Start the Money Printing Presses!

Ben Bernanke assured the world that the Fed is ready to support the economy, if needed with additional market operations, which in effect amounts to printing money and keeping treasury rates low.  Keeping rates low will be necessary, because the consequence of high US borrowing rates would otherwise create a debt crisis for the US government. Ultimately this will result in inflation, and then the real crisis will come about when the Fed has to choose between inflation, or forcing the US treasury into a default scenario. Inflation will clearly be the preferred outcome.

* Helicopter Ben to the rescue – Perpetuating the Lie. The markets took temporary solace from Ben Bernanke’s Friday morning speech in Jackson Hole. In short, he assured the markets and the world, that the Fed will respond with additional easing, as needed to counteract the economic slowdown, should such an event unfold. This came after Bernanke admitted that the economic forecast is uncertain, with a higher chance of a new recession, than the Fed had previously thought. (What about the recession we have been in for 2 years?)

It is presumed that the Fed will respond to economic weakness through its cogently titled “Quantitative Easing” operations. The reality is that the Fed is going to monetize the treasury’s debt, which helps keep interest rates low, and at the same time, the deficits which the Treasury spends, will result in more cash entering the economy. Ultimately, the increase in cash in circulation will result in selective price inflation, and investors will begin to sell the dollar. Because every other country’s economy is dependent on maintaining their currency at levels which supports exports, the battle amongst currencies will be a race to the bottom. At the end of the day, the countries which run the most cumulative surpluses will wind up with the strongest currencies. That should reduce the amount of exports from these countries, and in turn, is supposed to shift economic activity to those countries which are running the deficits. But the countries with positive trade surpluses do not want to see that happen, so in turn, they have chosen to accumulate the currencies of the US and Euro-zone, which are running deficits. In addition, China has started to accumulate the Japanese Yen, which is a net exporter.

The Yen is the most interesting because they have endured deflation over the last 20 years. They do not have a mortgage problem, as they have been working out their problems over the last 20 years. Their currency is sound, with one small caveat: The government’s debt is now 200% of GDP, which is funded by government controlled savings institutions and national pensions. Even more twisted than the situation in the US, rates on Japanese government debt is the lowest in the world, with 1% rates for 10 year paper. More on the Yen and the psychology of a trade war which will be fought via exchange rates tomorrow.

Here is the point: the Fed is going to monetize the nation’s debt, and ultimately unleash inflation. Just for the record, doing so, and keeping interest rates low will prevent a US treasury debt collapse. It was when interest rates on Greek debt rose above 6% that the market started to calculate the compounding costs of interest on interest at those higher rates. By keeping US rates low, the Fed will keep the markets from coming to the conclusion that higher rates have the potential to sink the US’s ability to service its debt. Imagine what the models would do to the US if the marginal rate for new debt was 7%? If you assume that the average US rate would drift up to an average of 5%, then that would mean that $700 billion a year would be spend on interest, about 3 times the current cost of servicing the US’s debt. On top of current projections of $1 trillion deficits as far as the eye can see, this would mean actual deficits of $1.5 trillion a year. The way the forecasting models work, if interest rates rise to a certain level, then the US would not be able to ever pay back its debt. This is why it is so important that the Fed keeps interests rates low. No one is talking about this, but in my opinion, it is extremely important to the viability of the US’s international credit standing.

Based on the praise which has been heaped on the Fed and Bernanke over the last two years, I wonder how invincible Bernanke thinks he and the Fed actually is. Obama has credited him with averting a depression. I am inclined to think that Bernanke has only delayed the inevitable. Because there has to be some unwanted consequences from the aggressive monetary policy the Fed is undertaking.

Listening this morning to CNBC, I could not help absorb the nonchalance with which Steve Leisman, CNBC’s economic reporter, and seemingly most competent Fed watcher, calmly asked his guests about their thoughts on the likelihood that the Fed will execute additional QE operations. This would have been heresy a few years ago. Now we accept printing money as a natural policy response to a deteriorating economy. Very little was said about Germany’s excursion into money printing in the 1920s, until it was too late. And few flags are being raised today.

I do not see a happy ending, with the size of the US deficits growing at a 7-10% annual rate. As total US debt levels rise, the threat of higher interest rates will eventually put the Fed between a rock and a hard place. The Fed will be able to keep rates low by buying treasury debt, but once inflation starts kicking in, in a year or two, the consequence of inflation will force the Fed to maintain a program of permanently buying treasuries, and printing money, since the alternative of higher rates will be even more damming than the hidden costs of inflation. Welcome to Germany in the 1920s, except this cycle is almost exactly 80 years later.

* Trading points: Stocks: I hate calling for something so dramatic as a crash, but we are rapidly approaching a time when stocks are likely to end up in a free-fall. Over my vacation I sent a preview of this likelihood to the “real time distribution”, which outlined the existence of 4 week and 4 year cycles, which are pointing down into October. I can send you a copy of that study if you would like to see it. While this is the bear camp I am in, I am also wary of the fact that I am not alone in this scenario, and when a trade gets crowded, it usually is time to go the other way. 

To repeat a prediction I made in June (which I believe will be between now and November), there will come a point in time when the equity markets experience a down draft which takes the stock market down at least 13% in 8 trading hours, about 1.25 days, which represents the peak downside acceleration experienced in October of 2008. A break below recent lows (1010 on the S&P) could gather steam real fast, and become that downside an acceleration.

And to tie this in with the Fed, if such an event were to happen, then you have to be sure that the Fed will rush in with the printing presses in full gear.