Bill Fleckenstein

It's time once again to check in on our fearless leaders at the Federal Reserve, as Wednesday was the scene of Chairman Ben Bernanke's most recent congressional testimony (as well as the release of the latest FOMC minutes).

 

Spoiler alert

But we already knew -- regardless of what Bernanke or the minutes said -- what the Fed is going to do, namely what it has always done since former Chairman Alan Greenspan manned the helm. This is not debatable: The central bank is going to print money -- too much money, it as it will turn out, and the central bankers won't understand that -- leading to a collapse in the economy and financial markets, and so the Fed will come back and do the same thing on an even bigger scale.

 

For five years now, there has been steady talk of exit strategies, yet none has occurred. Nor is exiting described as a binary on-off switch any longer, but rather as a dial whereby the flow of money can be scaled up or down, depending on the data.

 

Thus, the very concept of an exit strategy, where the Fed might suddenly stop buying or actually sell bonds and reduce its balance sheet, has been abandoned and is never going to happen.

 

This makes it rather annoying and maddening to deal with financial markets that move on every speech given by every Fed head as they work their jawbone standard. But that is where we are.

 

Fed won't hit the brakes until it's sure we've hit something

No one should be shocked to learn that Bernanke opened Wednesday's testimony by saying that a premature tightening risks slowing or ending the recovery.

 

That is all you need to know: There will be no premature tightening. Bernanke is not going to pre-empt anything, certainly not inflation.

In fact, he said, ". . . inflation, if anything, is a little too low."

 

All of the tough talk, I believe, is because the powers that be at the Fed have some inkling somewhere in the back of their minds that maybe if they "overdo it," financial markets might get a little (in Fed terminology) overheated.

 

Other than that, they have no interest in ending their massively stimulative policies in any time frame that could remotely be called early.

In any case, when the Bernanke headline hit the tape, everything vaulted to the upside. Then, during the question-and-answer period with lawmakers, Bernanke said he could raise or lower the purchase pace of Fed bond buying (gee, what a shock), depending on the data (ditto).

 

But then he dropped a supposed bombshell, noting that the Fed could cut the pace of bond purchases at one of its next few meetings (yes, slowly, or maybe not at all). That comment caused a great deal of selling in the bond, currency and metals markets, but it initially had only a modest impact on the stock market, which eventually sank with everything else.

 

Hanging ourselves on every word

The bottom line is that this is a whole lot of hot air, but we are forced to deal with it on a daily basis because we live in a world where central bankers think they know the future and the only standard that exists anymore is the jawbone standard.

 

(And, most importantly, the damage from money printing has already been done, the consequences just haven't yet fully manifested themselves.)

 

Are bonds u-ZIRP-ing control?

Bonds were deservedly smoked on Wednesday, and yields are approaching their highs of the year. If they keep sliding, stocks will get hit (though they could tank for any reason now, given how frothy the market is) and then the economic data will be seen for what it is: weak.

 

Of course, "taper talk" would then cease and folks would realize that the Fed is (and has been) trapped. You can't abandon zero-interest-rate-p​olicy (aka ZIRP) until the market forces you to via a funding crisis. Period!

 

At the time of publication, Bill Fleckenstein owned gold.

 

I was fortunate to spend a recent Saturday with my anonymous friend, to whom I refer in my columns as the Lord of the Dark Matter, and I wanted to share the key points of our conversation.

 

He believes that we need to stay focused on Japan because its stock and currency markets are acting as if they (preemptively) are rejecting the concept of money printing.

 

The yen has tanked 15% and Japan's bond yields have climbed from 0.50% to 0.82% (more than 60%) since Japanese quantitative easing commenced in November. That increase in volatility alone might begin to cause problems for Japanese derivative books.

 

Bonds? Aye!

When you are in a country such as Japan, where interest rates have been zero for a long time, you can be sure all manner of volatility has been sold (at the wrong price) in an attempt to enhance yields. So if volatility and interest rates increase, we could see quite a lot of chaos precipitated from Japan, just as when the housing bubble burst and it wasn't just declining housing prices that caused problems. (It was also the levered-up exposure to mortgage-backed assets and other crazy products.)

 

Thanks to the policies of central banks, we live in a world where there has been a mad scramble for yield, which means too much leverage has been employed and no one is paying attention to credit risk (or the absolute level of interest rates, for that matter). As said more cleverly by LODM, "the world is short gamma." That means that if the situation starts to get out of control in Japan, there will be big ramifications, there and here.

 

My, gamma, what big teeth you have

I don't want to get ahead of myself, because if the Japanese bond market revolts soon, it won’t be just a funding crisis, but a preemptive one as well. My thesis has always been that inflation will eventually cause bond buyers to take the printing presses away from central banks. That is, the funding crisis would be a reaction to inflation.

 

If Japan’s bond market trouble is imminent, it would be a proactive strike on the part of bond investors. Therefore, I am not quite sure a funding crisis can occur in the short run. But, given the insanity of the Japanese debt market and the monstrous size of the monetization program, we have to be alert to new developments.

 

We all know that the policies being pursued by governments and central banks are insane and ultimately disastrous, but they won't stop without being forced to. This is also why I would expect the Bank of Japan to do more rather than less at the first sign of real "front page news" trouble.

 

And what might the BOJ have up its sleeve to fight this unwanted development? The LODM suggested that if the Bank of Japan were really clever and wanted to stabilize the longer end of the bond market, it would do something like cap 10-year Japanese government bonds at 100 basis points, which isn't very far from where they are today. In that way, given the BOJ's inflation target of 2%, it would guarantee negative real returns and dampen volatility. Obviously, that wouldn't change the eventual outcome, but it would likely buy the BOJ some time.

 

Say a few 'Abe Marias' while they're at it?

Of course, nothing like that has been announced. But the point of this exercise is to acknowledge the fact that Japanese Prime Minister Shinzo Abe and his cohort at the BOJ are not going to give up easily. Capping the 10-year for a while is something they can do, and for all I know there are other clever maneuvers they could also try. At any rate, this is potentially a very serious problem, as JGBs comprise about 900% of Japanese banks' Tier 1 capital. Thus, authorities there are going to move heaven and earth as they fight the bond market.

 

So far, however, world markets have concluded that the BOJ's actions have been a thing of beauty (i.e., the Federal Reserve on steroids), as the Nikkei has levitated 45% this year with no negative ramifications. Thus, I don't want to become too alarmed, and I have taken no action regarding the potential for a Japan-centric financial nuclear event. But I wanted to call it to everyone's attention.

 

This process has just begun, and there is no point in getting excited too soon, but it is a very important development that bears watching.

 

Paul Singer, the founder and CEO of the extraordinarily successful Elliott Management, recently wrote an essay ("The Fed, Lost in the Wilderness") that was the most succinct and accurate discussion I have seen of where we are, how we got here and where we are headed.

 

Regular readers will not be surprised (given that I wrote the book "Greenspan's Bubbles: the Age of Ignorance at the Federal Reserve") that the first point I appreciate about the essay is that Singer lays the blame where it belongs -- something a surprisingly small number of people are able (or willing) to do.

 

"The Fed is primarily responsible for (the current) state of affairs, and it is out of its depth," Singer writes. "Former Chairman (Alan) Greenspan created -- and reveled in -- a cult of personality centered on himself, and in the process created a tremendous and growing moral hazard."

 

By embracing, rather than discouraging, his "maestro" mystique, Greenspan helped foster the sense that not only was he able to keep the economy "just right," but also that he could quickly correct any problems that might arise.

 

Jerk of all trades, maestro of none 

As Singer puts it, Greenspan "cultivated an ever-increasing (but unjustified) faith in the Fed's apparent ability to fine-tune the American (and, by extension, the world's) economy. Ironically, this development was occurring at the very time financial innovations and leverage were making the system more brittle and less safe."

 

In short, the Greenspan era represents the greatest failure of Fed policy this country has ever experienced. Not only did Greenspan fail to grasp the consequences of his leadership, but his "solutions" also laid the groundwork for the bigger problems of the housing/credit crisis. If not for his incompetence, none of the problems he created would have befallen us.

 

If Greenspan's tenure is marked by hubris, current Fed Chairman Ben Bernanke's tenure is (in Singer's view), "one of lower and lower discipline (and) less and less conservative stewardship of the precious confidence that is all that stands between fiat currency and monetary ruin. . . . Speculators win, savers are destroyed and the ties that bind either fray or rip."

 

The other invisible hand: Risk 

Singer correctly points out that while the Federal Reserve's money printing seems to be all gain and no pain, it comes at a price (greater  risk) that present-day investors have been conditioned to ignore.

Inflation, dislocations in stock and bond prices, and instability of financial institutions are all problems more likely to mount as a result of Fed policy. Yet, since stock markets continue to rise (on weak fundamentals) and there is no widespread concern about inflation (yet), many investors seem content to believe that our problems are being resolved.

 

Reality, according to Singer, is quite different: "We believe that the global central bankers, led by the Fed as 'thought leader,' have no idea how much pain the world's economy may endure when they begin the still-undetermined and never-before-attempt​ed process of ending this gigantic experimental policy."

 

And keep in mind, central bank recklessness is a global phenomenon, not a local one. In addition to rampant money printing by the Fed, the Bank of Japan, the Swiss National Bank, the Bank of England, the European Central Bank (in word, if not deed) and, just last week, the central banks of Australia and South Korea have all joined the party.

 

Also this past week, ECB President Mario Draghi made some bold claims when he stated during a speech in Rome that: "For the southern European countries, a euro above $1.30 would be too high for their economy. Among major central banks, the ECB has been the only bank that is not expanding its balance sheet. But it will likely consider such a step."

 

Assuming that Draghi follows through with the action he is implying, we will have unanimous and massive fiscal and monetary stimulus from every single G-7 country and, by extension, others as well.

 

Green with envy 

The amount of stimulus being applied is unfathomable. Thus far, the United States is perceived as being in the best position (i.e., the sweetest of the sweet spots), with Japan quickly catching up. It would seem that world governments are in the process of concluding that their stimulative policies are solving all problems and have no negative consequences (thus we are going to see more of them).

 

How long the deflationists can hold out with their bond bets remains to be seen, but only the bond market can stop these policies -- a point I have made many times. (I should also be clear that it does not look like the policies will be halted anytime soon.)

 

With the Dow Jones Industrial Average ($INDU) and Standard & Poor's 500 Index ($INX) hitting all-time highs even as we run trillion-dollar deficits, we are the financial and economic envy of the G-7 world, even with our massive problems. So you can be sure the Europeans are going to emulate us.

 

Summing up the current environment, Singer writes:

 

"Printing money by the trillions of dollars has had the predictable effect of raising the prices of stocks and bonds and thus reducing the cost of servicing government debt. It also has produced second-order effects, such as inflating the prices of commodities, art and other high-end assets purchased by financiers and investors. But it is like an addictive drug, and we have a hard time imagining the slowing or stopping of QE (quantitative easing) without large adverse impacts on the prices of stocks and bonds and the performance of the economy. If the economy does not shift into sustainable high-growth mode as a result of QE, then the exit from QE is somewhere on the continuum between problematic and impossible."

 

It is impossible to say when all this will unravel, but one thing I am certain of is that those who think it won't be painful are in for yet another rude surprise.
 

For years, Amazon.com (AMZN) always rallied after release of the company's quarterly results, regardless of what those results were. After starting out with its usual upside performance following release of results for last year's fourth quarter, however, the stock quickly gave up those gains, and more, before moving sideways. Thus, I was curious to see what it would do when the company announced its first-quarter earnings on April 25.

 

I had a feeling that the stock might be a canary in the coal mine for the stock market at large. It was just a guess on my part, and a pretty tenuous one; but to my way of thinking, Amazon essentially has no fundamentals, since there has been no way to handicap what might make the stock go up or down.

 

Being a contrarian is not easy. If you are right about a new idea, it always takes time to prove out. In the short run, you usually appear to be wrong, and you look -- and often feel -- silly.

 

While I don't consider myself contrarian for its own sake (I am a contrarian because it is the best way to improve your risk/reward odds), longtime readers know that I have no problem voicing unpopular opinions. I try to be disciplined about coming to my own conclusions, regardless of what anyone else might think.

 

About a year ago, I had a great opportunity to illustrate this point. On MSN Money on April 5, 2012, I published a controversial column titled, "Is it time to bet against Apple?" It certainly generated a lot of negative replies.

 

I was out of the country last week and thus did not post a column, but readers are no doubt aware that the gold market tanked about 14% between Friday, April 12, and Monday, April 15. So I will be devoting this week's column to that subject.

 

The first big question to consider is, Does this slide have predictive value? Does it tell us anything about the future?

 

I don't believe it does.

 

Seeing as how there has not been much new news to discuss, I thought I might take a moment to expand on the phenomenon of nonsense becoming news.

 

This is a variation of the old Wall Street saw (that I have noted from time to time) of the stock market action writing the headlines. The reason I bring it up is because Wednesday's Wall Street Journal had three news items that illustrated my point while also being nonsensical, maddening or both.

 

First off was an article headlined, "Silver bears pounce as manufacturing sputters." The article claims that the reason silver has been weak is because "mounting evidence that the rebound in global manufacturing is stalling has investors worried that industrial demand, one of silver's last remaining pillars of support, is crumbling as well."

 

Markets were initially soothed this week as bulls rejoiced over Cyprus finding a "solution" to its recent problems.

 

I suppose in a way that's true, but the differences between this week and the previous one are simply the institution of capital controls and the fact that larger depositors will take a big hit and smaller ones will get the guarantee they had been promised.

 

Thus, there was a bit of good news (along with the bad) in this decision, even if the consequences are liable to lead to plenty of trouble.