http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10702
Risk #3
- August 31, 2012
August 30 – Bloomberg (Mark Deen): “Yale University professor Stephen Roach said Federal Reserve Chairman Ben S. Bernanke shouldn’t be given a third term because of his role in managing the U.S. economy before the financial crisis. ‘I think Bernanke tried his best post-crisis, but he’s part of the problem pre-crisis,’ Roach said… ‘He and Alan Greenspan condoned asset bubbles at a time the economy needed more discipline.’ …For Roach, Bernanke’s work to calm markets following the financial crisis doesn’t mean his part in inflating asset bubbles in previous years should be overlooked. ‘To reward him for post-crisis, very valiant efforts of public service completely overlooks the role he played in getting the U.S. asset markets and an asset-dependent economy into this mess in the first place…”
Chairman Bernanke titled his 2012 Jackson Hole presentation “Monetary Policy since the Onset of the Crisis.” His review begins with the Fed’s initial response to the unfolding mortgage crisis in August 2007. The paper then details five years of policy measures, with section headings “Balance Sheet Tools,” “Communication Tools,” “Economic Prospects,” and “Making Policy with Nontraditional Tools: A Cost-Benefit Framework.” Dr. Bernanke concludes with coded dovish messages, including “grave concern” that “high levels of unemployment will wreak structural damage” – after earlier signaling support for the Draghi Plan (“recent policy proposals in Europe have been quite constructive in my view, and I urge our European colleagues to press ahead…”).
As noted above by the astute Stephen Roach, Dr. Bernanke played an instrumental intellectual role in crafting policy with Chairman Greenspan that fatefully nurtured the mortgage finance Bubble. In arguably history’s greatest monetary policy misadventure, the Greenspan/Bernanke Fed purposely ignored the unfolding Bubble, choosing instead to commit the Federal Reserve to aggressive post-Bubble “mopping up” strategies. Five years into the crisis, the extent of required “mopping up” remains an unfolding saga that will be analyzed and debated for decades to come. To be sure, the Federal Reserve’s framework for monetary policy cost-benefit analysis during the post-technology Bubble reflationary period (2002-2007) was an abject failure. Most of us strive to learn from our big mistakes.
Chairman Bernanke, not surprisingly, made it clear in Jackson Hole that he is prepared to move further into the uncharted waters of “non-traditional” monetary tools. His review came out on the side of benefits outweighing “manageable” costs, although perhaps to placate the hawks he cautioned, “The hurdle for using nontraditional policies should be higher than for traditional policies. At the same time, the costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions warrant.”
Before delving into his cost-benefit framework, it is worth mentioning that the word “Bubble” is nowhere to be found in Bernanke’s paper. I strongly argue that the issue of whether the Fed is once again accommodating a Credit (“government finance”) Bubble is today’s prevailing – potentially catastrophic - policy risk. The possible role that non-traditional policy tools might be playing in nurturing Bubble dynamics should be the focal point of any cost-benefit analysis related to the Fed’s experimental policymaking endeavor. Regrettably, it’s completely disregarded - hear no evil, speak no evil, and see no evil.
Dr. Bernanke highlights four potential costs of large-scale asset purchases (LSAP): 1) Impairment to the functioning of securities markets (“Fed dominance” “degrading liquidity and discovery”). 2) Substantial Fed balance sheet expansion could reduce public confidence (i.e. exit strategy and inflation expectation issues). 3) Risks to financial stability (i.e. “could induce imprudent reach for yield by some investors”). 4) “The possibility that the Federal Reserve could incur financial losses should interest rates rise to an unexpected extent.”
I take exception with those calling Bernanke’s presentation “balanced.” He again misjudges and woefully understates risk. My analytical focus is directed at Risk #3, with the view that the Bernanke Fed is again disregarding myriad risks to financial stability associated with marketplace interventions and manipulations. Indeed, it would appear that risks to financial stability are escalating in concert with the escalation in the course of global monetary management. Dr. Bernanke’s “imprudent reach for yield by some” contrasts with my fear of the greatest financial Bubble in the history of mankind.
From Bernanke’s paper: “Of course, one objective of both traditional and nontraditional policy during recoveries is to promote a return to productive risk-taking; as always, the goal is to strike the appropriate balance. Moreover, a stronger recovery is itself clearly helpful for financial stability. In assessing this risk, it is important to note that the Federal Reserve, both on its own and in collaboration with other members of the Financial Stability Oversight Council, has substantially expanded its monitoring of the financial system and modified its supervisory approach to take a more systemic perspective. We have seen little evidence thus far of unsafe buildups of risk or leverage, but we will continue both our careful oversight and the implementation of financial regulatory reforms aimed at reducing systemic risk.”
I will first note that the Greenspan Federal Reserve was caught completely off-guard by the market excesses that their policies had nurtured back during the (then) aggressive 1992/93 reflation period. It's worth noting that the hedge fund community has expanded about 20-fold since, to a record $2.1 TN. Global derivatives markets have mushroomed to hundreds of Trillions. Importantly, derivatives markets as well as the global “leveraged speculating community” have continued to grow post-2008 crisis – only further bolstered by aggressive policy regimes. The failure of JPMorgan’s “whale” derivatives trades to garner the attention of regulators (prior to disclosure) does not inspire confidence that the Federal Reserve can satisfactorily gauge the amount of leverage or other risks that have accumulated in the amorphous world of global securities and derivatives markets.
That non-traditional monetary policy tools today work similarly to how traditional measures functioned historically is one of the great policy myths of this period. There remains this notion, furthered again by chairman Bernanke, that some quantity of quantitative easing (additional debt purchases/liquidity creation/Fed balance sheet growth) today would equate to, say, a 25 bps point cut in the Fed funds rate 25 years ago. Yet the entire monetary policy transfer mechanism has been radically altered, foremost by the transformation of system Credit expansion from primarily bank loan-driven to one dominated by marketable debt and myriad risk intermediation channels.
Traditionally, central bank stimulus would entail adding reserves into the banking system to effectively reduce the cost of funds, thereby incentivizing additional bank lending. Today, Federal Reserve monetary stimulus is transmitted primarily through incentivizing risk-taking and leveraging in the securities, derivatives and other risk asset markets. We now have about 20 years experience in support of the thesis that there exists a dangerously powerful interplay between activist central banking, marketable debt and financial speculation. Yet the Fed somehow seems to ensure that its analysis avoids addressing the associated risks of an ever-increasing Federal Reserve role in the pricing and trading dynamics of an ever-expanding quantity of securities, derivatives and market speculation.
The media continue with this focus on the timing of the Fed’s QE3 announcement. This now seems archaic. Global central bankers, whether Draghi at the ECB, or the Bernanke Fed, the Bank of England, the Swiss National Bank (SNB), or others, now actively pursue the power of “open-ended” monetary and market support/intervention. No quantification necessary. This escalation to unconstrained monetary stimulus was the motivation for last week’s “Do Whatever it Takes!” Drs. Draghi and Bernanke have done nothing less than to signal to the marketplace that they at any point and to any extent deemed necessary will be there to backstop the markets. Worries – albeit those associated with so-called “exit strategies” or inflation risks – have been completely overshadowed by a resolute determination to avert another global crisis. It may have been subtle; it’s no doubt radical. The Draghi and Bernanke “puts” have been significantly bolstered and manifestly communicated. Sophisticated global speculators operate knowing central bankers are unequivocally determined to quell so-called “tail” risk of illiquid and faltering securities markets.
I know most would today consider this whole line of analysis wacko lunatic fringe stuff. I am, as well, confident that in, say, five or so years’ time analysts will look back at this period and state it was obvious that Fed policy had been fueling a Bubble in Treasury and other securities markets. We’ve seen it all before. Yet with markets rallying strongly over the past month and with heady 2012 gains only mounting, the bullish spirit has triumphed. Talk has turned to a new secular bull market, along with visions of the “American Decade” (and century!). If only Washington would get to work on the fiscal issue, sound economic fundamentals would be free from worry – or so the thinking goes.
I’m the first to admit that it’s easy to dismiss the view that, only a month or so ago, rapidly escalating European debt tumult was at the brink of unleashing the forces of global financial and economic crisis. The path from illiquid Spanish and Italian debt markets and a crisis of confidence in the euro to a more globalized panic was not so difficult to discern: illiquid markets, de-risking/de-leveraging dynamics, capital flight, systemic banking stability issues, derivative and counterparty concerns, hedge fund problems and a resulting abrupt tightening of global financial conditions. Draghi surely believed he had no alternative than to go radical – and now Bernanke and others are as well ready to do whatever it takes.
Let’s return to Risk #3. Global markets have rallied strongly. Those bearishly positioned have been mauled. Risk hedges have been unwound. The speculator community has positioned bullishly around the globe to profit from the latest policy-induced bout of “risk on.” Those betting on the power of the policymaker market backstop have been rewarded and emboldened. What if it doesn’t work? What if policymakers have prodded everyone to one side of the boat - and then it tips? Is policymaking bolstering stability or, rather, exacerbating instability? It is now generally accepted that additional monetary stimulus would have little economic impact. Yet moving toward aggressive “open-ended” market interventions is, understandably, having a major impact on marketplace dynamics. Is financial stability again being unwittingly subverted?
Monetary policy will not resolve deep structural financial and economic issues in Europe – nor in the U.S., Japan, China or elsewhere around the world, for that matter. History informs us that it will likely make things worse. With focus on Jackson Hole, it was easy Friday to miss the widening hole in the Spanish bond market. Spain’s 10-year yields jumped 27 bps to 6.81%, with yields up 45 bps for the week. Spain Credit default swap (CDS) prices jumped 21 bps this week (eight-session rise of 62bps) to an almost one-month high 518 bps. Italian CDS ended the week 12 higher to 467 bps. Curiously, precious metals gained this week while most industrial metals declined. Is this evidence of market players willing to bet on policy-induced currency devaluation, while less convinced that impending monetary stimulus will have much real economic impact?
Draghi clearly has his plan – and his wingman at the Federal Reserve. There may be no turning back. At the same time, the European financial, economic and political issues may very well prove insurmountable. Yet why would the speculator community spend much time fretting the next round of “risk off,” not with global central bankers waiting anxiously with bazookas fully loaded. In the end, I suspect policymakers will regret inciting this particular, potentially unwieldy, phase of “risk on” market speculation and financial mania.
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