Will the Fed's Last Bullet be Pointed Inward?
Russian Roulette for the Washington set.
“I know what you're thinking; "Did he fire six shots or only five?" Well, to tell you the truth, in all this excitement I kind of lost track myself.”
I’m reminded of a column I wrote in September 2007; while one could offer that the vibe is outdated, I would humbly counter that it’s not only alive and kicking, it’s increasingly cumulative in cause and effect.
And I quote:
“After years of focusing investor attention on the risks of inflation, the market demanded -- and the Fed delivered -- a policy shift designed to alleviate credit market pressures.
In doing so, it effectively told foreign holders of dollar-denominated assets that every nation must fend for itself. That, when push comes to shove, the devil we know -- inflation -- is more palatable than the devil we don’t.
As the dollar slips to multi-year lows, it's incumbent on us to understand the implications of this policy sea change. As such, we wanted to offer a few thoughts as they relate to the currency conundrum.
First, it would be helpful to familiarize ourselves with the underlying basics of the dollar dynamic. Kevin Depew wrote a fantastic primer that should be required reading for anyone trying to get a better grip on the subject.
For the last few years, while hiding behind the beard of hawkish vernacular, the FOMC has printed and pumped massive amounts of money into the financial system. That liquidity, while providing a rising tide for virtually every asset class, came at a cost.
It’s been my long-standing belief that we will toggle between “asset class inflation” and “dollar devaluation.” While both could manifest, I don’t foresee a scenario that includes both a stronger dollar and higher asset classes.
The Federal Reserve, if given the choice, would opt for hyperinflation over watershed deflation. With inflation the rich get richer, the poor get poorer, and the middle class steadily erodes. With deflation, everyone loses.
Wasn’t it Billy Ray Valentine who said that the best way to hurt rich people is by turning them into poor people?
We've been monitoring this evolution since 2002, opining that the 30% run in the S&P has been masked by the 33% decline in the greenback. That hasn't mattered to “us” but it's the central tenet of foreign angst and the seed that will sow protectionism and isolationism.
Think about it -- if you’re a foreign central bank and you bought the S&P in 2002, you’ve lost money on the margin. That’s the chief beef with the dollar being the world reserve currency; while we’re enjoying the benefits of our economic “expansion,” they’re sucking wind in local currencies.
That may seem like an obtuse perspective but it’s pertinent in the context of the global economy. Americans have been slow to embrace the notion that our basis of valuation is eroding. We earn, spend, and save dollars so, apples to apples there was little impetus to pay attention.
However, as globalization was the perceived catalyst on the front of the tech bubble, it stands to reason that it’ll be a culprit on the other side of the ride. International investors own over 50% of total US debt, which basically means that they’re holding the trump card on stateside policy.
In our finance-based economy, the velocity of money and elasticity of debt are essential ingredients to the upside equation. That is the crux of the credit crunch that brought this conundrum to bear; money stagnated and credit seized. The worldwide response, verbally and structurally, was to shock the patient back to life.
All things being equal, a decline in the dollar could be “asset class positive,” much as it has been for the last five years. But if the greenback finds a sustainable bid, it’ll likely serve as a clarion call that something entirely more disturbing is afoot.
At the end of the day, our financial health becomes a question of how far the dollar will fall before foreigners scream “Uncle Sam” and, by extension, unwind dollar-denominated positions without committing the financial equivalent of hari-kari.
And it leaves us, investors, in the unenviable position of gaming an invisible catalyst. For regardless of whether we’re wading into inflation, deflation, or both, we’re left to wonder how many weapons the Fed has left in its arsenal.
For when they arrive at the last bullet in the gun, it will likely be pointed inward.”
Fast-Forward to Modern Day
If we can agree that the last bullet in the Federal Reserve arsenal will be pointed inward, wouldn't that be triggered by a crisis of confidence?
And wouldn't that start with a negative market reaction to intentionally placed "positive" news?
This isn't a vibe for today, per se; I'm just putting it out there. The Bernanke Put is a walking, talking contradiction; it will arrive if the economy falters, but the economy won't improve without stimuli (or, it hasn't yet, despite oodles of infusions).
The definition of frustration is doing the same thing over and over again and hoping for a different outcome. That also happens to be the definition of "stuck."
As employment and housing continue to flounder, folks are waking up to the fact that there's the market... and there's an economic reality. There's inflation in things we need (food, energy, education) and deflation in things we want (laptops, plasmas, cell phones) and most of America is stuck in the middle with you.
Bottom line: Policymakers have a "God Complex" and the simple truth is that nobody is bigger than the market. It's clear that they -- and "they" includes European policymakers -- won't willingly give up the ball.
The market will have to take it from them.
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Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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