By Mike Whitney
Ever since he launched the second round of his bond-buying program (QE2), Ben Bernanke has been on a roll. The S&P has gained 10 percent and the economic data has improved dramatically. Manufacturing and retail have rebounded, consumer confidence has started to brighten, and personal consumption (PCE) is on the rise. Car sales, hotel occupancy and exports are all up, too. Even the banks seem to be more eager to lend than they were just a few months ago. Only housing is still in the doldrums and the Fed chairman probably has something up his sleeve for that, too.
Perma-bear Marc Faber thinks he’s figured out the secret of Bernanke’s recent successes. He says, “Never underestimate the power of printing money.” Indeed. Only, in this case, an asset swap of US Treasurys for bank reserves works just as well as a printing press. Bernanke simply buys up boatloads of Treasurys from the banks and, “Voila”, investors flock to riskier assets like lemmings to a cliff. And, just look at the results. Stocks keep climbing higher and higher, and everyone is happy. Well, almost everyone.
Richmond Fed President Jeffrey Lacker is not happy and he’s taken his grousing to the press. Lacker thinks that Bernanke should heed the market’s warnings and back off while he still can.
“The distinct improvement in the economic outlook since the program was initiated suggests taking that re-evaluation quite seriously,” Lacker said in a speech in Newark, Delaware. “That re-evaluation will be challenging, because inflation is capable of accelerating, even if the level of economic activity has not yet returned to pre-recession trend.”
Bernanke has brushed off Lacker’s inflation handwringing saying that he has matters under control. But does he? That’s not what the bond market is saying. Here’s the Wall Street Journal’s Mark Gongloff with the rundown:
“The U.S. bond market has begun sending a message that inflation risks are rising and the Federal Reserve may be too slow to act, potentially marking a significant turning point in the economic recovery. In the past week, Treasury-bond yields have jumped to their highest levels since last spring. Yields on 10-year Treasurys surpassed 3.5% and 30-year yields broke through 4.7%, which makes some worry could mean rates will march even higher.
Long-term rates have been gradually moving higher in response to an improving economy and rising commodity prices. But in recent days the increases in yields accelerated, a move many say is due to the worry that the Federal Reserve may be underestimating inflationary pressures in the economy, and may act too slowly to tame them…..
While raising alarm bells about inflation, the bond market is also indicating it sees no signs that the Fed will intervene. Short-term rates, which are most sensitive to Fed moves, have held relatively steady, causing the difference between two-year and 10-year notes to reach its steepest level since February 2010….
The yield on the 30-year Treasury bond ended Friday at 4.732%, its highest since last April. Adding to the almost-panicky feel in the bond market on Friday, traders circulated a chart of 30-year-bond yields showing that the yields had broken out of a 30-year trendline—a sign that the decades-long bull market in Treasurys may be drawing to a close….” (“Bond Market Flashes Inflation Warning”, Mark Gongloff, Wall Street Journal)
Investors want some indication from Bernanke that if inflation does takes root, he’ll fight back and raise rates. But Bernanke will have none of it. He’s focused laser-like on deflation and is determined to stay the course until unemployment drops. (Or so he says)
And he’s more confident in QE2 than ever. Just listen to him pat himself on the back in this clip from a speech he gave last week to the National Press Club:
“More recently, however, we have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. Notably, we learned last week that households increased their spending in the fourth quarter, in real terms, at an annual rate of more than 4 percent….
A wide range of market indicators supports the view that the Federal Reserve’s securities purchases have been effective at easing financial conditions. For example, since August, when we announced our policy of reinvesting maturing securities and signaled we were considering more purchases, equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed, and inflation compensation as measured in the market for inflation-indexed securities has risen from low to more normal levels….
The fact that financial markets responded in very similar ways to each of these policy actions lends credence to the view that these actions had the expected effects on markets and are thereby providing significant support to job creation and the economy.” (National Press Club address, Fed chairman Ben Bernanke)
While it’s a bit premature to boast about a “self-sustaining recovery” when rates are at zero and the Fed has affixed a $1 trillion liquidity pipe to the markets, Bernanke clearly believes in the policy. And, notice how he points to “rising stock prices” as a barometer of success even though he has repeatedly said that the Fed does not deliberately target the stock market. Now we have Bernanke’s own words to prove the opposite.
Also, it doesn’t take a genius to see that if someone buys tons of Treasurys, the money that was in those Treasurys, will go somewhere else. And, so it has. It’s gone into stocks, commodities and emerging markets. But how does that help to increase aggregate demand, lower unemployment, or improve household balance sheets? It doesn’t. It just creates more liquidity in the financial markets chasing more paper assets. And that is precisely the problem.
It also increases risk appetite which paves the way for another asset bubble. Is that what Bernanke wants, another economy-crushing meltdown? Here’s an excerpt from the Wall Street Journal which shows how Bernanke’s low rates and bond buying program are pushing investors into riskier and riskier assets:
“The average junk-bond yield fell below 7% for the first time in more nearly six years, moving within striking distance of its all-time low, as bond buyers are willing to take on more risk in order to boost returns….
Yields under 7% are more commonly associated with investment-grade bonds, but investment-grade bonds currently yield only 4.89% on average, according to J.P. Morgan. That is because market forces are squeezing the premium that high-grade bonds enjoy over Treasurys, and the Federal Reserve is suppressing short-term rates on Treasury securities to spur job growth.” (“Yield on ‘Junk’ Approaching All-Time Low”, Wall Street Journal)
So, the Fed’s low rates are forcing investors (including many fixed-income retirees) into more dangerous assets in an attempt to get some measly return on their savings. This exposes them to even greater losses when the Fed is forced to raise rates and the market tumbles. Here’s more from the article:
“Money continues to pour into junk bonds, with high-yield mutual funds recording $5.4 billion of net inflows since early December, according to Lipper FMI, a unit of Thomson Reuters.
Bank loans, a kindred market to high-yield bonds, have seen even greater inflows, of $6.7 billion, in that time. Similarly elevated flows into emerging markets have caused countries such as Brazil to adopt measures aimed at curbing inflation, which can result from torrents of incoming capital.
The cash influx into junk bonds has driven up prices and caused yields to drop over the past two months, even though yields on underlying Treasurys have risen sharply during that time….
Issuers continue to take advantage of elevated demand and falling yields, with $34 million of new high-yield bonds being sold in January, according to Dealogic. Six of the past 12 months have now recorded more than $30 billion in issuance, a threshold that had only been reached once before 2010. (“Yield on ‘Junk’ Approaching All-Time Low”, Wall Street Journal)
So the big banks are making money hand-over-fist, while the mom-and-pop investors–trying to eek-out some small return on his skimpy retirement savings–are hung out to dry. If that’s not class warfare, than what is? (Keep in mind, the banks borrow money from you, the depositor, for roughly 1% (1-yr CD) and then lend it back to you at 18% via your credit card. It’s a bigger ripoff than student loans.)
And big finance is not just scarfing up junk bonds either. They’re also adding to their trove of garbage adjustable-rate mortgages (ARMs), the notorious MBS that sent the housing market into freefall. Here’s a clip from Businessweek:
“Home loans that inflated the U.S. housing bubble…are fueling the fastest gains in the mortgage-bond market….Prices for senior bonds tied to option adjustable-rate mortgages, called “toxic” by a government commission, typically jumped 6 cents to 64 cents on the dollar in the past month, according to Barclays Capital.
Rising values show Federal Reserve efforts to stimulate the economy by purchasing an additional $600 billion of Treasuries and holding interest rates near zero percent are driving investors into ever-riskier securities…..
The market is pricing in defaults on option ARMs of about 75 percent, according to hedge fund Metacapital Management LP in New York. As the worst housing slump since the Great Depression deepened, assumptions reached as high as 90 percent, said Whalen, who’s based in Los Angeles.”(“‘Toxic’ Mortgages Rally as Resets Accelerate: Credit Markets”, Businessweek)
Got that? Investors are loading up on these garbage bonds even though they expect 75% of them will go belly-up. Hey, it’s a Bernanke gold rush! Is it any wonder why QE2 does not inspire confidence? It’s just more bubblenomics.
And Bernanke’s pledge to reduce unemployment is pure hogwash. In fact, the Federal Reserve Bank of San Francisco even admits that the effects of QE on unemployment will be negligible at best. Here’s an excerpt from the FRBSF’s Economic Letter:
“By 2012, the … program’s incremental contribution is … 700,000 jobs generated … by the most recent phase of the program. Increased hiring lowers the unemployment rate by 1.5 percentage points compared with what it would have been absent the Fed’s asset purchases… Based on other simulations, providing an equivalent amount of support to real economic activity through conventional monetary policy would have required cutting the federal funds rate approximately 3 percentage points relative to baseline from early 2009 through 2012, an obvious impossibility because of the zero lower bound.”
“700,000 jobs” in two years. Big deal. That winnows unemployment down to 8% by 2012. It’s a drop in the bucket, but it does show that Bernanke’s QE2 has nothing to do with jobs. It’s just more welfare for Wall Street.
So, where is all this headed? It’s not hard to figure out. For one thing, Bernanke will have to tap on the brakes a lot sooner than he thinks. Economic activity is picking up, the banks have started lending again, oil is rising sharply, and Wall Street speculators are snatching up every crummy bond in sight. Even consumer credit is expanding, which is a miracle given the dismal debt-to-disposable-income ratio that’s still way above trend.
Also, inflation expectations are on-the-rise along with food and oil prices. At the same time, the yield on the 30-year Treasury is inching higher because investors doubt that Bernanke will defend the dollar by raising rates. It’s a question of credibility.
Does this mean that deflation is no longer a problem?
Not at all. In fact, deflation is the main problem, but QE2 is sending false signals that are adding to the confusion. Unemployment is still very high, the output gap still very wide, and housing is in a historic slump. Consumers are still retrenching, households still deleveraging, and defaults, bankruptcies, and foreclosures are still at record highs. In other words, deflationary pressures are still strong and likely to stay that way through 2011.
On the other hand, things look altogether different in the financials, where a feeding frenzy is underway for everything from junk bonds to toxic ARMs. This hyperactivity is the result of flawed monetary policy, hundreds of billions of dollars are shifting out of risk-free Treasuries into other assets. Naturally, that’s driving up stock prices and sparking fear of inflation. But, unfortunately, it’s not doing anything for the real economy. The excess liquidity in the financial system is merely chasing paper assets, which is why yields on junk bonds continue to fall.
To fully appreciate the magnitude of the Fed’s failure to direct stimulus where it’s needed, consider this: Investors are now choosing to buy toxic ARMs (which are set to default at a 75%-clip) rather than plants, equipment, real estate or hard assets. That’s a good indication of how weak demand really is, and how inadequate the Fed’s attempts to fix the problem have been.
So, what does it all mean?
It means we’ve reached the limits of monetary policy. The stimulus that’s pushing liquidity into the markets, is not being transmitted to the real economy. It’s stuck financial La-la land where it can’t do any good. The problem is not that Bernanke is dropping money out of helicopters. The problem is that his helicopter never stops circling Wall Street.
The Fed’s exalted QE experiment is coming to an end. Bernanke has restored large parts of the Ponzi finance system that collapsed after Lehman, but the real economy is still mired in recession. It looks like Keynes was right after all. Trying to use monetary policy to revive the economy, when households and consumers are still underwater, is like pushing on a string.