26 July 2009


When will we see the inflation and dollar collapse...soonish

Chairman Bernanke committed another mistake this week. Removing monetary stimulus before inflation takes root was the focus of both his Wall Street Journal op-ed piece and this week’s congressional testimony. While I consider inflation to be a risk, it is definitely not the dominant systemic risk in play these days. Continuing its now traditional approach, the Federal Reserve is content to disregard unfolding asset Bubble risk. Today’s Bubble inflates rapidly throughout government finance – more specifically the enormous Treasury, agency debt and GSE MBS marketplace.

Actually, Dr. Bernanke did worse than ignore Bubble risk. The markets were promised the Fed would maintain its current ultra-loose monetary policy stance for an “extended period.” This is the same type of policy commitment that fostered speculative Bubbles in mortgages, housing, private-label MBS and CDOs. The Fed today is determined to peg short rates and market yields. Sure, there are obvious short-term reflationary benefits to such an approach. But such an endeavor also nurtures speculation and leveraging, especially in the Bubbling Treasury, agency and MBS markets. From my perspective, this is the most dangerous Bubble yet. It is addressed by no one.

I do appreciate that the Bernanke Fed has spent considerable time contemplating how to remove the past year’s unprecedented monetization. In a normal environment it would matter. But extraordinary circumstances would seem to completely rule out the possibility of Federal Reserve tightening. The risk of bursting the government finance Bubble is too great - and will become only greater. With Treasury, agency and GSE MBS now accounting for the vast majority of system Credit creation, economic and Credit system “recovery” would be stopped dead in its tracks by a surprising jump in market yields. The Fed has, once again, delegated itself to the role of Bubble enabler.

Tuesday, Bloomberg News went with the headline “Treasuries Rise as Bernanke Sees Limited Inflation…” The Sydney Morning Herald captured the true underpinnings of the Treasuries’ big gain: “Bernanke to Keep Easy US Credit Policy.” Dr. Bernanke did a nice job showcasing his inflation-fighting toolkit, although the markets really just needed reassurance he’s not going to back away from aggressive reflation anytime soon. And, here we are again, with Fed actions becoming a significant factor shaping/distorting market perceptions – hence the pricing and flow of finance throughout the economy. This becomes a critical dynamic with respect to the unfolding “government finance Bubble” because this Credit dynamic is capital markets driven (market perceptions of returns on securities dictating Credit expansion).

With U.S. inflation well in check, a strong bullish consensus sees prolonged loose monetary policymaking ensuring low and stable bond yields indefinitely. There is today a tremendous amount riding on this market view. At the same time, it is difficult to envisage a financial system and economy more acutely vulnerable to a spike in yields. How could the sanguine consensus view on rates be wrong?

First of all, it appears that global reflationary forces have reached critical mass. China and Asia are bouncing back. Loose financial conditions throughout the developing markets appear poised to spur robust economic recovery. Two important unknowns are how quickly inflationary pressures will reemerge and how soon foreign central bankers will begin feeling the heat. All eyes on China.

I am struck by a market disconnect. Each passing year finds market and economic forces increasingly globalized. Yet the view regarding favorable prospects for the U.S. fixed income market seems to be driven by favorable expectations of U.S. inflation and U.S. monetary policy. For the markets, Bernanke trumps international forces. The dollar hardly matters. And globally, the view seems to be that low U.S. market yields will continue to anchor global yields. But with financial and economic power having shifted markedly overseas, will there come a point in time when global factors play a much more significant role in determining our market yields. Has the Fed commenced a game of tug-of-war?

Listening to Chairman Bernanke this week, I couldn’t help but contemplate the prospect of waning Federal Reserve power. And I am not referring to regulatory power over our financial institutions. As I see it, the Fed is now locked into permanent monetary ease; they’ve let another Bubble get away from them. Resulting dollar devaluation traps the U.S. economy into a more inflationary backdrop. Meanwhile, the dynamic of massive flows of outbound dollar liquidity, coupled with unconstrained developing-economy Credit systems create powerful inflationary dynamics globally.

It would make sense to me that global forces increasingly tug U.S. yields upward. And we’ll have to wait and see how much the Fed is willing to use its balance sheet to try to tug them back down. Bernanke would clearly prefer to talk rates lower. It will be interesting to see how long talk suffices.


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