Stocks Leap 400 Pts Because BOJ Begins Negative Interest Rates?

This is stunning! Wall St sent stocks skyrocketing today because BOJ's Kuroda decided to try negative interest rates. More experimental monetary policy! Remember Mr. Bernanke's "unprecedented measures"? That's an admission that they are using us all as their economic experimental guinea pigs! Unproven economic policy without accountability! Eventually, one of them will bring a calamity!

Bernanke's Catastrophe

Interview with Lee Adler of Wall Street Examiner
Introduction by Ilene
Elliott, of PSW’s Stock World Weekly, and I began a series of interviews with Lee Adler, chief editor and market analyst at the Wall Street Examiner, on May 11, 2011. This is part 2. Lee's Wall Street Examiner is a unique, comprehensive investment newsletter that covers subjects such as the Fed’s open market operations, the impact of the Fed and the US Treasury on the markets, the housing market, and investment strategies. We often cite Lee’s analysis in Stock World Weekly and on Phil’s Stock World--his research provides invaluable information for formulating an overall market outlook.
(Here's part 1 of our interview: The Blinking Idiot & the Banking System)

Part 2: Bernankenstein's Monster 

Elliott: How should we invest in this environment - when we take into account the Fed’s huge interference in the markets?
Lee: Think like a criminal. Look, it’s a matter of knowing what the Fed’s next move is going to be, and knowing the investment implications.  You have to stay with the trend until the Fed sends signals that it is going to reverse. We’re at that inflection point. The issue is how much front running will there be? You definitely have to be out of your longs by now. When support fails after having succeeded, succeeded, succeeded, and every other previous retracement has held, then suddenly one doesn’t, it’s a huge signal.
Ilene: If the Fed wants oil and metal to go down, and the dollar to go up, is that saying it wants the stock market to go down as collateral damage? If pattern continues, the stock market will go down with the commodities.

Lee: No, the stock market is the center. Bernanke came out in November, the day they announced QE2, and did an Op-ed in the Washington Post saying exactly what he expected. He’s going to manipulate the stock market higher, and that’s going to create economic confidence and everyone’s going to be happy. His goal was to manipulate the stock market. The collateral damage, the stupidity of their policy, was that they didn’t take into account the inflationary effects on commodities. They kept denying it.  And Bernanke kept saying over and over, well, look the stock market is going up, QE2’s having the desired effect. He was willing to take credit for the stock market going up, but he refused to take responsibility for the same exact move in commodities. It’s the same, they move together. It’s just that one was an intended consequence (stocks going higher), and the other (inflation in commodities) was the unintended consequence. They took credit for the intended consequences, but wouldn’t take responsibility for the unintended consequences.
Ilene: What in the Fed’s creation gives it the power to manipulate the stock market? That wasn’t one of its dual mandates (maximum employment and price stability). Isn’t that beyond its scope?
Lee: Of course, but QE2 was a direct manipulation of the stock market.
Ilene: So the Fed knew the money they gave to the Primary Dealers would end up in the stock market. Do they have an agreement with Goldman Sachs, like “hey we’re going to print you this money and we want you to buy stocks?”

Lee: Look, Brian Sack, the head trader for the Fed, sits down with the Primary Dealer traders every morning before the NY markets open, and they have a conference call. Every morning. The Fed makes no secret of this, it’s all on the NY Fed website, the “Fed points.” They describe the whole thing. They discuss the dealers’ “positions and what their financing needs are”, but that’s code. The Fed decides what it wants, and the PDs execute the Fed’s wishes. So while government securities are usually the Fed’s focus, the dealers can trade whatever they want. Bernanke made it absolutely clear that stocks were his focus in that November 4 editorial in the Washington post.

Ilene: Even though manipulating stocks is not a legitimate focus of the Fed?
Lee: That’s what they get away with. The mainstream views pushing stocks higher as a legitimate policy. People want the stock market higher. But they don’t want to see oil prices over $100 a barrel, and gas prices over $4 a gallon, they don’t want that.

The Fed does not control what the dealers do with the money, they can only make their wishes clear. The Fed can make it difficult for the dealers, and now they are, because they finally got fed up with the commodity speculation. But the Fed does not control what Goldman Sachs does completely. In fact, it might be the other way around. There’s clearly collusion, it’s no secret.

Ilene: Why doesn’t anyone do anything to stop this?
Lee: Well, most of the FOMC members want stock prices higher. They believe the trickle down theory crap. They want to inflate, so it costs less to service our debt. But the kind of inflation we have is devastating. It impoverishes the middle class and makes the middle class unable to pay its debts to the banking system, which is a time bomb in itself.
The banks are not increasing their loss reserves at all. They’re shrinking their reserves so they can show profits when they should be going in the other direction because the ability of the public to service the debt is decreasing.
The Fed gets into these post-hoc crisis management modes where they will make another huge blunder. QE2 was a massive blunder. It did not achieve its desired goal. It got stock prices up but it didn’t get the economy turned around, and it made inflation much worse. They fucked up and the blunder will only be recognized after the fact. Mainstream media won’t get it until after the stock market collapses. By then it’s too late. But the blunder won’t be manifest till stock prices collapse, and then everyone will recognize what a damn idiot Bernanke is.

And now they’re going to sacrifice the stock market, because another problem is that they can’t afford to allow long-term bond yields to go up. The government can’t afford higher interest rates. They will sacrifice the stock market at the alter of the Treasury market. They will do whatever they can to support Treasury prices at high levels. That means they’ll force the liquidation of stocks, and once the wave of liquidation hits the stock market, the knee jerk reaction is for the money to flow towards Treasuries. Someday that’s not going to work, and I think that day may be coming pretty soon.

Ilene: What do you think about Bill Gross shorting Treasuries, is that going to work out for him?
Lee: William the Gross. Watch what he does, not what he says. The guy is a world class card player. For any public pronouncement he makes, generally, you have to consider the opposite. Think like a criminal. He’s the Godfather. When Gross comes on TV, I hear the Godfather music playing in the background. His track record of public pronouncements isn’t very good, yet he consistently makes more money than anyone else trading the bond market, so obviously you can’t be wrong all the time and make money all the time.
Ilene: So he’s front running?
Lee: If he’s making a pronouncement on CNBC, he probably has another reason for saying what’s he’s saying other than what it appears to be. He’s got a direct pipeline to the Fed. The Fed sends these coded messages. It’s not that hard to figure out by watching the data. The massive spike in bank reserve deposits at the Fed, starting right after the January Fed meeting, means something is happening there.
Ilene: You’ve concluded this game is going to stop in June?
Lee: Well, I always figured it would because commodity prices were getting out of control. The more Bernanke denied it, the more troubling it seemed he knew it was. It’s the old “[he] doth protest too much, methinks.”  Every time Bernanke claimed the inflation was transitory, the more clear it became that he knew it was a serious problem. But they didn’t do anything about till recently.
Ilene: So what is going to happen with the stock market? Will it sell off as QE ends? At what point will the Fed start a QE3 to stop the stock market from dropping - would it let stocks drop 10%, 20%...?
Lee: Oh yeah. The Fed’s job one is to preserve the Treasury market. With this enormous mountain of debt which the government is on the hook for, they can’t afford to pay 5% interest, or even 4%. They can’t afford any increase in Treasury yields. So, if necessary, they’re going to force a liquidation of stocks and spark a “flight to safety” panic again, as they did in 2008. Then, they needed to get the yields down, and they were also thinking it would help the housing market.
Ilene: But it didn’t really get to the housing market.

Lee: The problem in the housing market had nothing to do with mortgage rates but they didn’t understand that. It’s amazing how when you put all these smart people together how stupid they can be. It’s the problem with group think. When the FOMC gets together, it’s like having all these geniuses in the room coming up with idiotic decisions. They all have the same motivation - to become the next Fed Chairman. The way to do that is to comply with the mad scientist running the show. Bernanke’s whole life has been an ongoing doctoral dissertation in which he tries one experiment after another, based on the crap he wrote when working on his PhD.
The problem we’re experiencing now is that the system is imploding. It’s a slow motion implosion.
Elliott: When QE2 ends in June, will the pain of that ending be extreme enough cause the Fed to resume some form of QE3?
Lee: Yep. I don’t think it will take long.  We’re in bad shape, as bad as Greece. The only way we can pay our bills is if other countries and investors continue to lend us $100 Billion every month, and that could jump to $150 Billion a month in the summer. So we can’t pay our bills unless people lend us more money. That’s not paying bills. That’s creating a bigger problem.

Bernanke Is Making Things Worse

Elliott, writer of PSW’s Stock World Weekly, and I recently began a series of interviews with Lee Adler, chief editor and market analyst at the Wall Street Examiner. (The interview was on May 11, 2011.) The Wall Street Examiner is a unique and very comprehensive investment newsletter. Lee Adler’s work covers subjects such as the Fed’s open market operations, the impact of the Fed and the US Treasury on the markets, the housing market, and investment strategies. We often cite Lee’s analysis in Stock World Weekly and on Phil’s Stock World -- his research into the Fed’s and the Treasury’s activities – the money flows – provides invaluable information for formulating an overall market outlook. 

Part 1: A Blinking Idiot & the Banking System 

Ilene: Lee, I’ve gathered from reading your material lately that you think it’s time to be out of speculative trades, such as oil, now?
Lee: Yes, the Fed is serious about stopping speculation, and they are not waiting till the end of QE2. Bernanke wants to break the back of this thing. So if you want to trade the long side now, you’re playing with fire. The powers that be have put out the message that they won’t keep tolerating speculation in the oil and commodities markets.
Ilene: Because of the inflation that Bernanke denies exists?
Lee: Yes, the inflation is disastrous. They’ve known all along that inflation is real. You know it when you’ve got this situation in Libya with people getting killed. It started with food riots in Tunisia, but then it morphed into something else. People are starving all over the world because of these commodity prices, and the idea that it is not affecting Americans is crap because 80% of the people are affected by gas prices at these levels. They have to cut back on other spending, and the top 10% can’t carry the ball. If you’re spending an extra $100 – $200 to fill up your car and put groceries on the table, that affects your ability to service your debts, and that affects the banking system. This inability to pay back loans is showing up in mortgage delinquencies and credits card delinquencies.
Ilene: You also have written that the Dollar and commodities have an inverse relationship, why is that?
Lee: Because commodities, such as oil, are traded in Dollars. Commodities are basically a cash substitute at this point. The players don’t want to hold Dollars because the Fed is trashing the Dollar. If you’re a trader outside the U.S., and your native currency is the yen, for example, and you want to buy oil or gold futures, you need to sell Dollars in exchange for the gold or oil futures contracts you’re buying. So your action of buying the commodities in Dollars is in effect creating a short position in the Dollar.
So if commodities collapse and you’re forced to sell your positions, you’ll reverse that short position in the Dollar – trading the commodities back for Dollars. That creates demand for the Dollar. That’s why commodities and the Dollar definitely do have an inverse relationship.
With the margin increases that were implemented in the last month or so, the Fed is beginning to reverse the commodities price run up.  This is the precursor to the end of QE2. The Fed is sending warning shots across the bow. After the Jan 26 FOMC meeting, banks’ reserves began to skyrocket. Why did bank reserves suddenly skyrocket? There’s no overt reason. Something was going on behind the scenes.  I think banks and Primary Dealers (PDs) got the back channel message that it’s time to start building reserves because they’re really going to end QE in June – they really, really are. I give it six weeks to two months until the whole thing collapses and they have to start printing money again.
Ilene: Why do commodities and the Dollar have a more persistent relationship than the Dollar and the stock market, for which there is an inverse relationship now, but this is not always the case?
Lee: The Dollar/stock market inverse relationship is a correlation due to a common cause – essentially the actions of the Fed.  It’s not a cause and effect relationship.
Elliott: Will the Fed defend the Dollar?
Lee: They are starting to, but not officially. They’re doing it behind the scenes. That’s my theory. I’m a tinfoil hat guy…. I didn’t start out this way. I arrived at my tinfoil hat after paying careful attention to the data for 8 or 9 years. After a while I realized it’s kabuki theater. 
Elliott: As you say it is kabuki theater, and as Phil says, we don’t care if the markets are rigged, we just need to know HOW the market is rigged so we can place our bets correctly.
Lee: Exactly. All you need to know is what the Fed is doing. That’s my bread and butter. I watch what the Fed is doing every day.  I’m so familiar with the data that stuff jumps out and screams at me. The margin increases were not an accident. They were completely out of character, and they followed Bernanke’s press conference where he claimed he couldn’t stop speculation. He’s so manipulative. He says one thing and does another.
Elliott: But being Chairman of the Fed, doesn’t he have to lie? If he came out and said exactly what he’s planning to do, wouldn’t everyone and his dog get on the right side of the trade?
Lee: That’s what he does though – he lies, but in his backchannel way. He tells the favored groups exactly what he’s going to do. You have to read between the lines. The meeting minutes are pure propaganda. That is how they send coded messages to the market. 
In the last meeting minutes, or maybe the one before, the Fed said that wage increases were to be eradicated. I went ballistic when I saw that.
Elliott: Especially because they create all this inflation, and it trickles it’s way down. This is trickle down inflation. It’s gotten to the point where the people trying to make a living and ultimately buy things are being told that although prices are going up, we can’t allow you to earn anymore money…
Lee: It’s a moral outrage and a terrible policy. But that’s what they want. Their purpose is to keep the bankers in business. The Fed serves the banking system. That’s why it’s there, to make sure the banking system is profitable.
Ilene: So they are accomplishing their goal.
Lee: For the time being. In the end they cannot fulfill their purpose because the banking system is dead. This is Frankenstein’s monster. This is another one of Bernanke’s economic science experiments, Dr. Bernankenstein.  And the result of his policies is bernankicide – the financial genocide of the elderly in America.
Elliott: Then if Dr. Bernanke is Dr. Frankenstein, then what exactly is his monster?
Ilene: The banking system?
Lee: Yes, it’s got these screws coming out of its head, and stitches across its forehead. It’s the walking dead. The banks don’t make any money, the only way they appear to make money is by lying about it.
Ilene: But the people running the banks make money.
Lee: It’s a criminal syndicate for god’s sake.

Fed Not to Begin QE3 for Now

by John Hilsenrath at WSJ:


Federal Reserve officials are in no hurry to respond to recent indications U.S. economic growth has hit another soft patch, despite chatter in financial markets that the Fed might start a new program of U.S. Treasury-bond purchases to boost growth.
The central bank has already purchased more than $2 trillion of mortgage and Treasury bonds. The purchases are meant to hold interest rates down by reducing the supply of securities in private hands and to drive investors into areas such as stocks to encourage businesses and consumers.

Fed Chairman Ben Bernanke signaled in April that the hurdle to more "quantitative easing," as it is known, is very high and Fed officials have done nothing to indicate that Mr. Bernanke's guidance has changed as economic data has worsened in recent weeks.
In an April news conference, Mr. Bernanke said the tradeoffs that would come with additional purchases were becoming unappealing. "It's not clear we can get substantial improvements in [employment] without some additional inflation risk," he said.
Fed officials have largely held to that line. In comments last week, St. Louis Fed president James Bullard said the Fed was entering a period in which Fed policy will be on pause—meaning it won't be trying to push interest rates either higher or lower. Charles Evans, president of the Chicago Fed and a strong advocate of past programs, said earlier last month that what the Fed had done already was "sufficient."
In comments Wednesday, Cleveland Fed president Sandra Pianalto said the Fed's current stance was appropriate and added the recovery was likely to continue, even though growth "may be frustratingly slow at times."
Mr. Bernanke has argued that past bond purchases haveworked, but it has have taken a political toll on the Fed. Critics in Congress and overseas say the Fed is fueling inflation globally.
"They don't want to do QE3," said Vincent Reinhart, an economist who formerly ran the Fed's influential division of monetary affairs. QE3 is what many traders have dubbed the possibility of a third round of Fed securities purchases.The last round of quantitative easing, which will amount to $600 billion of bond purchases, is set to conclude at the end of June.
A boost from Congress, through additional deficit spending, looks equally unlikely. Republicans have crafted an agenda based on spending cuts and would likely be reluctant to embrace new efforts to stimulate growth through fiscal policy. New tax cuts would also face a tough reception, given Washington's currentfocus on reducing the long-run deficit.
The Obama administration wants more infrastructure spending in the near term, but administration officials, stung by the divisive legacy of the 2009 stimulus bill, don't call it stimulus.
Infrastructure spending, in addition to education and research and development programs already proposed by Mr. Obama, are "policies that have the potential to impact job creation now but also have the ability to increase our competitiveness," said Brian Deese, deputy director of the National Economic Council.
The current mindset could change if the economy deteriorates. Mr. Bernanke has indicated that the outlook for inflation will play a key role in his decisions about monetary policy. Rising inflation could force the Fed to raise interest rates. A declining rate of inflation could force it to consider startinga new easing program.
The Fed initiated its last program of quantitative easing in 2010 amid worries that the U.S. was slipping toward deflation, or falling consumer prices. The behavior of bond markets doesn't indicate that deflation is a serious worry right now. Prices of Treasury Inflation Protected Securities, also known as TIPS, indicate that investors expect 2.8% inflation in five years, substantially more than was the case last August when the Fed started talking about a new round of quantitative easing. Back then, expected inflation was on a downward trajectory, from 2.8% to less than 2.2% in a couple of months.
Measured inflation is also higher than it was last year. When the Fed initiated the program in November, consumer prices were up 1.1% from a year earlier, well below the Fed's 2% goal. In April they were up 3.1% from a year earlier.
"We don't think it's likely at all, but things could change," Michael Pond, a bond strategist at Barclays Capital, said of the chances of another round of easing. "If growth slows well below its trend and on top of that you have inflation and inflation expectations coming down, it is certainly possible. At this point it is not on the table."

Signs of Fed Desperation

from EconomicPolicyJournal.com:

Thanks to Ben Bernanke's new monetary "tools", the Federal Reserve continues to operate in panic mode. Specifically, because the Fed now pays interest on reserves held by banks at the Federal Reserve, excess reserves are piling up at the Fed at a remarkable rate.

There are now $1.5 trillion in excess reserves just sitting there that could explode and hit the economy at anytime and cause huge price inflation. There has never, ever, before Bernanke started paying interest on  reserves so much of an overhang in excess reserves. In the month before the Fed started paying interest on excess reserves, September 2008, excess reserves stood at only $27 billion.

Here's the difference between then and now:

THEN:      27,000,000,000

NOW:   1,500,000,000,000

Here's a graph of the situation:

Click on chart for larger view.

This is where most of the QE1 and QE2 money has been going. It hasn't even hit the economy, yet. The Fed has no idea what is going to happen with this $1.5 trillion once it does hit the system or how quickly it will flow into the system---and cause price inflation. Or how high they might have to raise interest rates to stop the flow.

An alternative the Fed is considering in draining the reserves by getting money market funds to conduct reverse-repos with the Fed. This gets a little technical, so just know that if the Fed does reverse-repos with money market funds, it will drain reserves from the system.

But the money market funds have nowhere near the cash on hand to do the sizable reverse-repos with the Fed that the Fed may need to do. The money markets have most of their funds in short-term paper that they would be required to sell (or certainly not roll-over) if the Fed came to them wanting to do sizable reverse-repos. Huge sales of short-term paper would panic the markets. It is a very dangerous scenario.

The Fed knows this. When they actually figured this out I am not sure. Trust me, they would have never started paying interest on reserves, if they understood the problem back then. So here we are with $1.5 trillion in excess reserves, with Bernanke not knowing when these might hit the system, and so the Fed desperately continues to add money market funds to the list of those they may in the future do reverse repos with. They are expanding the list hoping that with a larger list any reverse-repos conducted won't damage the economy. It's total desperation.

We're All Distracted Now!

by Mike Krieger:

Printing and Propaganda
As I have been saying for the past several years, the misguided Keynesian witch doctor central planners unfortunately in charge of our economic fate are attempting a grand experiment on us based on completely insane and nonsensical theories that have no chance at success.  These clowns claim to have all sorts of “tools” but in reality they have nothing.  When faced with a complete credit collapse of proportions never seen before in recorded history there were and are only two “tools.”  It’s the two P’s:  Printing and Propaganda.

While I have written about both of these “tools” before I am going to focus on the propaganda part today since it is the most applicable to the current state of the financial markets.  We all know by now that the centrals planners believe the tail wags the dog.  So the economy doesn’t lead to higher stock prices but higher stock prices will lead to a better economy.  Insane?  Absolutely.  Is it their religion?  100%.  The other important thing for investors to be aware of now when they are comparing the current state of affairs to what many lived through in the 1970’s is that the central planners have learned some lessons.  What we must always remember about central planners is that they will never renege on their core philosophy which is that an elite academic and political class in their wisdom are better stewards than free humans interacting in a marketplace.  That said, most people do not share their worldview for obvious reasons (who wants their lives micromanaged) so the trick of the central planners is to micromanage your life while you think you are in charge.  As Goethe said “None are more hopelessly enslaved than those who falsely believe they are free.”  He didn’t just make up this clever quote, it is a tried a true method of the most successful control systems throughout history.      

So even the brainwashed masses out there understand that price controls were tried in the 1970’s and failed.  We also know why.  Therefore, the last thing the current group of central planners will want to do is announce price controls.  That doesn’t mean they don’t attempt them anyway.  They have been rigging stocks in the United States consistently for the past two years and most people get this and accept it as a part of the current state of disunion we are in.  However, as I wrote last week we have now entered Phase 2.  This was represented by the raid on commodities. 

A tried and true strategy that TPTB have used in precious metals for years has been to create such tremendous volatility in gold and silver and especially the shares that most investors stay away since they can’t stomach it.  This strategy is now seemingly being employed to a much wider spectrum of commodities, hence my warning on trading futures last week.  The entire game was perfectly summarized by a quote in the most recent 13D report where it was stated:  “Unfortunately, this battle between finding a safe haven and the authorities’ desire to render it ‘unsafe’ is only in its earliest stages.  Our manta since 2007 – governments can and will do anything to survive.”

The Bernank Bluff    
So part of the propaganda “tool” used by the central planners is the manipulation of financial markets, which seems to increased in emphasis in recent weeks.  The other consists of outright lies and disinformation.  Put yourself in The Bernank’s shoes for a moment.  This guy loves printing more than Hewlett Packard.  He is despondent beyond belief that the markets and an increasing amount of financial commentators have criticized his precious QE insanity.  Meanwhile, the economic data is starting to roll over and housing looks set to launch into another spiral lower.  So what is a Bernank to do?  Bluff the heck out of the markets.  He knows that the only way he can have cover for his printing party is to smash commodities because the rise in commodities is the biggest point of contention amongst the masses.  Unfortunately, most people don’t delve deep enough into how the system works to have the serious moral and philosophical issues with the central planning system as I and many others do.  The Bernank knows this.  Bread and circus is a tried and true method.  Problems emerge when the bread runs out.  So the period we are in right now is huge for the Bernank and his merry band of mental patients.  They don’t have to make any decision on more printing until June when the current fiasco ends.  It is during this window when they think they can have their cake and eat it too.  They can print like mad yet at the same time claim they are about to stop and maybe even tighten.  Yeah, and the Easter Bunny is sitting next to me trading LinkedIn shares.

In any event, this is The Bernank Bluff and he is milking it for all it is worth while at the same time orchestrating raids on commodity futures.  This is just a massive psychological game against the investors class to keep them from the assets that will actually provide protection.  Well Bernank you’ve got a month left.  Make the most of it because after that you need to act.  I can’t wait to see you try to tighten as the economy rolls over. 

The Slut Walk
While millions around the world from the Middle East to Europe rush into the street to protest the rape and pillaging of their respective economies by the banksters and their political puppets guess what the good citizens of Boston, the heart and soul of the first American Revolution, are protesting.  For the “right to be dirty.”  I kid you not.  The article is right here http://www.telegraph.co.uk/health/women_shealth/8510743/These-slut-walk-women-are-simply-fighting-for-their-right-to-be-dirty.html.  Now let me make one thing crystal clear.  I am not trying to be the moral police.  I could care less how people treat themselves or behave as long as it doesn’t harm me.  The point I am trying to make is that as the biggest theft in American history has just occurred and continues to occur, this is what they are protesting about in Boston.  You know what the elites on Wall Street and Washington think when they see this?  They smile from ear to ear.  What a bunch of sheep.  We just stole trillions and they are protesting for the right to be slutty.  Look, I think I am a pretty decent observer of cultural trends.  Rest assured ladies, sluttiness is in a secular bull market.  It is encouraged by the elites.  What they fear is not degeneracy but rather self-respect and logic.  They want you to behave like animals so they can justify treating you like animals.  Has anyone read Aldus Huxley’s books?  This is worth reading http://www.huxley.net/bnw-revisited/index.html.   You go girl!
   
Peace and wisdom,
Mike

Fed Begins To Ease Off the Gas

The Fed -- Painting Itself Into a Corner of Monetary Mayhem

This is one of the reasons that I am convinced that much higher inflation is coming. If the Fed doesn't reverse its purchases of Treasuries, it will create a cash "hot potato" that will ignite rampant inflation. And if it does, who will want to buy all those treasuries, and what will be the impact on the broader economy of much higher interest rates? And if they can't accomplish this quickly enough, while maintaining a balance between these variable, then what could the the (unintended) consequences? I think that the result will be more monetary mayhem, and the likelihood is toward much higher inflationary pressures. That "hot potato" could bring hyperinflation!

John Hussman at Hussman Funds:


One of the most important factors likely to influence the financial markets over the coming year is the extreme stance of U.S. monetary policy and the instability that could result from either normalizing that stance, or failing to normalize it. It is not evident that quantitative easing, even at its present extremes, has altered real GDP by more than a fraction of 1% (keep in mind that commonly reported GDP growth rates are quarterly changes multiplied by 4 to annualize them). Moreover, it's well established - on the basis of both U.S. and international data - that the "wealth effect" from stock market changes is on the order of 0.03-0.05% in GDP for every 1% change in stock market value, and the impact tends to be transitory at that.

Still, by replacing an enormous quantity of interest-bearing assets with non-interest bearing money, quantitative easing has created profound distortions in asset prices, where Treasury bills now yield less than 5 basis points annually, while "risk assets" such as stocks and commodities have been driven to prices high enough that their likely future returns now compete perfectly (on a time-horizon and risk-adjusted basis) with the zero expected returns on cash.

Taken together, despite the limited and transitory real effects of QE on output and employment, the Federal Reserve has created an unprecedented monetary position that creates an extremely unstable equilibrium for the financial markets. There are several ways that this might be resolved. Based on the very robust relationship between short-term interest rates and the monetary base, it is clear that a normalization of short-term interest rates, even to 0.25-0.50%, would require the Federal Reserve to fully reverse the $600 billion of asset purchases it conducted under QE2. Alternatively, with the monetary base now exceeding 16 cents for every dollar of nominal GDP, any external upward pressure on interest rates (that is, not produced by a Fed-initiated reduction in the monetary base) would quickly provoke inflationary pressures.

Last week, my friend John Mauldin reprinted our April 11 market comment Charles Plosser and the 50% Contraction in the Fed's Balance Sheet . John told me that he had received several nearly identical questions, along the lines of "Wait, now I'm confused - I thought that the Fed reduces inflation pressures by raising interest rates. Why would higher interest rates trigger inflation?"

So, this is where that phrase "external upward pressure" comes in. We have to distinguish between what economists would call an "endogenous" increase in interest rates - one that the Fed itself provokes by reducing the monetary base - and an "exogenous" increase in interest rates - one that is produced by changes in the behavior of investors and the economy, independent of actions by the Fed.

See, when the Fed decides to raise interest rates, it does so by reducing (or slowing the growth) of the monetary base, which can reasonably be viewed as an "anti-inflationary" policy. However, if interest rates rise independent of any change in the monetary base, then cash - which doesn't bear interest - becomes a "hot potato" that is suddenly less desirable. Somehow, the excess cash has to be "absorbed" in the sense that someone becomes willing to hold it despite the higher interest rates. Unless real output expands sufficiently to absorb that cash, you get one of two alternative outcomes: people holding cash may bid up Treasury bills, lowering short-term interest rates to the point where people are again indifferent between cash and non-cash alternatives, or failing that, the attempt to get rid of cash holdings in other ways provokes inflation and a depreciation in the foreign exchange value of the dollar (which was the outcome in the 1970's).

As I've argued elsewhere, one of the primary sources of exogenous inflationary pressure is growth in unproductive forms of government spending (spending that creates demand but does not expand capacity or incentive to produce), but I'll leave that feature of the argument for another time.

Monetary Policy in 3-D

The extreme stance of monetary policy is such a critical factor in the financial markets here that it is worth spending a bit more time on the relationship between interest rates, inflation, and the monetary base.

Let's return to the concept of "liquidity preference" - basically the "demand curve" for base money (currency and bank reserves). To make this operational, we define liquidity preference as the amount of base money that individuals choose to hold per dollar of nominal GDP, given any particular level of short-term interest rates. The chart below shows this "demand curve" for money in monthly data since the 1940's. Notice that when interest rates are high, there is a significant "opportunity cost" to holding base money, so people cut back on the balances they hold. When interest rates are low, people are willing to hold a greater amount of non-interest bearing money per dollar of GDP.

What's critical about liquidity preference is this - while there are numerous combinations of T-bill yields, monetary base, and nominal GDP that will produce equilibrium (demand for money = supply of money), the three variables are "jointly constrained." For example, suppose that there is upward pressure on interest rates which reduces the attractiveness of non-interest bearing cash. If the Federal Reserve does not reduce the monetary base sufficiently to move left to the appropriate point on the "demand curve," the burden of adjustment is instead thrown onto nominal GDP. Since variations in real GDP have a fairly limited range, the majority of that adjustment is forced to take the form of price increases (i.e. inflation) sufficient to bring the ratio of the monetary base to GDP down to the appropriate level.

Similarly, if the Fed creates a great deal of base money, and the components of nominal GDP (real GDP and prices) are fairly "sticky", short-term interest rates will decline to a level sufficient to ensure that the additional money is held (this has been essentially the story of QE2).

If you like equations (if not, skip this paragraph), by our estimates, about 96% of the historical variation in U.S. money demand is described by a fairly simple equation relating the Treasury bill yield ("i") and the amount of monetary base per dollar of nominal GDP (M/PY): i = exp(4.25 - 129.87*M/PY + 84.42*M/PY_lagged_6_mos). In some of the recent pieces I've written, I've used the "steady state" of this equation, which is i = exp(4.27 – 45.5*M/PY). See the original "Sixteen Cents" piece for further details.

Below, I've plotted this liquidity preference relationship as a 3-dimensional surface. This is essentially the "policy surface" faced by the Federal Reserve. Nearly all of the historical data is captured by periods where the amount of monetary base per dollar of GDP changed by less than 1 cent either way over any 6-month period. The blue marbles on the graph represent actual data points since the 1940's. The marbles on the floor along the right side of the graph aren't technically off the policy surface, but are clearly outliers because of the abrupt shift in monetary base per unit of GDP that occurred between 6-month periods during the recent financial crisis, which were associated with a plunge in interest rates toward zero.

As should be evident, the historical liquidity preference relationships we've been discussing are very tight. This is why I am so adamant that quantitative easing is an irresponsible policy - we know how these variables are related. Specifically, it will be nearly impossible to normalize interest rates, even slightly, without a massive contraction in the Fed's balance sheet. Likewise, as we approach 17 cents of monetary base per dollar of nominal GDP, even the slightest exogenous interest rate pressure will imply the need for massive reversals in the monetary base in order to avoid steep inflationary pressures. My hope is that my previous comment Will the Real Phillips Curve Stand Up? makes it clear that there is very little "tradeoff" between unemployment and general price inflation.

Since a picture is often worth a thousand words, I've included a few additional perspectives of the "policy surface" that the Federal Reserve faces here. The chart below is a head-on view. The point at the far right shows the present stance of monetary policy. Charles Plosser of the Philadelphia Fed is quite correct that normalizing interest rates to about 2.5% would imply a reduction of nearly 50% in the Fed's balance sheet, but as I noted two weeks ago, the required cutback in the balance sheet is extremely front-loaded, as a non-inflationary move to a Fed Funds rate of just 0.25% would require a reduction in the monetary base from about 17 cents to less than 13 cents per dollar of GDP, taking the monetary base from $2.6 trillion to less than $2 trillion - effectively reversing QE2 in its entirety.

The following chart shows the policy surface, along with actual data points, from the origin. We are now way out on the flat part of the curve. Again, in order to achieve even a slight endogenous increase in interest rates, the Fed will have to reduce the monetary base sharply. Alternatively, in order to offset the inflationary pressure from a slight exogenous increase in interest rates, the Fed would be forced to respond with a sharp tightening in its balance sheet. Both normalizing policy, and failing to normalize it, now present the economy and the financial markets with hazards that, in my view, were needless in the first place.

As a final note, the Fed does have an additional policy tool - the ability to pay interest on bank reserves, in hopes of preventing base money from becoming an inflationary "hot potato." The difficulty here is that the Fed's balance sheet is now leveraged 51-to-1. Even 0.25% of annual interest on reserves works out to about 12% of the Fed's total capital. The Fed is already in a position where a 35 basis point increase in long-term interest rates would effectively wipe out that capital. Though the Fed does earn interest on the Treasury debt it holds (which is remitted back to the Treasury for public uses), it would still take an increase in long-term interest rates of less than 1% to wipe out the Fed's capital as well as its entire net interest margin. So while the Fed might have the latitude to pay another 0.25% of interest on reserves, every extension of its present policy course, be it more quantitative easing, or paying interest on existing bank reserves, substantially increases its already untenable level of balance sheet leverage, and the likelihood that the public will quietly need to subsidize that balance sheet.

The Fed Sends the Message That It Wants Speculation

by Bruce Krasting

So the president of the United States has ordered the Attorney General to go after the speculators who have been drive up the price of oil and therefore gas. What can I say about this? Does the President think the American people are stupid? No one is going to fall for this line of crap.


Up front, let me acknowledge my guilt in this matter. I’m a speculator. I try my best at it. Some of my best friends are speculators. Many of my readers are speculators. In one-way or the other we are all speculators. Those that don’t think they speculate are actually speculators.

My local oil delivery company let’s me play in the big casino. I bought an option at a fixed price for 5,000 gallons of heating oil. The premium for the option was 20 cents a gallon. So I paid them $1,000 cash. That was sort of gambling money. If the cash price were to fall I’d get the lower price. If it rises, my cost is locked in. Last I looked I was 70 cents in the money. My option cost was 20 cents so I’m “up” 50 cents on 5,000. That’s $2,500 so I’m feeling good on this spec.

It’s not hard to find ways to make money in a rising energy market. I don’t have the balls to trade Brent futures. I overweight energy names in the global stock market. It’s worked pretty well.

I have some investments with funds that do trade energy futures (a “macro” directional fund). They’ve been doing great. I have nothing to do with their market bets, but since I (and many others) provide the equity I have to take some responsibility for their actions.

So if the AG is looking for someone who’s hands are “dirty”, well, I guess I’m on the list. If he did look me up, I would tell him that it was the Ben Bernanke that told me to do it. If the Justice Department wants to lean on me they also have to lean on the Fed.

If the AG, Eric Holder, bothered to look it wouldn’t be too hard for him to see that the blame for all this speculating can be laid at the feet of the Fed. Mr. Holder will not need a PhD in Economics to make this conclusion. All he has to do is read the FAQ’s on the home page of the Federal Reserve. From the FAQ (link):

Monetary policy also has an important influence on inflation. When the federal funds rate is reduced, the resulting stronger demand tends to push wages and other costs higher.

Ah! This is easy. When the Federal Funds rate is low, inflation rises. The price of goods rise! So what is the policy on Federal Funds? Also easy. It has been ZERO for the past two and a half years! What’s the outlook for ZERO interest rates being maintained? That’s easy too!! The Fed tells us every six weeks or so:

Interest rates will be kept exceptionally low for an extended period of time.

So the Fed is telling us in its FAQ that they want goods to go up in price. Now all they have to do is push me into action as a speculator. More from the FAQ:

policy actions can influence expectations about how the economy will perform in the future, including expectations for prices

To me, this is pretty clear, hopefully Holder will agree. The Fed has succeeded in its effort to change my expectations of the future of my energy costs. With my expectations being influenced, it is only natural that I would react. When I pay $1,000 to lock in a price to heat my home it is exactly what Bernanke would want me to do. I’m the best evidence that he has that his policy is “working”.

I think most Americans understand that we import half our oil and that the value of the dollar is a big factor in the price we pay for crude. A weak dollar causes the price of oil to rise. So what's the Fed’s policy on the dollar? Once more from the FAQ:

movements in the exchange value of the dollar represent an important consideration for monetary policy--such movements exert influence on U.S. economic activity and prices

Bingo! The desired consequence of the Fed’s monetary policy is to devalue the dollar in order to increase economic activity. But that same action also results in higher imported prices for crude. The only conclusion that I can come to is that higher oil prices are the desired consequence of Fed policy. Bernanke has brought me to the water and strongly suggested I should drink some. It's all spelled out in the FAQs. Its not hidden in some obscure language. Shame on me (and the President) if I had ignored such an obvious outcome.

The President and the AG need to determine why folks like me are speculating rather than just blaming me for high prices. When they look at the facts they can’t help but see that it is Bernanke that’s behind all that high priced gas. The speculators like me are just the mechanism that Bernanke uses to achieve his ends.

David Stockman: Fed's Monetary Path of Destruction

This is part two of a two-part series. I value Stockman's opinion particularly because he is a partner in a Private Equity firm. They know what makes business and free enterprise tick better than any other group of people in the world.

GREENWICH, Conn. (MarketWatch) — The destructive result of the Federal Reserve’s earlier housing and consumer credit bubble became the excuse for embracing a destructive zero interest rate policy which is self-evidently fueling even more destruction.

This destruction is namely, the exploitation of middle class savers; the current severe food and energy squeeze on lower income households; the illusion in Washington that Uncle Sam can comfortably manage $14 trillion in debt because the interest carry is close enough to zero for government purposes; and the next round of bursting bubbles building up among the risk asset classes. 

Moreover, the Fed soldiers on with its serial bubble-making, even though it is evident that the hallowed doctrines of modern monetary theory and the inherently dubious math of Taylor rules have failed completely.

Indeed, the evidence that the Fed no longer has any clue about the transmission pathways which connect the base money it is emitting with reckless abandon (e.g. Federal Reserve credit) to the millions of everyday pricing, hiring, investing and financing outcomes on Main Street sits right on its own balance sheet. Specifically, if the Fed actually knew how to thread the needle to the real economy with printing press money it wouldn’t have needed to manufacture $1 trillion in excess bank reserves — indolent entries on its own books for which it is now paying interest.

So in the present circumstances, ZIRP and QE2 amount to a monetary Hail Mary. There is no monetary tradition whatsoever that says the way back to U.S. economic health and sustainable growth is through herding Grandma into junk bonds and speculators into the Russell 2000 (NASDAQ:RUT)  .

Admittedly, the junk-bond financed dividends being currently extracted by the LBO kings from their debt-freighted portfolios may enable them to hire some additional household help and perhaps spur some new jobs at posh restaurants, too. Likewise, the 10% of the population which owns 80% of the financial assets may use their stock market winnings to stimulate some additional hiring at tony shopping malls.

That chairman Bernanke himself has explained in so many words this miracle of speculative GDP levitation, however, does not make it so. The fact is, if transitory wealth effects add to current consumer spending, they can just as readily subtract on the occasion of the next “risk-off” stampede to the downside. Indeed, the proof — if any is needed — that cheap money fueled asset inflations do not bring sustainable prosperity lies in the still smoldering ruins of the U.S. housing boom.

In truth, the Fed’s current money printing spree has no analytical foundation, and amounts to seat-of-the-pants pursuit of a will-o’-wisp — the idea of a perpetual bull market. Like the Bank of Japan, the Fed has made itself hostage to the global speculative classes, and must repeatedly inject new forms of stimulus to keep the bubbles rising. 

This is the only possible explanation for its preposterous decision to allow the big banks to resume dissipating their meager capital accounts by paying “normalized” dividends and by resuming large-scale stock buybacks. These are the same financial institutions that allegedly nearly brought the global economy to its knees in September 2008, according to the Fed chairman’s own words.

In what is no longer secret testimony to the FCIC (Financial Crisis Inquiry Commission), Federal Reserve Chairman Bernanke claimed that the Wall Street meltdown “was the worst financial crisis in global history” and that “out of maybe 13…..of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two”.

That testimony was recorded just 15 months ago, but the financially seismic events it references have apparently already faded into the dustbin of history. Still, even if the dubious proposition that the banking system has fully healed were true, what did the Fed hope to accomplish besides goosing the S&P 500 (CME:INDEX:SPX)  via speculative rotation into the bank indices?

Well, there are no other plausible explanations. Certainly the stated theory — namely, that by green lighting disgorgements of capital today the Fed’s action will facilitate bank capital raising and new lending in the future —merits a loud guffaw. The fast money has already priced in whatever dividend increases and share buybacks may occur before the next banking crisis, but the last thing these speculators expects is a new round of dilutive capital issuance by the banks. Stated differently, the bid for bank stocks unleashed by the Fed’s relief action is predicated on speculators’ pocketing any near-term “surplus” capital, not leaving it in harms way.

Moreover, even if the Fed’s action had the effect of bolstering, not depleting, bank capital the larger issue is why does our already massively bloated banking system need more capital in any event? The reflexive answer is that this will help restart the flow of credit to Main Street, but it doesn’t take much digging to see that this is a complete non-starter.

The household sector is still saddled with massive excess debt — unless you believe that the credit bubble of recent years is the sustainable norm. The fact is, prior to the Fed’s easy money induced national LBO, debt-to-income ratios at today’s levels were unthinkable. In 1975, for example, total household debt—including mortgages, credit cards, auto loans and bingo wagers—was about $730 billion or 45% of GDP

During the 1980’s, however, this long-standing household leverage ratio began a parabolic climb, and never looked back. By the bubble peak in Q4 2007, total household debt had reached $13.8 trillion and was 96% of GDP. Yet after 36 months of the Great Recession wring-out, the dial has hardly moved: household debt outstanding in Q4 2010 was still $13.4 trillion, meaning that it has shrunk by the grand sum or 3% (entirely due to defaults) and still remains at 90% of GDP or double the leverage ratio that existed prior to the debt binge of the past three decades.

So the banking system does not need more capital in order to increase credit extensions to the household sector. In fact, the two principal categories of household debt — mortgage loans and revolving credit, continue to decline as American families slowly shed unsupportable debt. The only reason total household debt appears to be stabilizing in recent quarters is that student loan volumes are soaring, but this growth is being funded entirely by the Bank of Uncle Sam now that private bank loan guarantees have been eliminated.

Indeed, the startling fact is that the approximate $1 trillion of student loans outstanding — sub-prime credits by definition — now exceed the $830 billion of total credit card debt by a wide margin. While this latest student loan bubble will end no better than the earlier credit bubbles, the larger fact remains that the household sector is only in the early stages of deleveraging. Not the least of the self-evident motivating forces here is that the leading edge of the household sector — the 78 million strong baby boom generation — appears to be figuring out that it is not 1975 anymore, and that retirement and old age are approaching at a gallop.

This obvious household deleveraging trend remains a mystery to the Fed and to the Wall Street stock peddlers who occasionally moonlight as economists. One recent air ball offered up by the latter is that the ratio of debt to disposable personal income (DPI) has dropped materially, and that this proves the household sector has been healed financially and is ready to borrow again. Specifically, the household debt-to-DPI ratio has fallen to 116% from a peak of 130% in late 2007.

Never mind that this measure of household financial health stood at just 62% back during the healthier climes of 1975. It is evident that even the modest improvement in this ratio during the last three years is a statistical illusion. It turns out that the debt-to-DPI ratio is improving mainly because the denominator has gained about $885 billion or 8.3% since the end of 2007.

Yet this gain in DPI has nothing whatsoever to do with an improved debt carrying capacity in the household sector. Thanks to the more or less continuous riot of Keynesian stimulus in Washington since early 2008, we have had a tax holiday and a transfer payment bonanza. Specifically, in the three years since the fourth quarter 2007 peak, personal taxes are down at a $312 billion annual rate (which adds to DPI, an after-tax measure) and transfer payments are up by a $572 billion annual rate.

Both of these are components of DPI, and taken together ($884 billion) they account, quite astoundingly, for 99.8% of the DPI gain since Q4 2007. Moreover, it does not take a lot of figuring to see that these trends won’t last. The Federal tax take is now less than 15% of GDP — the lowest level since 1950 — and will be rising year-after-year in the decade ahead, as will personal tax burdens at the state and local level.

At the same time, the 30% surge in transfer payments over the last three years is mostly done. Unemployment insurance payments — which accounted for much of the rise — will be flat or shrinking in the near future, and various one-time low income programs have already expired. Moreover, the bulk of the current $2.3 trillion in transfer payments go to elderly and poverty level households which carry negligible portions of the $13.4 trillion in household debt, in any event.

By contrast, the ratio of household debt to private wage and salary income — a far better measure of debt carrying capacity — has not improved at all. Household debt amounted to 255% of private wage and salary income at the peak of the credit boom in late 2007, and was still 251% in Q4 2010. At the end of the day, the household debt-to-DPI ratio improved solely because Uncle Sam went on a borrowing spree and temporarily juiced DPI with tax abatements and transfer handouts.

In short, banks don’t need more capital to support household credit because the latter is still shrinking, and will be for a long time to come. Moreover, it might as well be said in this same vein that the business sector doesn’t need no more stinking debt, neither!

At the end of 2005 — before the credit bubble reached its apogee — the non-financial business sector (both corporate and non-corporate entities) had total credit market debt of $8.3 trillion, according to the Fed’s flow of funds data. By the end of 2007, this total had soared by 25% to $10.4 trillion. But contrary to endless data fiddling by Wall Street economists, the business sector as a whole has not deleveraged one bit since the financial crisis. As of year-end 2010, business debt was up a further $500 billion to $10.9 trillion.

The whole propaganda campaign about the business sector becoming financially flush rests on an entirely spurious factoid with respect to balance sheet cash. Yes, that number is up a tad — from $2.56 trillion in fourth quarter 2007 to $2.86 trillion at the end of 2010. Still, this endlessly trumpeted gain in cash balances of $300 billion is more than offset by the far larger gain in business sector debt — meaning that, on balance, the alleged cash nest egg held by American business is simply borrowed money.

At the end of the day, $10.9 trillion is a lot of debt in absolute terms, but based on the Fed’s data on the market value of business sector assets, it is also crystal clear that the relative burden of business debt has been rising, not falling. At the bubble peak in late 2007, business sector assets were valued at $41.5 trillion but alas this figure had shrunk to $36.9 trillion by the end of last year. The grim reaper of real estate deflation has done its work in the business sector, too.

Consequently, total business debt now amounts to 29.4% of business assets---a considerable rise from the 25.2% ratio at the bubble peak in late 2007. What the bullish cheerleaders of recovery constantly forget is that in an epochal deflation like the present one, debts remain at their contractual amounts, even as asset values wither.

So the real question regarding the Fed’s green light for bank dividends and buybacks is quite clear. Banks don’t need more capital to make new loans to households and business. What they actually need is to preserve their current artificially bloated retained earnings accounts in order to protect the taxpayers from the next — virtually certain — banking meltdown.

In this light, the Fed’s action is especially meretricious. If it weren’t in such a hurry to juice the stock market and thereby keep the illusion of recovery going, it might have considered extending the regulatory sequester on bank capital for a few more quarters or even years — thereby preserving a shield for the taxpayers until it has been demonstrated by the passage of time, not by the passing of phony stress tests, that the American banking system is truly out of the woods.

After all, the bottled-up profits currently alleged to be resident in the banking system have not been expropriated by the Fed; they have just been temporarily sequestered — a condition these wards of the state should gladly endure in return for continued access to taxpayer backed deposit insurance and the Fed’s borrowing widow, as well as their license to engage in the lucrative business of fractional reserve banking. Indeed, the fast money should be as capable of pricing in any “excess” capital in the banking system, as it has already been in goosing bank stocks in anticipation of higher profit distributions.

And it is here where the historical data on Bernanke’s 12 out of 13 crashing financial dominoes essentially speaks its own cautionary tale. At the peak of the credit and housing boom in 2006, these 13 most important financial institutions booked $110 billion of net income, and disgorged more than $40 billion of that amount in dividends and stock buybacks.

Would that these fulsome profits and attendant distributions had been real and sustainable, but the historical facts inform otherwise. By 2007, the groups’ profits had dropped to $64 billion, and then in 2008, the 10 institutions which survived to year-end reported a staggering loss of $56 billion. Moreover, if the massive loses incurred by the terrible three — Washington Mutual (NYSE:JPM) , Wachovia (NYSE:WFC) and Lehman — during their final, unreported stub quarter is added to the tally, losses for the year would approach $80 billion.

The unassailable truth here is that in 2006 and 2007 the banks were disgorging phantom profits to their shareholders. When the crunch came in 2008, bank capital had been badly depleted by these unwarranted dividends and stock buybacks.

The danger, of course, was buried in the balance sheets all along. Back in their 2006 heyday, the top 13 financial institutions had $10.2 trillion of total assets — and a not inconsiderable portion of that figure was worth far less than book value, as ensuing events proved. Today the nine banks which are the survivors and assigns of these 13 institutions still have $10.1 trillion in asset footings — hardly a measurable reduction despite the goodly amount of write-offs which have been taken in the interim.

The Fed’s foolish wager — and it is foolish because there is no real purpose other than a momentary boost to bank shares — is that this once toxic asset ridden $10 trillion balance sheet is now squeaky clean. Yet why would any sane observer embrace that dubious proposition?

While the banks have been relieved of mark-to-market accounting, they are still knee-deep in the very asset classes whose ultimate recoverable value remains exposed to the real estate meltdown. Residential housing prices are now clearly in the midst of a double dip, and rates of new construction and existing unit sales are spilling off the bottom of the historical charts

Still, the banking system holds $2.5 trillion of residential mortgages and home equity lines — plus $350 billion of construction loans and more than a trillion of mortgage backed securities. Maybe they have enough reserves to cover the remaining sins in this $4 trillion kettle of residential debt, but betting on housing bottom has been a widow-maker for several years now — and there is nothing on the horizon to suggest that this epochal bust will not make a few more.

Likewise, the banking system is carrying $1 trillion of commercial real estate loans, and the open secret is that “extend and pretend” refinancing is the primary underpinning of current book values. Similarly, the Fed has rigged the steepest yield curve in modern times, but it is a fair bet that as it is gradually forced to normalize interest rates, current record net interest margins will be squeezed. And it is also probable that some of the $2.7 trillion of government, corporate and other securities owned by the banking system may be worth less than par in a world where money rates are more than zero.

In short, a banking system that by the lights of the Fed was on the verge of extinction just 28 months ago could not possibly have gotten well in the interim. In shades of 2006, the nine survivors did report net income of $54 billion in the year just ended, and it is these retained earnings that have purportedly brought bank capital ratios to the pink of health. Then again, the cynic might wonder whether the trading book and yield curve profits of 2010 might not disappear as fast as did the mortgage origination, securitization and trading profits of 2006-2007.

One thing is certain, however, and that is that these behemoths are now truly too big to fail. At the end of 2006, the asset footings of the Big Six — J.P. Morgan, Bank of America (NYSE:BAC)  , Wells Faro (NYSE:WFC)  , Citigroup (NYSE:C) , Goldman Sachs (NYSE:GS)   and Morgan Stanley (NYSE:MS)  — were $7.1 trillion. Saving the system through shotgun marriages in the interim, our financial overloads have permitted the group to grow its assets by 30% to $9.2 trillion.

If you believe that these massive financial conglomerates are a clear and present danger to the American economy, you might opine that they are too big to exist, as well. But even from a more quotidian angle — unless you are in the banking index for a trade — it’s pretty easy to see that so-called banking profits should have remained under regulatory sequester for a few more economic seasons, at least.

David Stockman is a former member of the House of Representatives and a member of the Reagan administration. He currently owns his private equity fund, Heartland Industrial Partners, L.P .

David Stockman: Fed Practices Chrony Capitalism

By David Stockman

This is part one of a two-part series by David Stockman.

GREENWICH, Conn. (MarketWatch) — Someone has to stop the Federal Reserve before it crushes what remains of America’s Main Street economy.

In the last few weeks alone, it launched two more financial sector pumping operations which will harm the real economy, even as these actions juice Wall Street’s speculative humors. 

First, joining the central banking cartels’ market rigging operation in support of the yen, the Fed helped bail-out carry traders from a savage short-covering squeeze. Then, green lighting the big banks for another go-round of the dividend and share-buyback scam, it handsomely rewarded options traders who had been front-running this announcement for weeks.

Indeed, this sort of action is so blatant that the Fed might as well just look for a financial vein in the vicinity of 200 West St., and proceed straight-away to mainline the trading desks located there.

In any event, the yen intervention certainly had nothing to do with the evident distress of the Japanese people. What happened is that one of the potent engines of the global carry-trade — the massive use of the yen as a zero cost funding currency — backfired violently in response to the unexpected disasters in Japan.

Accordingly, this should have been a moment of condign punishment — wiping out years of speculative gains in heavily leveraged commodity and emerging market currency and equity wagers, and putting two-way risk back into the markets for so-called risk assets.

Instead, once again, speculators were reassured that in the global financial casino operated by the world’s central bankers, the house is always there for them—this time with an exchange rate cap on what would otherwise have been a catastrophic surge in their yen funding costs.

Is it any wonder, then, that the global economy is being pummeled by one speculative tsunami after the next? Ever since the latest surge was trigged last summer by the Jackson Hole smoke signals about QE2, the violence of the price action in the risk asset flavor of late — cotton, met coal, sugar, oil, coffee, copper, rice, corn, heating oil and the rest — has been stunning, with moves of 10% a week or more. 

In the face of these ripping commodity index gains, the Fed’s argument that surging food costs are due to emerging market demand growth is just plain lame. Was there a worldwide fasting ritual going on during the months just before the August QE2 signals when food prices were much lower? And haven’t the EM economies been growing at their present pace for about the last 15 years now, not just the last seven months?

Similarly, the supply side has had its floods and droughts — like always. But these don’t explain the price action, either. Take Dr. Cooper’s own price chart during the past 12 months: last March the price was $3.60 per pound — after which it plummeted to $2.80 by July, rose to $4.60 by February and revisited $4.10 per pound.

That violent round trip does not chart Mr. Market’s considered assessment of long-term trends in mining capacity or end-use industrial consumption. Instead, it reflects central bank triggered speculative tides which begin on the futures exchanges and ripple out through inventory stocking and de-stocking actions all around the world — even reaching the speculative copper hoards maintained by Chinese pig farmers and the vandals who strip-mine copper from the abandoned tract homes in Phoenix.

The short-covering panic in the yen forex markets following Japan’s intervention, and the subsequent panicked response by the central banks, wasn’t just a low frequency outlier — the equivalent of an 8.9 event on the financial Richter scale. Rather, it is the predictable result of the lunatic ZIRP monetary policy which has been pursued by the Bank of Japan for more than a decade now--and with the Fed, BOE and ECB not far behind.

Thinking beyond the Fortune 500 for women

Claudia Goldin tells WSJ's Alan Murray that women are making their way to the top at many Ivy League schools. Plus: Saadi Zahidi of the World Economic Forum discusses how women in foreign countries are contributing to their nations' economies.

Japan has been suffering from a real estate asset deflation which followed the collapse of its spectacular 1980’s financial bubble — but not price deflation on consumer goods and services. In fact, Japan’s headline CPI index was 94.1 in 1990 compared to 99.8 during the last quarter of 2010. Thus, during the past 20 years there has been a slight CPI inflation (0.3% annually) — notwithstanding the incessant deflation-fear mongering of the Keynesian commentariat. 

To be sure, Japan’s so-called “core” CPI is down several points during that long period, but by all accounts the Japanese people have been eating, driving and heating their homes for the past two decades on a regular basis. Accordingly, they have paid slightly more for mostly imported food and energy and slightly less for everything else. But the overall consumer price index has been flat, meaning that real interest rates have been zero for the better part of a decade now.

And that’s the evil. Free money has not reflated domestic real estate because Japan’s bubble era prices were absurdly high and can’t be regained, and because Japanese real estate — both residential and commercial — is still heavily burdened with debt which cannot be repaid. Yet market economies — even Japan’s cartelized kind — are not disposed to look a gift horse in the mouth. Free money always finds an outlet, and the pathway of choice has been the transformation of the yen into a global “funding” currency.

This sounds antiseptic enough, but it means that in its wisdom the BOJ has invited the whole world — everyone from Mr. and Mrs. Watanabe to state-of-the-art London hedge fund traders — to short the yen in order to finance speculations in the Aussie dollar, the big iron and copper miners, cotton futures, the Brent/WTI spread, and an endless procession of like and similar speculative cocktails. Yet as the speculators rotate endlessly from one risk asset class to the next they can remain supremely confident that their yen carry cost will remain virtually zero. Yen interest rates will not go up because the BOJ is intellectually addicted to ZIRP, and because, in any event, it dare not surprise the market with an interest rate hike, thereby triggering a violent unwind of the yen carry trades it has fostered

In short, the BOJ is sitting on a financial fault line. The post-intervention rip to 76 yen to the dollar was not the work of a fat finger; instead, it represented a real-time measure of the furies bottled up in the system due to Japan’s foolish rental of its “funding currency” to global speculators. Having long ago urged the BOJ to embrace this absurd monetary policy, it is not uprising that Bernanke and his confederates have come to the rescue—for the moment.

It is only a matter of time, however, before the yen explodes under the accumulated short seller’s pressure, and then the lights will really go out on Japan Inc. In the meanwhile, ordinary people the world around will get less food per dollar from Wal-Mart Stores Inc. (NYSE:WMT)  and speculators, basking in the wealth effect, will have even more dollars to spend at Tiffany & Co. (NYSE:TIF)  

In this context, there can also be little doubt that the Fed is trying really hard to transform the dollar into a funding currency, too. In the name of fighting a phantom deflation, the nation’s central bank has kept interest rates absurdly low—transforming the dollar into a weakling even against the misbegotten Euro, and therefore something which speculators can more safely short.

But just like the case of Japan, there is no sign of CPI deflation in the U.S. Our headline CPI index has gone from 130.7 in 1990 to 218.1 in 2010 — marking a 2.6% annual inflation over the past two decades. And, no, it hasn’t slowed down much during the Bernanke era of deflation phobia.

The headline CPI index has risen at a 2.4% rate in the last 10 years, hardly a measureable de-acceleration; and it has gained at a 2.2% rate in the last five years — a rate at which, as Paul Volcker right observed, the purchasing power of the dollar would be cut in half during the typical American’s working lifetime. Even since the alleged June 2009 recession bottom, the headline CPI has climbed at a 2.1% annual rate.

So there is no deflation — just a simulacrum of it based on the observation that the CPI less food and energy has randomly fluttered around the flat-line on several recent monthly readings. It is not obvious, of course, that the rise of this index at a 1.1% annual rate during the last 20 months of recovery is a bad thing — for at that rate we begin to approach the idea of honest money. But the spurious circular logic of the Fed’s focus on this inflationless inflation index is self-evident upon cursory examination of its internals.

Fully 40% of the CPI less food and energy is owner’s equivalent rent—the one price that is actually deflating and which is doing so precisely due to the Fed’s own policies. Residential rents are falling or flat because the market is being battered with a) millions of involuntary rental supply units owing to the wave of home mortgage foreclosures, and b) an extraordinary shrinkage in the number of rental units demanded due to the doubling-up, and even tripling-up, of destitute households.

Part two of this column will be published next week.

David Stockman is a former member of the House of Representatives and a member of the Reagan administration. He currently owns his private equity fund, Heartland Industrial Partners, L.P.

Roller Coaster Day for Stocks

I'm seeing a new phenomena over the past few weeks. In the past, when the stock market opened, we would see buying at the open that would drive the market higher. Now, over the past several sessions, we are seeing selling at the open instead.

In this chart, prices chopped higher on thin volume in a melt-up overnight, but sold off at the market open. While the buying is thin, the selling is occurring on heavy volume, which is suggestive of fund selling of all kinds (hedge, pension, mutual funds, etc.). The volume has shifted from bullish to bearish, at least temporarily. The same thing has occurred several times in the past few weeks.

There appears to be a change in the wind, and I suspect that it is because the market is anticipating the end of the Fed's quantitative easing program in June. The nearly infinite liquidity that the Fed has provided will soon come to an end -- for the time being. Of course, anything could change by summer. I'll be anxiously awaiting the Fed's policy statement following its meeting at the end of April.

Reserves May Ignite Much Higher Inflation As Banks Ramp Up Lending

by Scott Grannis at Calafia Beach Pundit blog:

 

Even as the evidence of rising inflation expectations mounts, it's important to not lose sight of the bigger monetary policy picture. The Fed has taken some extraordinary measures to ensure that the U.S. and world economies do not have to struggle with any shortage of liquidity. That involved the purchase of almost $1.5 trillion worth of MBS and Treasury notes. But the popular perception that they have expanded their balance sheet by printing massive amounts of new money (aka monetizing the deficit) is incorrect. Yes, they have created massive amounts of bank reserves, but almost all of those reserves are still sitting on the Fed's books—they have not been turned into newly printed money. The world probably has too many dollars, as suggested by the declining price of the dollar and the rising prices of gold and commodities, but the excess of dollars is not measured in trillions.

As I explained in a prior post, the Fed has not printed $1.5 trillion of new money—they have simply swapped $1.5 trillion of bank reserves for $1.5 trillion of notes and bonds. The bank reserves they have created are functionally equivalent to 3-mo. T-bills, and thus are viewed as among the very safest of asset classes on the planet. The Fed has apparently satisfied the world's demand for safe cash equivalents. By swapping reserves for notes and bonds, the Fed also has effectively shortened the maturity of outstanding Treasury debt. They haven't monetized the debt, they've shortened its maturity. That may well prove to be a very imprudent move from the government's perspective, especially if interest rates rise significantly, but it will shift a meaningful portion of the mark-to-market losses on notes and bonds in a rising interest rate environment away from the private sector and onto the Fed's books. Our government, and ultimately, taxpayers, are now more exposed to rising interest rates, whereas institutional investors are less exposed.

The charts that follow demonstrate that the only extraordinary result of the Fed's extraordinary actions has been an extraordinary increase in bank reserves. All other measures of the money supply are behaving within the range of historical experience. 

Bank reserves have increased by $1.4 trillion since September, 2008, when the Fed first began to implement its Quantitative Easing program. About $400 billion of that increase has occurred since QE2 began last November.

The Monetary Base (which consists of bank reserves and currency in circulation) has increased by about $1.6 trillion since quantitative easing started. $1.4 trillion of that increase represents bank reserves, and most of the remaining $200 billion consists of an increase in currency in circulation. As the second chart above shows, the growth of currency has not been exceptional at all when viewed in an historical perspective. In fact, currency growth was much faster during the 1980s and 90s, when inflation was generally falling. The most important fact to remember when it comes to currency is that the Fed only supplies currency to the world on demand. The Fed does not print up piles of currency and then dump them into the world. People only hold currency if they choose to hold it; excess currency can be easily converted into a bank account at any bank, and the Fed must absorb any unwanted currency at the end of the day, since banks are free to exchange unwanted (and non-interest-bearing) currency for interest-bearing reserves, and would be foolish not to.

The M2 measure of the money supply includes currency, checking accounts, retail money market funds, small time deposits, and savings deposits. As the chart above shows, M2 has been growing about 6% per year on average, after experiencing a "bulge" in late 2008 and early 2009 that was caused by an exceptional increase in the public's demand for liquidity. If banks had been turning their extra reserves into newly-printed money (which our fractional-reserve banking system allows), then M2 would be growing like topsy: $1 trillion of new bank reserves could theoretically support about $10 trillion of new M2 money, and nothing like that has happened.

So, at the end of the day, about all that has happened is that the Fed has exchanged about $1.4 trillion of bank reserves for an equal amount of notes and bonds. No new money has been created in the process, beyond that which would have been created in a normally growing economy with relatively low inflation.

That's not to say that banks will forever allow their reserves to sit at the Fed. In fact, banks appear to be stepping up their lending activities to small and medium-sized businesses, but these actions are still in the nature of baby steps. If the Fed fails to take action to withdraw unwanted reserves in a timely fashion, or to somehow convince banks to leave their reserves on deposit at the Fed, then we could have a real inflation problem on our hands. But that remains to be seen. The weak dollar and rising commodity and gold prices suggest we are in the early stages of a rise in the general price level that, in turn, would equate to a rise in inflation to, say, 5-6% per year. If banks begin to turn their reserves into new money in a big way, then we could potentially see inflation rise well into the double or even triple digits.

Allen Meltzer yesterday proposed one solution to this potential problem in yesterday's WSJ: "The Fed Should Consider a Bad Bank." He suggests that the Fed simply transfer all the extra reserves to a separate bank where they would be held until maturity, and thus unavailable to the banking system. I think it's also possible that the Fed could sell a significant portion of its reserves, by effectively reversing the swaps that created them in the first place. Would banks, and the financial system they serve, be willing to swap their risk-free reserves for notes and bonds? They might, especially if interest rates rise by enough, and if the world sees that the Fed has embarked on a viable exit strategy that will avoid totally undermining the value of the dollar.

The monetary policy picture is far from clear, and it is still potentially very disturbing. But it is not impossible or even catastrophic, not yet.