Actions Speak Louder Than Words

With global equity markets continuing their parabolic climb, central bankers have slowly begun to signal that they are considering ways to reverse the unprecedented liquidity that has been pumped into the financial system over the past year.  Adding up the direct cash injections, loans, assumptions of debt, commitments, guarantees, and other obligations, the total comes to a mere $11.6 trillion dollars!  To put $11.6 trillion into context, lets add up some major US expenses, adjusting for inflation:  take the Marshall Plan ($115.3 billion), the Louisiana Purchase ($217 billion), the Race to the Moon ($256 billion), the S and L Crisis ($256 billion), the Korean War ($454 billion), the New Deal ($500 billion), the Invasion of Iraq ($597 billion), the Vietnam War ($698 billion), all of NASA since ($851 billion) and World War II ($3.6 trillion).  All of the above totals $7.52 trillion.  The bailouts have been the greatest commitment of capital the US has ever engaged in.   To be fair, the Federal Reserve considers much of the $11.6 trillion a form of secured loans, but because the Fed refuses to identify the collateral backing its loans, no one really knows the quality of the assets on its balance sheet.  What we know for sure is that the policies that the Fed has embarked on, most notably quantitative easing (where the Fed buys government bonds, agency debts and  mortgage backed securities) which began in earnest in spring 2009 has fundamentally deteriorated the central bank’s balance sheet.   Not by coincidence, this also happens to be around the time when the stock market bottomed and began its current rally.  In an effort to save the troubled banking system, banks’ balance sheets have improved, but the central bank’s balance sheet deterioration has turned it into the very type of “bad bank” that it was trying to rescue. 

Minutes from the last Federal Reserve meeting stated that quantitative easing will continue at least until the end of the year.  According to the latest report, the Federal Reserve has an additional $500 billion of mortgage backed debt it intends to buy out of the proposed total $1.2 trillion.  With such a large buyer artificially propping up the mortgage market, it’s no surprise that house prices have bounced back and construction activity is up this past month.  However, this is not a true housing market recovery, but rather one that is propped up by easy money.  Therefore, at some point, when the money is withdrawn, the housing market is likely to fall back, putting stress on the banking system again.  As an example of what can happen after government subsidies and spending programs end, look no further than your local car dealership.  After a strong summer season due to the Cash for Clunkers program, September auto sales fell by a staggering 35% compared to the previous month as the program expired. 

Although the Federal Reserve and Treasury continue to publicly state that they support a strong dollar policy, market participants understand that actions speak louder than words and have pushed the dollar to its lowest level in 14 months.  But the dollars loss is the commodity markets gain with gold for example, now sitting at multi-year highs of $1060 an ounce.  Whether or not the move in gold will be sustained is anyone’s guess, but the market is signaling that the current state of affairs, with central bankers printing money simultaneously and with no end in sight, is creating inflation.  In his latest speech, Mr. Bernanke said that the Federal Reserve will be prepared to tighten monetary policy when the outlook for the economy “has improved sufficiently”.  He continued by saying that “as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation down the road”.  Other central banks have also began to signal that interest rates may have to be increased to stem the possibility of inflation, with the Australian Central Bank raising its benchmark lending rate by .25% to 3.25%. 

Interest rate increases outside of the US will continue to cause further pressure on the dollar.  We are nearing the crossroad where US policy makers will have to start thinking about either raising interest rates or withdrawing liquidity in an attempt to stem inflation.  With oil back over $75 and rising, any further increases will surely put pressure on an already weak consumer.  In addition, we are also starting to see positive numbers from real operating companies like Intel for example, although much of the growth is coming from international markets due to the weaker dollar.  While we are hopeful that Chairman Bernanke can withdraw liquidity without hurting the economy, it will be a very difficult task as the two worst depressions in US history were caused by liquidity shortages.  The first depression in 1837, when the Second Bank of the United States removed its primary instrument, Second Bank bills from the system.  And, of course the Great Depression (1930-1932), which was sparked in part to the closure of the Bank of the United States, a major New York retail bank, which caused a withdrawal of deposits from the banking system and a cascade of bank failures.  The next 3 to 6 months should tell us how the Federal Reserve is going to begin the process of withdrawing liquidity.  One solution would be to raise interest rates sharply (perhaps to 2%, or more if inflation takes off) while maintaining high liquidity.  If there is enough liquidity in the system, the higher rates should serve to deflate the various bubbles, and force the government to rein in the budget deficit, but not hamper the recovery in the real economy as banks will be able to raise rates and small business’ will have access to loans.  At this point, liquidity can be gradually removed from the market, as both the governments financing needs and the potential bubble is removed from the market (which was itself draining liquidity).  The other option the Federal Reserve has is to keep interest rates at historic lows, and try to withdraw liquidity as the economy improves.  In our opinion, if the Fed decides to take this course (withdrawing liquidity while keeping interest rates at 0%), the chances of hyperinflation increases dramatically as keeping rates at 0% will most certainly fuel a bubble in commodities as the dollar comes under pressure in response to interest rate increases outside of the US.  Even worse, if liquidity is withdrawn too quickly, the risks of a hyperinflationary depression will rise as the economy suffers from a lack of liquidity and prices continue to rise due to continued pressure on the dollar.  If this were the case, all bets are off and we would expect the market to quickly break the lows it set last March.  Thus, as policy makers begin to form their plans to withdraw liquidity from the system, it will be important to figure out which course they decide to take, and of course actions speak louder than words. 

With the latest economic readings on housing and construction coming in below expectations, we believe that the market has priced in a much stronger recovery than what the economy can support.  It is our opinion, that as the stimulus and government support is withdrawn, we will begin to see the market realize that the economy, while stabilized, is still very weak.  As readings on the economy continue to show signs of weakness, we believe that we will see the market trade down and possibly very rapidly.