When first appointed in 2006 by President Bush, Ben Bernanke probably didn’t expect his two terms as the Chairman of the Federal Reserve to be the most decisive ones of the past century. First denying an housing bubble, he had to face its real burst and the most threatening crisis since 1929. In 2008, he adopted the 101 monetary policy and started the first out of three (soon four) quantitative easings buying mortgage-backed securities and treasury notes. The Federal Reserve balance sheet is now more than four times larger than it was in 2008 and with a substantial higher exposure to risky assets. More than 21% of the 2008 US GDP has been injected in the economy since but GDP has only grown 10% over the same period. However, this “easy money” (the QE’s monthly injection accounts for approximately 8% of NYSE monthly volume) has led the S&P and Dow Jones to beat their own records and go above the pre-crisis levels.

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If we can say that the first quantitative easing and was crucial during the crisis to avoid a massive and destructive credit crunch thanks to increased liquidity, the results of the successive ones is quite vulnerable to critics even within the Fed’s Board.

As a result, and even if it was announced that the near-zero interest rates policy would not change before 2015, Ben “Helicopter” Bernanke

(http://www.thestockenthusiast.com/opinion/how-bernanke-got-the-nickname-helicopter-ben-why-it-matters-right-now/) announced on last May that the Fed would soon temper the QE, confident that the wealth effect was important enough for the economy to continue to grow. In the following seconds, markets fell down sharply and rose questions about weather it is the right time and if the cure has not become an addiction. However there is no such thing as a free lunch and QEs have a cost and a risk proportional to their duration, as diplomatically stated by Larry Fink, the CEO of BlackRock:

“The biggest risk in not tapering was that the longer the program ran, the harder it would be to unravel”

This announcement came sooner than expected, but it was rational to assume the Fed would progressively slows down its liquidity injection as markets were at a record high and unemployment was slowly decreasing below 8%. But this assumption holds only if the Fed can be considered as a rational and truthful agent which some people have lately started to doubt.

On September 18 everybody was waiting the withdrawal timetable and many took short position on short-term t-bills. Surprisingly, Bernanke announced that the QE would continue at its current pace. The most valuable asset of Central Bank is its credibility among investors and this last announcement has undoubtedly damaged it. The question is what does the Fed knows that made it to take this decision and go against its own word ?

There is a basic rule for a capitalist economy to work properly and grow: risk-takers should be more rewarded than annuitants. Risk-takers are rewarded with profits (that follow GDP growth in average) and annuitants with interest rates (cost of capital for private agents, like the BAA Corporate Bond Yield). If the former is lower than the latter, there are very few reasons for an entrepreneur or a company to be audacious, create wealth and jobs, as he would earn more just sitting and waiting. So what’s the actual situation ?

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Since April-May Aaa and Baa Corporate bonds have rose by 80 basis points while actual and expected gdp growth is falling down. As a result the gap between annuitants and risk-takers that was hopefully slowly decreasing since 2008 has suddenly increased. If this tendency holds during the following month, the US economy will be on a very bad path. Statistically, each time Baa bonds were 250 basis points higher than growth during a quarter, a recession came up. If 3rd quarter previsions are verified true, we will be in this tricky situation.

 

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Facing that the Fed had two options:

– Taper Quantitative Easing and take the risk of engendering a new recession

– Surprise investors by keeping the current pace hoping this would lower long-term corporate interest rates

The Federal didn’t lose its mind and chose the less worse choice. However it may have lost its credibility and it is necessary to actively follow long-term interest rates as a proxy. They seem to decrease for now which is reassuring.

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The Federal Reserve Movie is not over as Ben Bernanke’s second term will be terminated next January. After the withdrawal of Larry Summers, the main remaining candidate is Janet Yellen, a partisan of negative interest rates.

It is therefore very unlikely that the Federal Reserve will slow down its liquidity injection and if Yellen is confirmed we can expect even an acceleration. But if the cost of capital for private agents doesn’t decrease, we can expect soon a new recession. However, even if things go well the Fed’s policy will be way more difficult to unravel. But that won’t be Bernanke’s problem anymore.


Trading idea for the next month: monitor Baa Corporate Bonds yield. If it hits and stay above 5.5% long put position on DJ and S&P before the release of the 3rd Quarter GDP growth on October 30.

A special thanks to Charles Gave for inspiring this article


2 Comments

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