolls without some additional inflation risk. And in my view, if we're going to have success in creating a long-run, sustainable recovery with lots of job growth, we've got to keep inflation under control. So we've got to look at both of those -- both parts of the mandate as we -- as we choose policy"

http://economix.blogs.nytimes.com/2011/04/28/how-bernanke-answered-your-questions/

This admission marked the beginning of a process through which the US Federal shifted its policies from those of aggressive monetization to those of verbal or symbolic intervention.

I addressed this at length in previous articles. But the main issue is that the Fed backed off from rampant monetization and began to simply issue verbal statements that it would ease if needed, thereby getting the same impact (boosting stock prices) without actually having to monetize debt/ print more money.

Indeed, the only monetary change the Fed has made in nearly a year was the launch of Operation Twist 2 in October 2011. However, even this policy was more about meeting immediate debt issuance needs in the US rather than printing money to prop up the market.

Operation Twist 2 was a policy through which the Fed would sell its short-term Treasury holdings and use the proceeds to buy longer-term Treasuries. The purpose of this policy was two fold:

1) To make up for the lack of foreign demand in long-term Treasuries.

2) To provide capital to banks by permitting them to unload their long-term Treasury holdings in exchange for new cash.

Regarding #1, the Fed is now obviously aware that the policies it has pursued in tandem with the Federal Government, namely maintaining low interest rates while running massive deficits and increasing the Federal Debt to the tune of $100-200 billion per month, have severely damaged the US Treasury market.

This is only common sense. By running Debt to GDP and Deficit to GDP ratios that are on par with the European PIIGS, the US has made it clear that those investors who lend to it for the long-term (20+ years) are likely going to experience a haircut or bond restructuring much as Greece bondholders recently experienced.

Because of a lack of foreign interest in long-term Treasuries, the Fed decided to step in to pick up the slack. As a result of this, the US Federal Reserve has accounted for 91% of all new debt issuance in the 20+years bracket. Put another way, the US Federal Reserve is now effectively the long-end of the US debt market.

Operations Twist 2 has also allowed US commercial banks to unload their long-term Treasury holdings in exchange for new capital: something most of the Primary Dealers are in dire need of. This in turn helps to explain why the US stock market has advanced despite the fact that retail investors have been pulling out of the market in droves.

Put another way, the markets have been ramped higher by more juice from the Fed (and corporate buybacks). However, the fact remains that this juice has come from the Fed reallocating its current portfolio holdings, NOT printing more money outright to monetize US debt via QE.

So while the media and 99% of analysts believe the Fed is and can continue to act aggressively to prop up the markets, the fact is that the Fed has been reining in its monetary stimulus over the last nine months, largely relying on verbal intervention from Fed Presidents to push stocks higher.

We have known this for some time. But the general public and financial media are only just starting to realize that the Fed, in some ways, is at the end of its rope in terms of monetary intervention. This has become increasingly clear in the Fed FOMC statements.

Consider the latest FOMC statement released a few weeks ago...

Fed Signals No Need for More Easing Unless Growth Falters

The Federal Reserve is holding off on increasing monetary accommodation unless the U.S. economic expansion falters or prices rise at a rate slower than its 2 percent target.

"A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below" 2 percent, according to minutes of their March 13 meeting released today in Washington. That contrasts with the assessment at the FOMC's January meeting in which some Fed officials saw current conditions warranting additional action "before long."

http://www.bloomberg.com/news/2012-04-03/fomc-saw-no-need-of-new-easing-unless-growth-slips-minutes-show.html

Ignore the verbal obfuscation here. The Fed knows that inflation is higher than 2%. It also knows that US growth is faltering. The above announcement is the Fed essentially admitting its hands are tied regarding more easing due to:

Gas being at $4 and food prices not far from record highs.
This being an election year and the Fed now politically toxic.
Growing public outrage over the Fed's actions (secret loans, etc.) in the past.

Again, we are in a process of slow awakening to the fact that the Fed has not solved the problems that caused 2008. Instead, the Fed has exacerbated these problems (excess leverage) and created new problems in the process (inflation).

Fortunately for the Fed, the European Central Bank has picked up the intervention slack since the Fed began pulling back in mid-2011. Indeed, between July 2011 and today, the ECB has expanded its balance sheet by an incredible $1+ trillion: more than the Fed's QE 2 and QE lite combined (and in just a nine month period).

The two largest interventions were the ECB's LTRO 1 and LTRO 2, which saw the ECB handing out $645 billion and $712 billion to 523 and 800 banks respectively.

As a result of this, the ECB's balance sheet exploded to nearly $4 trillion in size, larger than the GDPs of Germany, France, or the UK.

This rapid and extreme expansion of the ECB's balance sheet (again it was greater than QE lite and QE2 combined... in nine months) indicates the severity of the banking crisis in Europe. You don't rush this much money out the door this fast unless you're facing something very, very bad.

This rapid expansion has also resulted in the ECB obtaining a similar political toxicity to that of the US Federal Reserve. Indeed, those European banks that participated in the LTRO schemes have found their Credit Default Swaps exploding relative to their non-LTRO participating counterparts.

The reason for this is obvious: any bank that participated in either LTRO implicitly announced that it was in dire need of capital. As a result of this the markets have stigmatized those banks that participated in the schemes, thereby:

1) Diminishing the impact of the ECB's moves.

2) Indicating that the ECB is now politically toxic in that those EU financial institutions that rely on it for help are punished by the markets.

Thus the two biggest market props of the last two years: the Fed and the ECB have found their hands tied. What will follow will make 2008 look like a joke. On that note, if you have not taken steps to prepare for the end of the EU (and its impact on the US and global banking system), you NEED TO DO SO NOW!

Labels: collapse, Crash, credit, Crisis Crash, Debt crisis, Default, Dollar, Euro Collapse, Euro crisis, Euro default