The Real Reason for Fed Easing? Debasement Inflation?

Well, one of my major arguments made it to the op-ed page of the Wall Street Journal today, but I didn’t write it: Andy Kessler, a former hedge-fund manager wrote it. I agree with most of what Mr. Kessler says in his piece, “ What’s Really Behind Bernanke’s Easing?” (See http://professional.wsj.com/article/SB10001424052748704648604575621093223928682.html?mod=WSJ_Opinion_LEFTTopOpinion&mg=reno-wsj.)

I have been arguing for more than a year that the real concern of the Federal Reserve is the solvency of the banking system. The Fed’s given arguments for pumping so much liquidity into the banking system is that the economy is weak and the level of unemployment is unacceptable. The Chairman of the Board of Governors of the Federal Reserve System cannot say just say out loud that “the banking system is at risk.” Nor can any other Federal Reserve figure say this out loud.

My concern over the past year of so has constantly been that the economic and financial situation did not warrant the injection of all the Fed was throwing at it. See my post “Bernanke’s next round of spaghetti tossing”: http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.) A recent post continues to exhibit my belief that the justification for the Fed actions has been the solvency of the banking system and not just the health of the economy: http://seekingalpha.com/article/229385-is-a-crunch-coming-for-smaller-banks.

But, the behavior of the central bank not only represents concern for the commercial banks, but also for the real estate market. Elizabeth Warren, in Congressional testimony earlier this year, indicated that 3,000 commercial banks were threatened over the next 18 months or so, especially in loans in the area of commercial real estate. Plus, we have a massive problem in the municipal bond markets concerning the solvency of our state and local governments. The pension programs of these entities loom large over the financial markets and many individuals I know that work in this sector are scarred silly.

The efforts of the Fed, therefore, are attempts at “debasement inflation”. This was uttered by William Browder, who now runs an investment fund in London. (In the morning New York Times: http://dealbook.nytimes.com/2010/11/18/from-russia-expert-a-gloomy-outlook/?ref=todayspaper.) “Emerging markets went through more than a decade ago in the Asian Financial crisis what developed markets are experiencing now.” Browder added, “you want to own hard things that can’t be printed.”

But, these efforts extend beyond the borders of the United States. Given the fluidity associated with funds flowing throughout the world, the additional liquidity extends to the situation related to many Euro-nations in terms of their sovereign debt. Writedowns are going to occur in Ireland, Portugal, Greece, and possibly Spain and Italy. Even France is feeling some of the heat. International financial markets also need liquidity.

The question here is whether this concern over sovereign debt will extend to the United States. Browder goes on to say that there are limits to how much governments are able to borrow. And, investors move from one weak market to another. Eventually, these investors work through to even the “strongest” of the fiscally challenged states. When it gets to this stage, he argues, the only thing these governments can still do is print money.

Where are the hard assets? Real estate. Commodities. Companies.

These are the areas that will attract a lot of the money going around.

The prices of commodities have already experienced a significant bounce. This will continue.

Big money will also eventually be made in real estate and the merger and acquisition business of corporations. The prelude to this is the massive buildup in the cash holdings at many of the largest companies in the world, in the largest commercial banks in the world, and in hedge funds and other private equity funds. And, really, the move has already started in a very selective way.

I continue to believe that over the next five years of so we will see a substantial acquisition of assets, across the board, of a size we can barely imagine now.

The objective of the Federal Reserve is to keep things as stable as possible so that the FDIC can continue to close banks as smoothly as it can; that mergers and acquisitions can occur in an orderly fashion so that weaker institutions can be removed from the scene; and that more and more money will move into the real estate area so as to eventually put a floor under real estate prices.

All this may be done, but it may not exactly take the path that Mr. Bernanke would like it to take. Furthermore, all of this activity may not achieve the goals that President Obama would like to achieve.

Mr. Kessler argues that, in his view, the stock market will not view these developments as favorably as they have received earlier efforts at spaghetti throwing. He claims that this attitude has been shown by the recent behavior of stock prices. In addition, bond yields have backed up (prices of bonds have fallen) not what quantitative easing was devised to do. Both of
these outcomes are “exactly the opposite of what Mr. Bernanke was trying to achieve.”

In the case of mergers and acquisitions and the acquisition of real property, the early results are indicating that the bigger organizations are getting bigger, both financial and non-financial institutions, and the wealthy are getting wealthier. These outcomes are exactly the opposite of what President Obama was trying to achieve.

Mr. Browder spoke to students at the Columbia Business School several weeks ago. He argued that “the high-inflation scene” described above “could be another lucrative opportunity” similar, although not as great, to one he made so much money in while in Russia.

In such a situation, therefore, the emphasis in investing should be on what companies or assets can be acquired that will benefit from the credit inflation. Caterpillar, for example, moved into the mining equipment field, one reason being that mining will benefit from the surge in demand coming from emerging nations like China and Brazil. So, one is looking for “targets” and not long-term value creation.

One has to be careful, however, in buying into acquiring companies. Not all companies are good acquirers. History shows that many acquirers have to “unwind” their acquisitions within five years or so because the purchases are done for the wrong reasons or the managements cannot effectively integrate the properties they have obtained. However, there may be some very good “buys” amongst the acquirers.

For example, the value of the Caterpillar stock went up after the acquisition was announced. There is the feeling that the Caterpillar management can effectively put the two companies together to the benefit of the shareholders.

The Federal Reserve is creating a lot of opportunities with its new policy stance. However, the beneficiaries of the policy may not be the people it wants to help: the unemployed and the less-well-off.

An Option on Monetization and Inflation

You want to place a bet on future inflation? Well, an opportunity for you to bet on inflation is now in the works. The hedge fund Universa Investments L. P. is planning to open a fund in the near future that will allow you to back up your concern with the possibility that inflation is coming around the corner.

The fund will invest in options tied to commodities and Treasury bonds, among other things. The strategy is a “Black Swan” strategy aimed at taking advantage of wide swings in the prices of these assets.

Of course, the fund is connected with Nassim Nicholas Taleb, the infamous author of the best sellers “The Black Swan” and “Fooled by Randomness.” To Taleb, the probability that high rates of inflation might result from the stimulus efforts of governments around the world has substantially increased. This means that the possibility of a “fat tail” event happening, the chance that hyperinflation might occur, is a reasonable wager.

Mr. Taleb, in an interview, argued that “We think these things are going to see massive volatility.” These things being the price of corn, crude oil, copper, the stocks of oil drillers and gold miners, and the price of Treasury bonds and the value of the United States dollar. (For a more information see, “Black Swan Fund Makes a Big Bet on Inflation,” http://online.wsj.com/article/SB124380234786770027.html#mod=todays_us_money_and_investing.)

This effort is nothing new. It is just a high profile attempt to do what international investors have done for the last fifty years. (I know, it has been done for longer than that but I am just focusing on the modern era of imprudent government budget management.) And, there has been nothing more successful than betting against large fiscal deficits that put pressure on central banks to monetize the debt. The examples are numerous; see George Soros, the British Pound, and 1992 and Fancios Mitterand, the French Franc, and 1983 and more! The currencies of countries following Keynesian policies in which government budget deficits were used to stimulate economic growth and low levels of unemployment were easy targets for the international investment community.

Of course, inflation is not a problem now. And, many would argue that deflation is the real near term threat. Yet, the United States government, among others, is following a very “Keynesian” stimulus program with deficits that dwarf anything that has been seen in the past. The Federal Reserve System has forced an enormous amount of reserves into the banking and financial systems. For example, the year-over-year rate of increase of total reserves in the banking system was over 1,900% in April. The Fed’s purchase of mortgage-backed securities stood at $428 billion at the close of business on Wednesday May 28.

Chairman Bernanke has stated that the Fed will “reverse out” of these positions once the economy begins to pick up some speed. He may believe this and be very serious about achieving this end. BUT, there still are the large government deficits. How is the Fed going to handle them?

Not very easily, as is evident from the behavior in the bond market over the past couple of weeks. In fact, history is on the side of those that believe that the Fed cannot control long term interest rates over the longer run. Central banks all over the world have tried before, but success has only come in the short run and at the expense of monetizing too much of the government debt. This is the worldwide experience of the past 50 years! Governments all over the world have not been able to successfully combat the will of international financial markets if the participants in these markets believe that the fiscal policy of a government is not being conducted in a prudent manner.

The Federal Reserve got the first real taste of this in the last two weeks. There is more to come. The cycle is that the central bank tries to keep down long term rates by buying government securities. This is successful for a while, but the market observes that the central bank is monetizing the debt and so more pressure is put on bond prices forcing long term interest rates higher. Continued central bank efforts to hold down rates only result in the purchase of more government securities which then leads to more market concern about this monetization of the debt. Another round of central bank activity can follow. This picture of the dog chasing its tail only ends in frustration for the central bank and finally resignation that its goal cannot be achieved.

And, all during this time, the value of the currency of the country falls. Sound familiar?

When does the inflation occur?

That is uncertain. It will occur some time in the future. We know, however, that with large amounts of uncertainty, volatility increases.

In the meantime, you have a good argument for buying options which is what the Universa effort is going to do.

The question then becomes one about whether or not another Black Swan will occur. How are you betting?