Posts Tagged ‘Federal Reserve’

Will there be a surprise rally in the USD?

Wednesday, October 27th, 2010

Everyone knows that the US Federal Reserve is going to print money (quantitative easing) in November. Hence, the financial markets have already priced that in. To them, this is a foregone conclusion. Surely, Bernanke is going to print trillions of dollars right? There?s no way he?s not going to do that right?

At this point, investors should be alert. When almost everyone thinks that a future outcome is a slam-dunk certainty, it?s the time when the market is most vulnerable to a significant setback. Since everyone is expecting that Bernanke is going to print so and so amount of money, and if it turns out that he is not printing as much as expected, the reaction by the financial markets can be savage. Any hints of dithering by Bernanke will be very negative for asset prices in the very short term.

Surely it wouldn?t happen right?

Well, who knows.

As the Americans accused the Chinese of manipulating their yuan, the Chinese will be accusing the Americans of manipulating their dollar through money-printing devaluation. Perhaps behind the scenes, both sides are negotiating a middle road. Maybe the Chinese will promise the Americans that they will appreciate their currency a little more than expected and the Americans will promise the Chinese that they will print a little less than expected. That way, the Chinese can cool their economy and pop their speculative property bubble while the Americans can benefit from a sell-off in gold and commodity prices and trigger a mad scramble for US Treasuries, which the US government will happily oblige because they are in need of cash to borrow.

Be ready for surprises!

Expectation of US Dollars (USD) printing creates an Australian Dollar (AUD) bubble?

Sunday, October 10th, 2010

Everyone on the streets know that the Australian Dollar (AUD) is rampaging towards parity with the US Dollar (USD). Joining the media circus, some forex pundits are even prophesying that the AUD could reach $1.20 against the USD. The masses in Australia are cheering because it is now cheaper to buy stuffs overseas due to the ?strong? AUD. Politicians (Wayne Swan) are cheering because it is a great excuse to brag about the ?strength? of the Australian economy under the stewardship of their political party. Businesses that has their costs paid directly or indirectly in terms of USD are cheering (e.g. retail import). Businesses that receive their revenue in terms of USD (directly or indirectly) are in pain (e.g. mining, tourism).

We wouldn?t be surprised if the next round of readings for consumer confidence in Australia will show a marked increase. We have no doubt that this in turn will add fuel to more cheering by politicians and the media circus.

But as contrarian investors, you have to understand the context and big picture behind the surging AUD. Do not be like the masses by being caught up with the euphoria. Instead, be prepared and even profit for what is to come.

Firstly, it is not just the AUD that is rising against the USD. The euro, yen, base metals, gold, silver, etc are also rising too. However, the expectation of more interest rate rises by the Reserve Bank of Australia (RBA) is acting like rocket boosters to the already rising AUD (see Return (and potential crash) of the great Aussie carry trade). In other words, it is more of the USD that is deprecating, not the AUD appreciating. As we wrote in What if the US fall into hyperinflation? on April 2008,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

Already, the Japanese central bank are cutting interest rates, taking token measures to intervene in the forex market to weaken the yen and even talking about buying government bonds (i.e. ?printing? money). Basically, the Japanese want to devalue the yen. For Australia, we would hazard a guess that one of the major contributing reasons why the RBA did not raise interest rates last week is because of the surging AUD (that was also the suggestion of one of the economists in CommSec).

To put it simply, the depreciating USD is creating a bubble-like conditions for the currencies of foreign countries. That is problematic, not the least because it is making their exports uncompetitive (just ask any Australian mining company). What is the solution for these countries? Devalue their currencies too (if it can be done without the masses being aware, all the better).

The next question is: why is the USD depreciating?

The reason is simply because of the expectation that the Federal Reserve is going to embark on a second round of massive money printing (see Bernanke warming up the printing press). What is the background behind the Federal Reserve?s money printing idea? To answer this question, we would refer to the late Professor Murray Rothbard?s book, Mystery of Banking:

In Phase I of inflation, the government pumps a great deal of new money into the system, so that M increases sharply to M?. Ordinarily, prices would have risen greatly (or PPM fallen
sharply) from 0A to 0C. But deflationary expectations by the public have intervened and have increased the demand for money from D to D?, so that prices will rise and PPM falls much less substantially, from 0A to 0B.

Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices will rise only by a little bit!

It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it will grab on to it. It will continue to pump new money into the system, and, given a high or increasing demand for money, prices, at first, might rise by only a little.

Murray Rothbard wrote this book more than 25 years ago. Yet, it is pertinently relevant for today?s context. The US government?s budget is in great deficit. It will get worse as they have to spend even more money to prop up and stimulate the economy. The current environment of deflationary expectations is providing an excellent cover for Bernanke to print money (see Bernankeism and hyper-inflation).

But as Murray Rothbard continued,

But let the process continue for a length of time, and the public?s response will gradually, but inevitably, change. In Germany, after the war was over, prices still kept rising; and then the postwar years went by, and inflation continued in force. Slowly, but surely, the public began to realize: ?We have been waiting for a return to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.? As this psychology takes hold, the public?s thinking in Phase I changes into that of Phase II: ?Prices will keep going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.? The public?s deflationary expectations have been superseded by inflationary ones. Rather than hold on to its money to wait for price declines, the public will spend its money faster, will draw down cash balances to make purchases ahead of price increases. In Phase II of inflation, instead of a rising demand for money moderating price increases, a falling demand for money will intensify the inflation.

Given the large and exponentially growing debt of the US government, monetary inflation is the only path they can take as far as the eye can see.

There is a lot more in Professor Murray Rothbard?s Mystery of Banking if you want to learn how money and credit are related to each other through the banking system work. You can read a sample of this book here (at the right of that page, click on the ?Read First Chapter Free? button).

Are deflationists missing the elephant in the room? Or are they believing in something more sinister?

Sunday, August 1st, 2010

As you scour around the blogsphere, you will see that there are contrarians who still believe that it is impossible for the US to prevail against deflation. The most extreme of deflationists is Robert Prechter (from Elliot Wave International), who is still predicting that the Dow Jones will go all the way down to 1000. Up till March 2009, it seemed that the deflationists’ argument was correct. In the Panic of 2008, deflationary forces were so strong that asset prices were even more oversold than the infamous 1987 crash. Unfortunately for the deflationists, the subsequent rally (reflation) till May 2010 was so enduring that their argument was discredited in the eyes of many.

Our view, on the other hand, belongs to the inflationists’ camp. From what we can see, there is a big elephant in the room that deflationists miss. But as we think about the deflationists’ argument, it suddenly dawn on us that perhaps deep in the soul of the deflationists’ argument is the belief of what some may call a “conspiracy theory.” Of course, we guess not all deflationists hold (or even aware of) such a belief. But the more extreme and strident a deflationist hold on to the deflation argument, the more we suspect that they are holding on to the belief of the “conspiracy theory.” Although we do not know whether that “conspiracy theory” is true or not, it certainly helps to explain the extreme position held by some deflationists.

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When to start speculating again?

Thursday, July 8th, 2010

As we wrote before in Notice the change of narratives in the financial markets?, the theme for the coming months is likely to be deflation (contraction in the supply of money and credit). The symptoms of deflation will include falling asset and commodity prices and appreciation of the US dollar.

The reason why deflation is gaining the upper hand is that governments are not renewing their appetite for maintaining the crutch (economic ?stimulus?) to keep the economy from sinking. In Europe, the government themselves are deleveraging (see Keep up spending- Who?s right? Europe or America?).

But as contrarian investors, we have to keep one step ahead. As deflationary forces gather steam, eventually the government will be spooked. Eventually, they will be pressured politically to do ?something? about the situation. That ?something? will ultimately boils down to turning on the monetary printing press.

For example, as this news article reported, there is an expectation that the Chinese government will do ?something? if stock prices continue its downward trajectory. In the US, RBS recently warned its clients to be prepared for a ?monster? money-printing operation from the Federal Reserve (long before RBS released this, readers of this blog already know beforehand that this will happen- see Bernankeism and hyper-inflation).

When governments do ?something? about the deflationary pain, it will be a signal to shuffle your money back into speculation.

How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate

Sunday, February 7th, 2010

Whenever we hear that the Federal Reserve is going to keep the interest rate close to zero, we may wonder what is meant by “interest rate?” Specifically, which interest rate does it mean? After all, there are many “interest rates,” from 30-day bank bill rates to 30-year Treasury bond yields. As it turns out, the “interest rate” that the Federal Reserve controls is the Fed Funds Rate.

The Fed Funds Rate is basically the rate that banks lend to each other overnight. Also, the Federal Reserve (so do many other central banks like our RBA) does not set the interest rate in the form of a decree to be followed. Instead, the Fed Funds Rate ‘sets’ the Fed Funds Rate by adjusting the supply of money such that it reaches a target that is intended (see How does a central bank ?set? interest rates?). The Fed Funds Rate in turn influences the interest rates in the market.

Well, not quite.

At least that’s true for the past two decades before the Panic of 2008. Ever since the September 2008 bankruptcy of Lehman Brothers, the Fed has lost control of the target Fed Funds Rate, as it begin to ‘print’ copious amount of money to save the world from a Greater Depression. As you may recall from How does a central bank ?set? interest rates?, the central bank can either control the quantity of money or the target Fed Funds Rate- it cannot control both. The GFC forced the Fed to flood the financial system with heaps of ‘printed’ money, which undermined its ability to control the target Fed Funds Rate.

So now the problem is to find another “interest rate” that is more relevant. As this Bloomberg article wrote,

Federal Reserve policy makers are considering adopting a new benchmark interest rate to replace the one they?ve used for the last two decades.

One of the “interest rates” that is under consideration is the interest rates paid by the Federal Reserve to commercial banks’ reserves. A simple way to understand what “reserves” are is to imagine the Federal Reserve being the bank of commercial banks. “Reserves” are simply the ‘cash’ that they ‘saved’ at the Federal Reserve.

Originally, the Federal Reserve did not pay any interests on reserves. After all, the whole point of banking is to get the banks to lend out their money to the wider economy. By not paying interest on reserves, they became unproductive assets. Thus, that prodded the banks to lend out their reserves to make their assets more ‘productive.’ As you can see by now, buying supposedly ultra-safe Treasury bonds at whatever yield was even better than keeping the reserves at the Fed at zero yield.

But the GFC messed everything up.

On October 6 2008, the Fed announced that they will be paying interests on banks’ reserves. The reason for doing so is to allow the Fed to control market interest rates and the quantity of money (reserves) via its various liquidity facilities. As the Fed said in that announcement, it

… give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets [e.g. banks refusing to lend to each other] while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

In other words, the interest rates on reserves is now the only tool at the hands of the the Fed to influence market interest rates. (Note: if you want to understand why, you can read this paper from the Federal Reserve here).

Now, there is a worry that with so much excess bank reserves (thanks to money printing) in the financial system, inflation will take hold once banks start lending them out again. What is the Fed going to do to restrain the banks from lending, thus causing inflation?

We will look into it in the next article.

Booming real economy, falling stock market?

Tuesday, November 10th, 2009

One of the most common ideas floating around is that the real economy must be on its way to recovery because the stock market, which is often a leading indicator, is recovering. The mainstream economist will tell you that the contradictory newspaper headlines that we showed in our previous article are not really contradictory at all. They will say that since the stock market is a leading indicator, then it will bottom out first before the real economy bottoms out. According to their logic, that’s why you can see rising unemployment and rising stock prices simultaneously.

The idea that the stock market predicts the business cycle is a very dangerous one for the investor. The truth is that, as we said before in Is this a bear market rally or a turning point?,

To be more precise, the stock market anticipates but not predicts turning points. What this means is that economic recoveries are followed from recoveries in the stock market, but a stock market rally does not necessarily indicate an economic recovery.

So, assuming that this stock market rally does not signify an economic recovery, what will be the outcome? The deflationist believes that this rally will eventually run out of steam and collapse into a rout. The inflationist believes that the worse the real economy is, the bigger the bubble in the stock market will be (see Should you be bullish on stocks?) because of unprecedented money printing.

If you subscribe to the inflationists’ view then it follows that should the real economy recovers, then it will be very bad for the stock market. To understand why, consider what will happen if the real economy really recovers:

  1. Stimulus will be withdrawn.
  2. The Federal Reserve will mop up the ‘printed’ money from the financial system.
  3. Government tax revenue will increase sustainably, which means the the size of the budget deficit can decrease, which in turn means that the government will be less sensitive to rising interest rates by the Fed.
  4. The Fed will then raise interest rates.

A truly recovering real economy will result in liquidity draining out of the system. Since the current rally is fuelled by massive loosening of liquidity, draining liquidity will imply that the stock prices will fall and the US dollar strengthens. As the US dollar strengthens, then the short squeeze in the US dollar will happen (see Currency crisis ahead? Part 1- Potential short squeeze on the US dollar), which implies that the Aussie dollar and stock prices will tank.

So, beware of the stock market rally!

Who’s the boss? The Fed or the American people?

Thursday, March 5th, 2009

As we all know, the American tax-payers are on the hook to lend money, up to the amount of US$2.2 trillion, to ailing banks. So, isn’t it fair that the American people should at least know to whom these money are lent to?


In a Senate Budget Committee hearing (see UPDATE 1-U.S. senator wants Fed to name loan recipients), there was a heated exchange between Sen. Bernie Sanders and Ben Bernanke:

Sanders: My question to you is, will you tell the American people to whom you lent $2.2 trillion of their dollars?

Bernanke gave a generic answer by saying that the Fed explained the various lending programs on its website, and details the terms and collateral requirements. So, Sanders began to press Bernanke again for the specific names. That was Bernanke’s answer:

Bernanke: No.

What? Bernanke refused to answer this question?

Well, as he explained, doing so will stigmatise the banks and discourage them from borrowing from the Fed, which in turn is funded by the American tax-payers. Sanders cut Bernanke off,

 Sanders: Isn’t that too bad, they took the money but they don’t want to be public about the fact that they received it.

Later, as the senator said “businesses in his state were in trouble and needed loans, but were not permitted to borrow from the Fed.” So, he asked Bernanke,

Sanders: Do you have to be a large, greedy, reckless financial institution to apply for this money?

Bernanke replied that the Fed could not do that legally. The exchange continued,

Bernanke: We have never lost a penny doing it

Sander: Let me just say this, Mr. Chairman. I have a hard time understanding how you have put $2.2 trillion at risk without making those names available, those institutions public. It is unacceptable to me that that this goes on.

As this Bloomberg article says,

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson said in September they would comply with congressional demands for transparency in a $700 billion bailout of the banking system. Two months later, as the Fed lends far more than that in separate rescue programs that didn’t require approval by Congress, Americans have no idea where their money is going or what securities the banks are pledging in return.

So, who’s the boss?

Are government interventions the first steps towards corruption & inefficiencies?

Tuesday, January 27th, 2009

The global financial crisis (GFC) has seen governments all over the world engaging in stimulus, special plans, guarantees, rescues, bailouts, nationalisation and other forms of interventions. The Australian government is no different. The first was the guarantee of all Australian bank deposits and loans. Next was the AU$10 billion economic stimulus. Then recently, there was a plan to set up a special purpose fund to help banks refinance as much as AU$75 billion worth of loans. Other plans include help for certain industries (e.g. car, construction, child-care, property sectors) cope with the global shortage of money (credit crisis). In addition, the Reserve Bank of Australia (RBA) is busy cutting interest rates. In the US and Britain, massive banks and GSEs were gobbled up through nationalisations while their limping peers have their incompetence covered by the monetary printing press. As Australia approaches a hard landing (see Realisation of hard landing ahead for Australia), we can expect what happened overseas to happen in Australia.

Among the various forms of government interventions, we have the strongest reservations against bailouts and rescues. While they ease the pain in the short term, they are detrimental to the economy in the long term. While the sting of this GFC may be soothed by each government intervention, there will always be longer term side-effects, many of which will be unintended and initially unforeseen. All these unintended side-effects will eventually accumulate and turn the GFC into a long-term economic malaise that result in a bleak future for the next generation. In other words, anyone who is concerned for the next generation will have strong reservations for today’s bailouts and rescues.

Here are some of the issues with bailouts and rescues:


They are inherently unfair because the government will have to act as the judge and decide which businesses/industries should live and which ones should die. Unfairness, by its very nature, implies preferential treatment. What is the government’s basis for favouring one business/industry over the other? Due to the ’emergency’ nature of bailouts and rescues, transparency over such government decisions will be in short supply. This will open the door for corruption as lobby groups and vested interests jostle and fight over the government’s preferential treatment. This is not to say that the current government is corrupt. Instead, our concern is that this will open the door for future governments to be corrupt.

Moral hazards

Bailouts and rescues introduce moral hazards because by not letting the free market punish incompetent, reckless and stupid business behaviours, they are making conditions ripe for more of such nonsense to continue. After all, why bother be good when bad behaviours are not punished?

The whole point of free market capitalism is to let the incompetent businesses be eliminated so that the competent ones can take over the incompetent ones and be rewarded. This competition forces the survival of the fittest and most efficient. By bailing out and rescuing, the government is taking precious economic resources (which is scarce in such a time) from the competent (via taxes) and awarding them to the incompetent. The net result is that the economy as a whole will become more and more inefficient. This is precisely the reason why communism ultimately fails.

Now, there are talks of the need for more government regulations to curb such nonsense in order to prevent future financial crisis. The idea is to bailout and rescue first, then come up with more rules and regulations to ‘prevent’ another global financial hazard from happening again.

The problems with rules and regulations are:

  1. Administering, monitoring and enforcing them are costly. They are a drag on economic growth as they introduce more red tape for businesses to handle.
  2. Rules and regulations may be so effective that while they prevent the bad things from happening, they cab also stifle the good things from bearing fruit too. Those entrepreneurs with brilliant ideas who have to battle government red tape to get their projects moving another step forward can relate to that.
  3. As we said before in Where do we go from here? A journalist?s questions…,

    … at the root of this Global Financial Crisis (GFC) lies the moral failure of humanity. Through this moral failure, the world is allowed to get carried away and believe in what it wants to believe.

    Rules and regulations can only work up to a certain extent because beyond that, it is impossible to legislate morality.

  4. No matter how tight and comprehensive rules and regulations are, there will always be loopholes and gaps to allow circumvention. For example, as Satyajit Das revealed in his book Traders, Guns & Money, derivatives routinely make a mockery out of laws. It has come to a point that poking holes at the legal system via derivatives has become a sport!

As we quoted Jimmy Rogers in Jimmy Rogers: ?Abolish the Fed?,

More regulations? You want Alan Greenspan and Ben Bernanke? These are the guys who got us into this situation. They are supposed to be regulating the banking system for the past 50 years. These are the guys who let it all happen. I don?t want more regulations. Let the market regulate it. If xyz needs to go bankrupt, let them go bankrupt. I promise you, that will send a very straight signal and you will have a lot of self-regulation when these guys start to go bankrupt.

If the Federal Reserve did not bail out LTCM in 1998 and let it go bankrupt instead, it would have sent a very strong signal to the market back then.


One day, the GFC will end. But this generation will leave a legacy of corruption and inefficiency for the next if today’s governments continue to intervene in such an unprecedented scale.

Changing the rules of the game

Monday, December 15th, 2008

Next year, the US government needs to borrow US$1.5 trillion to pay for its expenditure. Up till the end of November 2008, $4.16 trillions worth of spending programs were endorsed by the US government to bail out Wall Street and stimulate Main Street. There are rumours that the upcoming President Obama will sign in a trillion dollar economic stimulus package when he takes office next month.

Not too long ago, hundreds of millions of dollars were an unimaginable sum of money. After a while, the concept of million is replaced by the billion. Today, trillion supplanted the billion. How much money is a trillion dollars? Imagine you have a stack of US$1000. For that stack to reach $1 trillion, guess how high it has to go? The answer is: 109 kilometres! By comparison, the earth’s atmosphere is only 120 kilometres.

As we mentioned before in How is the US going to repay its national debt?, the US national debt stood at more than $4 trillion at the beginning of this year. With all these extra spending programs, bailouts, rescues and stimulus, it could easily more than double.

So, where is the US government going to get the money from? Will the Chinese, Japanese and Arabs be kind enough to lend them? Probably not, because the US government still owe these foreigners trillions of dollars of outstanding debt. Will they borrow from the American people? No, the American people are too deep in their own private debt to spare a dime. Will they tax the American people? No, because the US government want them to spend in order to ‘stimulate’ the economy. The only to do so is to shower them with even more money.

That leaves only one option- print money. The traditional way to do so is for the government to issue Treasury bonds to the Federal Reserve, which in turn conjures up the money from thin air to pay for them. But even then, at the rate at which the tide of financial destruction is going, the government cannot print fast enough. After all, there is a legal limit on the amount the Treasury Department can borrow. To break that limit, it has to seek the permission of Congress.

Is there a way to break tradition? In this recent Wall Street Journal article, it reported that the…

… Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.

It isn’t known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn’t explicitly permit the Fed to issue notes beyond currency.

Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.

So, they are thinking of new ‘ideas’ to change the rules of the game in the middle of the session? Remember what we wrote in Recipe for hyperinflation:

One thing we have to be clear. Assuming that the ?rules? are strictly adhered to, there will only be one outcome for the current credit crisis: deflation.

Since the current structure of ?rules? will be too restrictive in such a war against deflation, there will be popular momentum towards the bending and rolling back of these ?rules.? If they press on relentlessly till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilization.

Bernanke ticking off another inflation trick- buying Treasury securities

Wednesday, December 3rd, 2008

Remember, back in Bernankeism and hyper-inflation, we had a list of Ben Bernanke’s ‘unconventional’ (read: crazy) schemes to fight deflation. One of the schemes was already implemented (see Bernanke ticking off another inflation trick- becoming a business lender). That’s one tick in the list. Another scheme in the list is

Purchase of long-term US Treasury bonds.

Today, we heard news that Ben Bernanke is suggesting just that. As reported in Bloomberg,

Bernanke yesterday said he may use less conventional policies, such as buying Treasury securities, to revive the economy, because his room to lower the main U.S. rate from the current 1 percent level is ?obviously limited.? Even so, reducing the rate is ?certainly feasible,? he said.

Watch this space.