Bernanke's Bluff

Dear Reader,

The practice of Zen revolves around the idea of being “in the moment,” clearing the mind and being fully engaged in what you are doing at any given time, regardless of whether that activity is pondering the local vegetation or stomping on a spider.

Wait, I’m not so sure about that last bit, but you get the idea.

While I aspire to such streamlined awareness, I fear my path to a Zen-like enlightenment will be a long one. At this very moment, well before sunrise, as part of a regimen to adjust my internal clock precedent to a whirlwind trip to four countries in eight days kicking off this weekend, I am attempting to more or less simultaneously (a) catch up on the pile of work I need to get done before said trip; (b) drink enough coffee to melt away the cobwebs that have built up in my brain overnight, and (c) put together coherent and at least mildly useful thoughts for this weekly missive.

With the strong suspicion I won’t be doing much navel pondering today, I begin.

Bernanke’s Bluff

In April of 2011, writing in The Casey Report, I warned readers of a pending shift in the Fed’s accommodative monetary policy. My view at the time was that the shift would result in a rebound in the dollar, which was in a state of near collapse at the time.

Should the Fed not end its quantitative easing on schedule in June, but rather roll straight into a new round of easing (QE3), it will send an unequivocal signal to the market that the dollar is to be sacrificed for political expediency. At which point the waterfall collapse in the world’s reserve currency could very well occur and any potential Treasury bond buyers – outside of the Fed, that is – will begin demanding higher interest rates. Those demands will have to be met, because the day that the Fed is effectively the sole buyer of Treasury debt will be the day the dollar dies.

Should the Fed step away from the auctions starting in June (and maybe, for propaganda points, in May), then the interest rate picture becomes a bit less clear. Will non-Fed buyers step into the $50 billion or so monthly gap left by the Fed’s exit? Or will they demand higher interest rates, setting off the death spiral in the process?

While it can only be conjecture at this point, I think the end of the Fed’s monetization will not cause an immediate spike in rates. For four reasons:

1. The dollar’s precipitous slide will suggest to traders and institutional market participants that it’s overdue for a rebound. A perfectly logical conclusion, given that should the dollar continue on its current steep downward trajectory, its days will be quickly numbered. As that is the sort of monumental event that happens only every few generations, most big money players will discount the demise of the dollar as a credible scenario, and so many will come back to Treasuries to play the bounce.
    
2. There are few alternatives to the U.S. Treasury market when it comes to parking big money. Even the relatively small amount of money now flowing into gold has sent it to nominal record highs – can you imagine what would (and ultimately, will) happen to the price if $500 billion tried to flow quickly into precious metals?
    
3. By exiting its quantitative easing, the Fed will be formally announcing a shift from a loose monetary policy to what might be called a “neutral” policy. Not too loose, not too tight, but just right (they hope). That will give potential buyers some degree of confidence that it’s okay to go back into the Treasury waters.
    
4. Last but not least, institutional equity managers are fully aware of the importance that free-flowing money has played in the recent rally. A tightening by the Fed could almost certainly be the pin that breaks the equities balloon. In the case of Japan’s first experiment of QE, following the collapse of its own housing and stock bubbles, during the quantitative easing the stock market rallied about halfway back to the bubble top. But almost immediately on stopping the easing, the stock market crashed back to earth, giving up about 50%. And what would happen in an equity market crash? If history is any guide, money would flee the equities in favor of the “safe harbor” of Treasuries. You can bet that this is also part of the Fed’s calculations.

As far as the Fed is concerned, it has done exactly what Chairman Ben Bernanke has said it would do – shower the economy with dollars. By stepping away from the quantitative easing, Bernanke begins to act on part two of his monetary hypothesis; that the Fed can mop things up before the dollar dies and inflation runs out of control.

At this point, seeing that the dollar is crashing and inflation and interest rates are already on the rise, the Fed’s hand is being forced. It really has no option but to step aside and hope for the best.

For awhile (two months? three? six?) the Fed’s gambit may pay off as a sufficient number of fools rush in to take the Fed’s seat at the Treasury auctions. So maybe rates remain flat or don’t rise overly much. But in the absence of the government making substantive cuts to current spending – there is, after all, an election to be bought – it is only a matter of time, and not very much time, before the Treasury’s borrowing needs will outstrip available buyers and interest rates will have to rise.

At that point, the endgame begins, leading to massive wealth destruction for the unprepared.

The Casey Report, April 2011

Likewise, in my article, Forlorn Hope, in the April 22, 2011 edition of this service, I repeated the warning about a turnaround in the dollar, especially as it related to the commodities in general, and the smaller resource exploration companies in particular.

If I am right, then the way to play it is to expect a near-term rally in the dollar. While the U.S. dollar is toilet paper, it is of a better quality than the euro or the yen. Which is not to say that it doesn’t deserve its ultimate fate – the fate of all fiat currencies – but rather that, as long as the Fed shows some restraint here, it may be able to stave off that fate a bit longer.

And that could put some serious pressure on commodity-related investments, especially the more thinly traded junior exploration stocks. The chart here shows the relative performance of the Toronto Stock Exchange Venture Index – the index offering the best proxy for the micro-cap resource stocks favored by so many dear readers – against the price of gold.

As you can see, there can be quite a divergence in the performance of these small stocks over the price of bullion. While gold’s rise has been remarkably orderly, the rise in the stocks has occurred in fits and starts, with some breathtaking setbacks along the way. Of late, the stocks have had a substantial run-up, which again gives me pause. I think it is a fairly safe bet, therefore, that if gold were to correct 15% or so, the juniors would again go on sale.

In time, however, because interest rates are so low, and the sovereign debt problems so acute, the worst-case scenario – of rates spiking – followed by the Fed quickly reversing course, is a certainty.

Which is to say that, in the now foreseeable future, all things tangible will do the equivalent of a moon shot.

Again, you have to make your own decision as to which scenario we are most likely to see. In my view, from a risk/reward perspective, as long as you have a core portfolio in precious metals and other tangibles (including energy), then selling some of your more speculative positions (you know the ones) to raise cash can make a lot of sense. That way you’d have the ready funds available to snap up the bargains that will be created during the Fed’s brief attempt at slowing the dollar’s current fall.

With apologies for being something of a stick in the mud for raising these concerns again, the way I figure it, at this point you can find all manner of analysis that will tell you it’s all blue sky from here for the commodities. Thus, a cautionary note seems justified.

Casey’s Daily Dispatch, April 22, 2011

So, what has happened in the year and a bit since those articles? Well, for starters, the Fed did, in fact, pause in its quantitative easing in June 2011. Triggering the following…

1. As you can see in the chart here of the Dollar Index (the dollar against a basket of major currencies), the dollar reversed its sharp downward trajectory. For context, I ran the chart showing April 22 2010 through the present, with the arrow marking the approximate date when the above articles appeared.
2. In response to the policy shift, the US stock market fell sharply in July 2011. It subsequently bounced around at lower levels until early October 2011 following the Fed’s decision to swap short-term Treasury holdings for those of longer duration as part of its “Operation Twist.” It undertook this operation to keep interest rates low – and succeeded.more here