By Dan Amoss
November 2, 2010
We could see some fireworks in the market this week. We have the midterm elections in the U.S., of course. But we also have what some are billing one of the most important policy meetings of the Federal Reserve is its history.
The Fed is boxing itself in, allowing the markets to dictate its decisions. Over the next few years, as a huge portion of the national debt needs to be rolled over, political pressure on the Fed to keep rates low will grow dramatically. With repeated doses of quantitative easing (QE), the Fed risks surrendering its remaining shreds of credibility and independence.
If bond investors lose confidence in the Fed, then financial markets will be in serious trouble. It may happen soon, depending on how aggressively QE2 is implemented. In his latest Investment Outlook, Bill Gross of PIMCO hits the nail on the head: “Check writing in the trillions is not a bondholder’s friend,” Gross writes; “it is, in fact, inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public debt, actually, has always had a Ponzi-like characteristic.”
PIMCO’s opinion matters, as it’s the largest bond manager in the world.
This may represent a prudent course of action for the PIMCOs of the world, but what of other Treasury bond holders — banks, insurance companies, and foreign central banks? What if they look for the exits? If so, the Fed would have to print much more money than it expects in order to “cap” or “target” long-term Treasury yields.
This is why the Fed is playing with fire starting next week. It was one thing to open the “liquidity” floodgates in 2008 when everyone wanted to dash to cash, no matter how cheap the assets they had been holding. It’s another thing entirely to try to use monetary policy to lower unemployment. This notion is so ridiculous that only an academic in an ivory tower could dream it up. It’s very likely to fail, and when it does, the financial markets won’t like it. The bond market could start looking more like it did in the late 1970s than in did in the 1930s.
Gross lays blame for reaching this unpleasant state on the spendthrifts we elect to Congress. That’s only partly true. Past Congresses could not have spent nearly as much if it weren’t for the Federal Reserve.
Since the end of the gold standard, we’ve been left with a Ponzi paper currency system — one without any guarantee that its value will be safeguarded by constraints on its supply. The concept of funding investments with savings went out the window a long time ago. Now, new credit largely funds investments. The mantra of propping “demand” up — by any means necessary — is the mainstream economist view. This begs the question: How can you have demand without supply? The answer is you cannot — not for very long, anyway.
A country that consumes far more than it produces can live off its accumulated capital for a while, until it self-cannibalizes. Claims on production and capital can be handed out with gusto. Today, they take the form of new Treasury notes and new U.S. dollars. But sooner or later, producers begin to question the value of those paper claims. At that point, they require a few more currency units to part with a unit of their production. Saudi Arabia lifting its target range for crude oil prices would be just one example.
Control over the world’s reserve currency is a privilege that shouldn’t be abused. Yet the Fed has abused it, and doesn’t look to be letting up.
Savers and investors could choose to implement their own monetary policy. It’s pretty certain that more and more people with capital will shift a percentage of their assets to gold, as insurance against a bonfire of fiat currencies.
Savers and investors must cooperate if central banks are to achieve their absurd “goals” of tweaking the economy here and there. If Ben Bernanke is giving savers no reason to treat the U.S. dollar as a store of value, then it should be no surprise that they will not.
If QE2 backfires, resulting in continued price strength in “undesirable” items (i.e., food and energy), then the Fed will be compelled to tap on the monetary brakes.
Meanwhile, in the wake of the market’s “QE2 anticipation rally,” technical trading conditions are signaling danger for bulls in the near future.
Sincerely,
Dan Amoss
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