How Should Investors Respond When The Markets Overrule the Fed?

If what I’m about to say sounds like Greek to you, I suggest you find an investment advisor who understands these issues. It’s a confusing topic for many, but the implications are enormous for every investor.

In 2002, when examining the unresponsiveness of the Japanese economy to a decade of extraordinary fiscal and monetary stimulus, and with deflation on its hands, Ben Bernanke, then a junior member of the Fed board, gave an out-of- the- box speech entitled: “Deflation: Making Sure ‘It’ Doesn’t Happen Here”.

The “Not Here” speech laid out a menu of what could be done by the Fed if its money shock therapy supplied to commercial banks did not stimulate banks to lend and borrowers to spend in order to escape a recession. The issue as reflected in the speech title was not just overcoming a recession but preventing deflation.

In a consumer debt satiation economy over burdened consumers need to get out from under debt in order to return to normal spending patterns. In this environment, inflation is a debtor’s best friend, as rising wages create more income with which to retire past debts. Deflation spoils that deal, and on top of that asset prices drop (including home values).

Fast forward eight years and it is no longer Japan’s problem. The US is facing the same circumstances, as we enter three years of deflationary economic malaise, with an economy in a classic Keynesian liquidity trap. The Fed has been shoveling money at banks but the accumulated commercial bank liquidity has largely been reinvested as bank deposits with the Fed and the banks’ private lending continues to shrink. With the Fed unable to stimulate either lending or spending from traditional monetary policy, the economy languishes and the inflation rate is trending to the border line of deflation.

The “Not Here” speech laid out the game plan of how to respond in this case, and the notion of Quantitative Easing (QE) was born. Instead of attempting to force feed commercial banks with liquidity via the purchase of Treasuries (with the expectation the banks will finance the private sector) the Fed is set to leap over the banks and directly finance the private sector itself, something it has never done before. In essence the Fed will likely become a private bank with private assets on its balance sheet.

For the last year or so the Fed implemented QE by a $1.25 trillion purchase of private securities in the secondary capital markets. Their first target of private lending was residential mortgages encapsulated within Residential Mortgage Backed Securities for the good reason to reduce the cost of mortgage finance and to support the prices of RMBSs which are a main staple of commercial bank holdings.

Three points to note:

  1. The Fed’s private financial asset purchase program increased the Fed’s balance sheet by 150% as compared to a normal year expansion of 4%.
  2. Hence the money and purchase shock therapy was 37 times its normal annual amounts, truly a monetarist’s nightmare producing visions of excess money that by textbook would be expected to result in inflation.
  3. Despite this highly aggressive financial buy program, the commercial banks contracted lending, virtually no residential housing construction took place, bank dependent borrowers are still shut out from the credit markets and the mega private asset buy failed to move the inflation needle.

Given this, the “Not Here” formula calls for more of the same as reflected in the most recent Fed statement, but with the major addition that the express purpose of the asset purchase program is to stimulate inflation. In Fed speak they will be engaging in what is called Price Level Targeting, which means keeping the financial purchase spigot open until the inflation needle responds.

There are many things that could be debated (that I will take a pass on at this time) such as the question of which private securities to purchase. For example, should the Fed mimic the recent Bank of Japan QE policy statement that they will purchase corporate obligations, ETFs (presumably corporate equities), Government debt to facilitate its ballooning deficit, and/or the purchase of foreign currencies in order to cheapen Japan’s currency and hence promote exports. Japan has indicated they are experienced in quantitative easing and the above gives the biggest bang for the buck.

What is missing from this list of financial buys is the consumer and small business, and what is needed is a means to put the cash in their hands as they cannot sell their bonds to the Fed on capital markets and banks will not lend to them. Consumers and small businesses are most impacted with a debt overhang and are in need of easier terms of finance.

My interest here is pointing out that the Fed can have a stated policy of buying private securities, but the US corporate sector that reaches the public capital markets is not likely to respond with enough spending to create inflation. The reason is that the corporate sector has significant excess productive capacity, and has been a significant recipient of the market’s new found aversion for risk and preference for fixed income (including corporate debt). The US corporate fixed income market pricing is already in a bubble, so if the Fed were to add more air to the corporate fixed income bubble it’s not likely to generate inflation producing corporate spending at a level that would move the economy and the inflation needle.

However, what the Fed has been able to produce instead of actual inflation is inflation expectations and this chills the spine of those with a monetarist inclination. Hence, rather than controlling the economy, the Fed is in command of inflation expectations, as revealed in the recent market response to the suggestion of Price Level Targeting.

This is reflected in investors reallocating to inflation hedges, which in turn is changing relative financial prices in a big way. It is also generating total return or appreciation for the market’s pet inflation hedges. The asset class recipient of the inflation hedge play have been investments denominated in foreign currency, particularly the growing emerging markets, and other fiscally solvent developed countries where a central bank bailout of the government is not on the radar screen.

Also benefitting with high total return are precious metals (gold) and commodities in general, or even more generally real assets with the notable exception of US residential real estate (for good reason).

Most notably is the difference in the number of put vs. call options on US Treasury bonds, but most of all the extreme pricing now being paid for inflation adjusting US Treasury bonds (called TIPs). At this week’s Treasury auction, the five year inflation adjusting bond was auctioned off for $106 for every $100 of principal repayment. That is to say, investors are willing to pay an inflation insurance premium equal to 6% of the $100 principal in order to have their principal thereafter inflation indexed.

The flip side of the pricing in the TIPs market is price declines in Treasury prices which do not contain inflation protection. This is already underway with the thirty year Treasury yield rising 40 basis points in the past two weeks. This flight from US fixed income is elevating long term yields in the US market, as inflation is not the friend of bonds no matter how safe they are perceived to be. What a great irony and a wonderful exam question: How is it possible for the Fed to run an expansionary monetary policy and create higher interest rates?

The bottom line is Bill Gross, the Bond King from PIMCO this week concluded that US bonds have reached the zenith of their three decade long price trajectory and it’s time to switch to the above mentioned asset classes.

While the market responds to the prospect of inflation, I am far from sure whether the Fed has yet figured out how to produce inflation if it really wants it. If that is the case, and lot of printed money does not beget inflation, we might yet come to another recalibration of relative asset values because an equally plausible outcome is the return of the recession. This is especially so when the market has acted to drive interest rates higher.

At some point in the future either inflation expectations will converge with a lower inflation or deflation rate or the inflation rate will rise to its expectation being priced in the market. For now, I am riding the crest of the market wave into inflation hedges. The surf is up and running. Enjoy the ride.

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