Peng: Fed Tapering to What?

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.

Except for a couple of technical details:
  1. 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.
  2. 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.

The following chart demonstrates the bind the Fed is in. It shows the five year Treasury yield after Constant Maturity adjustment, the five year TIPS ( iShares TIPS Bond ETF ( TIP)) yield (real yield excluding inflation effect), and the difference between the two (five year breakeven, or inflation expectation implied by the market) since the beginning of 2009 (Source: Federal Reserve.)

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%.

And, for the first time since early 2008, the nominal GDP growth fell below 3.7% since Q4 2012, as reported by ECRI :

"In any case, yoy nominal GDP growth at or below 3.7% has been seen only in recessionary contexts. In Q1 2013, it fell to 3.4%, the second straight quarter below 3.7%"

I don't think this necessarily means imminent recession, since core CPI has been stuck around 0, ( with the lastest, for April at 0.1% ), much lower than previous instances of 3.7% crossing. But at least it requires a strong dose of optimism boosting medicine to believe in the prevailing chatter about strong recovery after seeing this chart.

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.

But why the taper talk then, even by Bernanke himself on Wednesday? I think three recent developments have significantly shifted the cost/benefit balance of QE and eroded the Fed control of money supply. They need to respond with corresponding (and so far unknown) flexibility. The taper talk is to condition the market to the new uncertainty in Fed policy.

First, several international developments conspired around the beginning of the year to cause of tsunami of hot money into the U.S.:
  1. 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.
  2. 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.
  3. 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.

Secondly, and partly because of international hot money, there's clear evidence of equities, junk bonds, and housing prices in certain areas being in the bubble territory. The reason is clear from the yield chart above. The market seems unwilling to accept nominal 5Y treasury yield below 0.6%. Where does the liquidity go if not the treasuries? As always in financial bubbles, it starts to chase more risky assets.

But isn't the wealth effect from such bubbles supposed to trickle down and wake up the animal spirit? Yes, but only a small section of the society gets to benefit. Unlike the dot-com bubble, these bubbles are not driven by innovation and productivity increase. Only those with significant assets in such markets, or privileged access to liquidity (the upper end of capital chain, big banks), have a chance, hence the soaring suburban poverty .

Recently a Fed council of bankers warned of credit risk and asset bubbles, as reported by Bloomberg . While Bernanke tried to refute this Wednesday, the defense itself proves at least he's aware of the possibility. The bigger the bubble, the uglier it gets when the eventual Fed exit occurs. The taper talk is his attempt at managing the bubble. Nobody has succeeded in this feat. Good luck to you, Bernanke.

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.

I believe the collateral squeeze is an important reason behind the taper talk. The Fed has pushed itself into a paradox with ever larger QE. They try to help banks and get the money flowing by buying up treasuries; but this instead hampers banks by sucking the collateral pool dry. The first two factors imply that taper talk is not about tapering at all. But this one means the Fed may have to either find a way to reduce treasury purchase or somehow persuade Congress to borrow more debt. With almost all of agency bonds already going into QE3, to where can the Fed divert the treasury purchase, stocks and junk bonds? Hey, here's an idea!

Desperation is often disguised as heroism. I'm not ruling anything out, including negative interest rates.

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.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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