Bernanke Jilts Markets on Steroids, Suffers Violent Withdrawal Symptoms

Despite my current circumstances, I felt the compulsion to offer a reaction on today’s market meltdown.

Here is what I recently wrote,

I would certainly watch the US Federal Reserve’s announcement and the ensuing market response.

If team Bernake will commence on a third series of QE (dependent on the size) or a cut in the interest rate on excess reserves (IOER), I would be aggressively bullish with the equity markets, not because of conventional fundamentals, but because massive doses of money injections will have to flow somewhere. Equity markets—particulary in Asia and the commodity markets will likely be major beneficiaries.

As a caveat, with markets being sustained by policy steroids, expect sharp volatilities in both directions.

Obviously the market’s response on team Bernanke’s failure to deliver on what had been expected has apparently been violent.

The Philippine Phisix (chart from technistock.net), as well as ASEAN equity markets, has basically suffered the same degree of bloodbath relative to her developed economy equity market peers

This reaction from a market participant captures the underlying sentiment. From a Bloomberg article

“This is not likely to provide any significant stimulus,” said Jason Schenker, president of Prestige Economics LLC in Austin, Texas. “The market really needed a boost of confidence. There is no confidence from this.”

So what did the Mr. Bernanke deliver?

Again from the same article at Bloomberg

The Federal Reserve will replace $400 billion of short-term debt in its portfolio with longer- term Treasuries in an effort to reduce borrowing costs further and counter rising risks of a recession.

The central bank will buy securities with maturities of six to 30 years through June while selling an equal amount of debt maturing in three years or less, the Federal Open Market Committee said today in Washington after a two-day meeting. The action “should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative,” the FOMC said.

Chairman Ben S. Bernanke expanded use of unconventional monetary tools for a second straight meeting after job gains stalled and the government lowered its estimate of second- quarter growth. Yields on 30-year Treasuries fell below 3 percent for the first time since 2009 and U.S. stocks had their biggest drop in a month on the Fed’s plan, dubbed “Operation Twist” after a similar Fed action in 1961.

The twist, as earlier stated, has been telegraphed. What was not expected has been the non-appearance of Bernanke’s QE which resulted to today’s convulsions.

The ‘twist’ which essentially attempts to flatten the yield curve basically reduces the banking system’s profitability from the borrow short and lend long (maturity transformation) platform that has partly catalyzed these selloffs.

From the Wall Street Journal

But for bankers, who are already struggling with low interest rates on loans and tepid loan demand, the twist option could further dent already-weakened profits. That is because lower long-term interest rates would result in contracting net interest margins for banks—essentially, the profit margin in the lending business—at a time when their revenue is growing slowly, if at all. Banks would earn less on loans and investments, and might end up making fewer loans as well.

"Ouch" is how one executive at a big retail bank described the prospect of Operation Twist. (Bankers typically don't publicly comment on Fed policy given the central bank's role as a bank regulator.)

Austrian Economist Bob Wenzel says that Operation Twist represents a failed experiment…

So how did the original Operation Twist turn out? Three Federal Reserve economists in 2004 completed a study which, in part, examined the 1960's Operation Twist. Their conclusion (My bold):

“A second well-known historical episode involving the attempted manipulation of the term structure was so-called Operation Twist. Launched in early 1961 by the incoming Kennedy Administration, Operation Twist was intended to raise short-term rates (thereby promoting capital inflows and supporting the dollar) while lowering, or at least not raising, long-term rates. (Modigliani and Sutch 1966).... The two main actions of Operation Twist were the use of Federal Reserve open market operations and Treasury debt management operations.. Operation Twist is widely viewed today as having been a failure, largely due to classic work by Modigliani and Sutch.”

The economists go on to state that the size of Operation Twist was relatively small, possibly too small to determine if such an operation could be successful if carried out at on a larger scale. That experiment is now being conducted on the economy of the United States with the $400 billion Operation Twist announced today. How big was the original Operation Twist? $8.8 billion.

The three Fed economists, who seem to concur that the first Operation Twist was a failure, are sure going to get an experiment on the United States economy on a much grander scale to see if this time it will work different than it did the first time. So who are these three lucky Fed economists who are now going to be able to witness Operation Twist on a grander scale? Vincent R. Reinhart, Brian P. Sack and BEN S. BERNANKE.

So part of the market’s virulent reaction signifies a revolt on Bernanke’s experimental policy. This is an example of how interventionist measures prompts for heightened uncertainties.

The Fed also promised to support mortgage markets by keeping the interest low. Again from the same Bloomberg article,

The central bank said today it will also reinvest maturing housing debt into mortgage-backed securities instead of Treasuries “to help support conditions in mortgage markets.”

Yields on Fannie Mae and Freddie Mac mortgage securities that guide U.S. home-loan rates tumbled the most in more than two years relative to Treasuries. The average rate on a typical 30-year fixed loan fell to a record low 4.09 percent last week.

So why has Bernanke failed to live up with the expectations for more QE?

Like in the Eurozone, there has been mounting opposition to Bernanke’s inflationist bailout policies as seen by a divided FOMC… (same Bloomberg article)

The FOMC vote was 7-3. Dallas Fed President Richard Fisher, Minneapolis Fed President Narayana Kocherlakota and Charles Plosser of the Philadelphia Fed voted against the FOMC decision for a second consecutive meeting. They “did not support additional policy accommodation at this time,” the Fed statement said today.

…and from some Republicans who mostly recently who made public representations against further QEs.

Republican lawmakers including Boehner and Senate Minority Leader Mitch McConnell urged Bernanke in a letter this week to refrain from additional monetary easing to avoid “further harm” to the economy.

This is aside from political pressures applied by his predecessor, Paul Volker

In my view, Chairman Ben Bernanke could be:

-trying to lay the blame of policy restraints at the foot of his opponents in the recognition that markets would behave viciously from a stimulus dependent ‘withdrawal syndrome’, or

-that his penchant for grand experiments made him deliberately withhold QE to see how the markets would respond to his innovative ‘delusion of grandeur’ measures.

By withdrawal, I don’t mean a reduction of the Fed’s balance sheet, which the Fed aims to maintain (which probably would incrementally expand on a less evident scale) but from further specifically targeted asset purchases. The ‘twist’ essentially sterilizes the operation which means no money supply growth.

Today’s brutal reaction in global financial markets essentially validates my view that the contemporaneous market has been built on boom bust policies such that NOT even gold prices has been spared.

The tight correlations in the collapsing prices of equities and commodities as well as the rising dollar (falling global currencies) are manifestations of a bust process at work.

The primary issue here is that in absence of government’s backing via assorted stimulus, mostly via monetary injections, artificially established price structures from government stimulus or from credit expansion unravels.

Only when the tide goes out, to paraphrase Warren Buffett, do we know who has been swimming naked.

Or as Austrian economist George Reisman writes,

A fundamental fact is that our present monetary system is characterized both by irredeemable paper money, i.e., fiat money, and by credit expansion. There is no limit to the quantity of fiat money that can be created. This is the foundation for potentially limitless inflation and the ultimate destruction of the paper money, when the point is reached that it loses value so fast that no one will accept it any longer. The fact that our monetary system is also characterized by credit expansion is what creates the potential for massive deflation — for deflation to the point of wiping out the far greater part of the money supply, which in the conditions of the last centuries has been brought into existence through the mechanism of credit expansion