Ben’s Rocket to Nowhere
By: Peter Schiff
Monday, November 25, 2013
Herd mentality can be as frustrating
as it is inexplicable. Once a crowd starts moving, momentum can be all
that matters and clear signs and warnings are often totally ignored.
Financial markets are currently following this pattern with respect to
the unshakable belief that the Federal Reserve is ready, willing, and
most importantly, able, to immediately execute a wind down of its
quantitative easing program. Although the release last week of the
minutes of the Fed’s last policy meeting did not contain a shred of hard
information about the certainty or timing of a “tapering” campaign,
most observers read into it definitive proof that the Fed would jump
into action by December or March at the latest. The herd is blissfully
unaware that the Fed may not be able to reverse, or even slow, the
course of QE without immediately sending the economy back into
recession.
In an interview this week, outgoing Fed Chairman Ben
Bernanke likened the QE program to the first stage in a multiple stage
rocket that gets the spacecraft off the ground and accelerates it to the
point where it is close to achieving permanent orbit. Like a first
stage that has spent its fuel and has become dead weight, Bernanke seems
to concede that QE is no longer capable of providing positive thrust,
and as a result can now be jettisoned (like a first stage) so that the
remainder of the spacecraft/economy can now move higher and faster. The
Chairman’s nifty metaphor provides some inspiring visuals, but is
completely flawed in just about every way imaginable.
In real
rocketry, when the first stage separates, it falls back to earth and is
no longer a burden to the remainder of the ship. Subsequent booster
rockets (which in economic terms Bernanke imagines would be continuation
of zero interest rate policies) build on the gains made by the first
stage. But the almost $4 trillion in assets that the Fed has accumulated
as a result of the QE program will not simply vaporize into the
stratosphere like a discarded rocket engine. In fact it will remain
tethered to the rest of the economy with chains of solid lead.
In
the process of accumulating the world’s largest cache of Treasuries,
the Fed has become the most important player in that market. I believe
the Fed can’t stop accumulating and dispose of its inventory without
creating major market disruptions that will drag the economy down.
This
would be true even if the economic rocket were actually approaching
escape velocity. In reality, we are still sitting on the launch pad. By
keeping interest rates far below market levels and by channeling newly
created dollars directly into the financial markets, the QE program has
resulted in major gains in the stock, real estate, and bond markets.
Many have argued that all three are currently in bubble territory. Yet
to the casual observer, these gains are proof of America’s surging
economic vitality.
But things look very different on Main Street,
where the employment picture has not kept pace with the rising prices
of financial assets. The work force participation rate continues to
shrink (recently falling back to levels last seen in 1978),real wages
have declined, and since the end of 2009 the temporary workforce has
grown at a pace that is 14 times faster than those with permanent jobs.
Americans are driving less, vacationing less, and switching to lower
quality products and services in order to deal with falling purchasing
power. But the herd is closely watching the Fed’s rocket show and does
not understand that stocks and housing will likely fall, and bond yields
rise steeply, once the QE is removed. The crowd is similarly ignoring
the significance of the Chinese announcement.
But while the Fed
was gaining much attention by saying nothing, the Chinese made a
blockbuster statement that was summarily ignored. Last week, a deputy
governor of the People’s Bank of China said that buying foreign exchange
reserves was now no longer in China’s national interest. The
implication that China may no longer be accumulating U.S. government
debt would amount to the “mother of all tapers” and could create a clear
and present danger to the American economy. But the story barely rated a
mention in the American media. Over the past decade or so, the People’s
Bank of China has been one of the largest buyers of U.S. Treasuries
(after various U.S. government entities that are essentially
nationalizing U.S. debt). China currently sits on $1 trillion or more in
U.S. bond obligations.
So, just as many expect that the #1
buyer of Treasuries (the Fed) will soon begin paring back its purchases,
the top foreign holder may cease buying, thereby opening a second front
in the taper campaign. This should cause any level-headed observer to
conclude that the market for such bonds will fall dramatically, causing
severe upward pressure on interest rates. But the possibility is not
widely discussed.
Also left out of the discussion is the degree
to which remaining private demand for Treasuries is a function of the
Fed’s backstop (the Greenspan put, renewed by Bernanke, and expected to
be maintained by Yellen). The ultra-low yields currently offered by
long-term Treasuries are only acceptable to investors so long as the Fed
removes the risk of significant price declines. If the private buyers,
the Fed, China (and other central banks that may likely follow China’s
lead) refuse to buy Treasuries, who will take on the slack? Absent the
Fed’s backstop, prices will likely have to fall considerably to offer an
acceptable risk/reward dynamic to investors. The problem is that any
yield high enough to satisfy investors may be too high for the
government or the economy to afford.
Little thought seems to be
given to how the economy would react to 5% yields on 10 year Treasuries
(a modest number in historical standards). The herd assumes that our
stronger economy could handle such levels. In reality, 5% rates would
likely deeply impact the financial sector, prick the bubbles in housing
and stocks, blow a hole in the federal budget, and cause sizable losses
in the value of the Fed’s bond holdings. These developments would
require the Fed to devise a rocket with even more power than the one it
is now thinking of discarding.
That is why when it comes to
tapering, the Fed is all bark and no bite. In fact, toward the end of
last week, Dennis Lockhart, President of the Federal Reserve Bank of
Atlanta, said that the Fed “won’t taper its bond-buying until the
economy is ready.” He must know that the economy will never be ready.
It’s like a drug addict claiming that he’ll stop using when he no longer
needs them to stay high.
But the market understands none of
this. Instead it is operating under dangerous delusions that are
creating sky-high valuations for the latest social media craze,
undermining the investment case for gold and other inflation hedges, and
encouraging people to ignore growing risks that are hiding in plain
sight.
This is not unusual in market history. When the spell is
finally broken and markets wake up to reality, we will scratch our heads
and wonder how we could ever have been so misguided.
- Source, Peter Schiff via Value Walk
Peter Schiff is a well-known commentator appearing regularly on CNBC, TechTicker and FoxNews. He is often referred to as "Doctor Doom" because of his bearish outlook on the economy and the U.S. Dollar in particular. Peter was one of the first from within the professional investment field to call the housing market a bubble. Peter has written a book called "Crash Proof" and a follow-on called "The Little Book of Bull Moves in Bear Markets". He is the President of EuroPacific Capital, which is a brokerage specializing in finding dividend-yielding, value-based foreign stocks.
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