NEW YORK (TheStreet) -- Fed Chairman Ben Bernanke's Congressional testimony Wednesday left the market gyrating in schizophrenia and confusion. In his opening remarks, he seemed to emphasize that the recovery is still fragile and QE has been helpful, thus implying continued QE. Equities (SPDR S&P 500 Index ETF (SPY)), bonds (iShares 20+ Year Treasury Bond ETF (TLT)), and gold (SPDR Gold Trust ETF (GLD)) all exploded.Then, during Q&A he started talking about discussing scaling back asset purchases in the coming FOMC meetings. All markets promptly turned tail and closed in red. In order to parse Bernanke's seemingly self-contradictory remarks properly, it helps to take a step back first and set up the proper context. Here's how QE is supposed to work: you inject liquidity, or, as in the case of Abenomics QQE (Quantitative-Qualitative Easing), liquidity and base money, into the economy, force up inflation expectation and intimidate people into spending. Never mind the poor folks without means of effective inflation protection, e.g., retirees relying on life savings and workers with little bargaining power.
Or, as Japanese Deputy Prime Minister Taro Aso put it with menacing candor in January, those useless people should just "hurry up and die." From there it becomes a self-fulfilling prophecy: everybody spends and/or invests, actual inflation goes up, economy goes up, everybody spends more and so on. Simple enough. Can't fail.
- Central bank can easily control liquidity, but cannot control access to it, as shown by five years of relentless Fed QE. Structural deficiency in demand is insensitive to interest rates. It does not respond to declining interest rate unless it goes negative. As a result, liquidity channels are clogged. Lots of borrowed money is piled on at the top segments of the liquidity chain, desperate to find enough yield, while the real economy ignores all the fanfare and continues worrying about petty non-issues such as return on investment, retirement income, and kids' college tuition. This causes financial bubbles, the kind that are even worse than those caused by over-heating economy, which at least could drive some productive innovation as in the 90's. This is where we are today.
- Where does the Fed channel the liquidity? If they buy up Treasury bonds, it drives down the yield, which implies deflation, the opposite of what they hope to broadcast. They wish Washington would get the hint, take advantage of the free offer, and start issuing enough bonds to drive up yield. And they wish they could actually drop cash from helicopters -- why not, if in the end everyone is better off? Unfortunately for Keynesians, people are not rational beings seeking to maximize their economic interest today. People have children and tomorrow, and make decisions, often less than rational, based on incomplete and/or inaccurate information, with unknown degrees of uncertainty, and using the unreliable, heavily heuristic neurochemical circuitry manufactured by evolution. To Keynes, we all die in the long run; to most people, we worry about tomorrow and our children after our individual "long run." The current U.S. politics is such that binge borrowing is out of question (yes, we could borrow much more if we wanted, for the time being.) As to helicopters dropping cash, money is not just a number to people; it means something upon which our sense of fairness and value is based. Handing out free money beyond necessity, or rather the perception of it, violates that sense of fairness at the emotional level. The central philosophical failure of Keynesianism, in its relentless pursuit of rationalism and quantitative analysis of economics, is that people actually care about future and fairness. Well, a big portion of us do.
For all its shock and awe, QE3 has had little effect on its most prominent targets, the inflation expectation and the Treasury yield. The 5Y CMT yield has been stuck around 0.75% since Twist2, while the 5Y TIPS yield has bottomed out at -1.5% since QE3. And inflation expectation has been in the range of 2.0% to 2.3%, and heading down since February, shortly after the latest round of "green shoots" talks started. The most one could say is that QE3 perhaps provided support on inflation expectation at 2%.
To summarize this part of analysis, QE may have prevented deflationary spiral, but stoking inflation is another matter and stimulating economic recovery is even further away. With Fed balance sheet projected to be $4 trillion by the end of the year, and assuming a simplistic flat maturity distribution over 10 years, it'd take $33 billion/month purchase just to avoid tightening. As an old Chinese saying goes, riding a tiger is the easy part; it's the getting-off part that bites.
- The dramatic Abenomics in Japan started a wave of overseas investment , as domestic investors leaving the sinking yen (after fiscal-year-end repatriation booking profits in March) and searching for yield around the globe. A big part of that money no doubt has come to the U.S. While specific data in equities are hard to come by, Bloomberg has highlighted Japanese purchase of Ginny Mae bonds.
- The Cyprus template of bank bail-in with deposits, as I argued for in March and recently discussed by European Parliament , has driven a lot of Europeans, especially Russians barely escaping Cyprus, and Arabs to diversify their money away from the continent. Anecdotal evidence abounds that they have been a big part of home buying frenzy in certain areas in the U.S. in recent months.
- China's power transition, which officially took place in March but had been in the works for months before, has prompted a wave of money outflow. Concrete data is impossible to get, since a large part of the money is presumably illicit and, even if the money is legit, the movement of any large sum in short order could not possibly be. But stories like Chinese buying up luxury Manhattan apartments in cash surprise nobody.
Such hot money inflow could help driving up inflation, which is what the Fed desperately hopes for. But the big risk is that they're out of the Fed's control, be it the amount, the timing, the destination, or even the direction, since large events anywhere could quickly turn the tide. This adds a big uncertainty to the Fed's already troubled plans for action and communication.
What's still more alarming is that even the big banks are being squeezed for collateral . General Collateral repo rate, which is a key rate in the vast inter-bank short-term funding market, going negative means banks are willing to borrow treasury bonds with more than 100 cents on the dollar, in cash. This betrays common sense, much as negative interest rates. In short it implies banks are desperate to either expand their speculative bets or avoid liquidation of existing positions. It often indicates extraordinary stress in banks. In this instance I'm not sure that's the case; it could just be that banks and their institutional clients are scrambling to get on the equities/junk-bonds/FX/new-CDO bandwagon. Regardless, however, the irony of banks running out of collateral in the era of practically unlimited liquidity is a strong testimony to unintended consequences of too much QE. After all, the Fed has swept up all the treasuries.
In summary, all the taper talk is nothing but talk, the Fed's effort in trying to limit damage without taking the actions that are necessary but they don't have the political courage to take. In fact, I think the frothy equities and junk bond markets are indeed calling the taper talk bluffing, as opposed to the mirage of "sustained recovery" as presented by the mainstream media. After all, if the market actually believes tapering is coming, it would've started selling. If you're in the market, there's no need to panic right now. Let your winners run and enjoy the ride, perhaps with gradual tapering -- and there's the only sensible tapering I see. Just try not to be the last one out when it turns. And shorting it here is of course very risky. But the risk/reward calculation now hardly justifies any significant increase in risk exposure. Sitting on cash may burn a hole in your back pocket. But at least you still have your cash, which is not bad before inflation takes off. At the time of publication the author is long GLD. Follow @BoPengNY This article was written by an independent contributor, separate from TheStreet's regular news coverage.