Why We Can't Avoid Ben Bernanke's "Monetary Cliff"

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When it comes to the Federal Reserve, an accurate "reading of the tea leaves" means paying attention to all of the fine print.

And while the markets cheered last week's FOMC meeting with yet another rally, a deeper look at Ben Bernanke's press conference left me with a slightly different take.

Sifting through the Fedspeak, it became obvious that the Fed is now lining up a "monetary cliff" that's bigger than the fiscal one we spent the last half of 2012 worrying about.

Let me explain…

Here's Where the Fine Print Gets Interesting

According to the release from last week's meeting, the Fed will continue to purchase $85 billion of Treasury and agency bonds every month. Doing so, Bernanke explained that at some point he does expect to reduce that amount. However, he also explained that the recent string of good unemployment data (five months above 200,000 new jobs) wasn't enough yet for him to make the change.

The Fed also stated that it expects a "considerable period" to elapse between the conclusion of the purchase program and raising rates.

Interestingly, that matched with the intentions of the 19 Federal Open Market Committee members. Only a few expect to raise rates before the end of 2014, compatible with the current Fed outlook.

But here's where the fine print gets really interesting: All but one of the members now expects to raise rates in 2015.

What's more, they said once they start, they won't be shy. In fact, the average opinion would put rates at 1.35% by the end of 2015. It may not seem like much at first glance but that's actually quite a big move from six-plus years at zero. And further on into the future, the consensus long-term goal was for rates to hit 4%.

Of course, with inflation around 2%, my goal for the Fed funds rate would be higher than 4% and a lot higher than 1.35% by the end of 2015. But alas, I'm not the Fed chief.

The point is that with the Fed expecting the economy to grow steadily between now and then, and no immediate sign of even a slackening in bond purchases, the turn by the Fed supertanker in late 2014 and 2015 is going to be pretty abrupt.

In fact, chances are it will cause a big wake, and drown quite a few people who have become used to current policies.

Make no mistake, the Fed's current policies are right at the extreme of what can be done.

The partial fiscal cliff and the sequester have reduced the projected U.S. budget deficit for the year to September 2013 from $1,089 billion to $845 billion, and to $616 billion in the year to September 2014. That may not look like much progress, but you have to remember the Fed is buying $1,020 billion of bonds per annum. (OK, some of them are agency bonds, but that doesn't make a huge difference in overall market impact.)

In the year to September 2012, the Fed bought bonds covering about half the federal deficit; this year it will buy bonds covering 121% of the deficit; and next year, if bond purchases continue at the current rate, it will cover 166% of the deficit.

Congress has done its job, for a change. (Treasury Secretary Jack Lew must have been happy about this in China last week; for once he didn't get smacked around by Chinese holders of U.S. Treasuries!)

But it does mean that the inflationary effect of Fed purchases is increasing, as is the boost they give to asset prices. After all, all of that "extra" liquidity has to find a home.

A Difficult Turn for Investors

For us as investors that makes life bloody difficult.

At the moment, Fed policy is getting more and more "stimulative." As a result, for the moment we can expect a strong stock market, rising commodity prices and, with a bit of luck, a nice run in gold and silver. The U.S. economy should also continue its current sluggish but adequate growth.

Mad money printing by the Japanese under their new central bank governor, by the British trying to kick-start growth, and by the Europeans trying to stop the euro falling apart, will only exacerbate this tendency.

But at some point, probably around mid-2014 if you asked me to guess, the Fed will notice that 2015 is approaching, that unemployment is still trending down, and that inflation is trending upwards, above their "target" 2% — however much they try to fudge it.

That's the point when the Fed will take the first tentative step towards tightening.

The market will then see that the easy-money game from which it has done so well is over, and that a lot of tightening is to come quite soon.

In all likelihood, it will panic. Bull market constructions such as mortgage REITs and leveraged buyouts will totter. And we will head into a credit crunch that will differ from 2008 only in that governments won't be able to bail us out.

Why?…

Because interest rates will already be near zero, inflation will be rising and debt will be too high.

For investors that doesn't paint a very rosy medium-term outlook for the markets. The truth is we may need to be 100% long for the next year, then at some point reverse quickly to become 100% short. Given the timing it promises to be no fun at all.

Of course, the Fed could pre-empt this by beginning its tightening now, while the stock market is still only around its old record and inflation is quiescent.

By doing so, it would signal to the market not to get over-excited and would turn the monetary supertanker more slowly. For the next 12-15 months, unemployment declines would be lower than projected. But avoiding the meltdown 15 months out would really make life easier in the long run, even for the unemployed.

But let's just say, I'm not holding my breath on that one. I've been watching Ben Bernanke for far too long.

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  1. John J Ciulla | March 28, 2013

    For investors that doesn't paint a very rosy medium-term outlook for the markets. The truth is we may need to be 100% long for the next year, then at some point reverse quickly to become 100% short. Given the timing it promises to be no fun at all.

    I such a scenario how would gold and silver fare?

  2. Dimi Chakalov | March 28, 2013

    Thank you for your brilliant article, again. You wrote: "But at some point, probably around mid-2014 if you asked me to guess, …"

    I think the timing of USD crash is tricky, since it depends on the banks:

  3. H. Craig Bradley | March 28, 2013

    RETAIL INVESTORS AND VOTERS "DON'T CARE"

    It would appear to me Martin that most retail investors are not inclined to make huge tactical allocation changes ranging from "100%" long in stocks to "100" short. Market timing is always a losers game anyway. This sounds as implausable as FED Chairman Ben Bernanke preemptively raising interest rates while the stock market remains at reasonable levels (no bubble). I agree with you that Gentle Ben is likely to hold the course.

    You see, when the majority of American voters chose to reelect President Obama they got a "package of benefits" (besides food stamps) including of course none other than Ben Bernanke and Co. as well as a full dose of ObamaCare, and higher taxes to cover some of the extra Federal spending. Future benefit cuts and eligibility changes are to be expected for Social Security and Medicare in the process.

    Its too bad Mitt Romney was so "boring" to the voters while President Obama was so "cool". The choices in our elections have very little to do with policies like interest rates or the FED chairman. Mitt Romney said last year he intended to replace Ben Bernanke and encourage a gradual, albeit slow, increase in interest rates. We probably would already have seen a slight rise in rates by now had Mitt Romney been elected. The truth is investors and voters don't much care, so there.

    • H. Craig Bradley | March 28, 2013

      THE EXPERIENCE OF A LIFETIME: 2007-2020

      You also could speculate that we are going to see a significant rise in financial (risk) assets during the next year, engineered largely by the FED. It may turn out to be a record breaker for the major indices. Who knows?

      If financial assets and housing do indeed inflate that much, then we could expect mass inflation to follow (20%-30%/year), not just a bit over the Feds current target level of "2%-3%" /year. Some say we will never see "hyperinflation" in America but others such as myself are not fully convinced.

      In any event, accelerated inflation rates will only be sustained for 2-3 years. After that, comes a financial collapse and a deflationary depression the likes we have never experienced. Nothing will matter much in the U.S.A. after that because all your readers will be as poor as anyone else is and the Government will be totally broke.

  4. james donegan | March 28, 2013

    Somehow I have not received my share of all this new money the fed has pumped into the economy. And I want it! Oh so it all ended up in the hands of banks, now sitting on their balance sheets. O.K then just how does this increase inflation? So until banks start lending this "money" to customers how can there be an increase in inflation? Would someone please explain this tome.

    • Trent Steele | April 2, 2013

      Banks do not loan the funds, so it remains in excess reserves. But the actual base currency is moving from institution to institution. There is nothing to prevent its movement. The only way for the fed to create a sterile operation is under a Reverse Repo ( paying interest to hold funds until a mandatory return date)

  5. Bob | March 28, 2013

    Bernanke has been playing with fire by his irresponsible monetary experiment far too long. Unfortunately, heir apparent Yellen is of the same mind set. The ouster of both of them would be a tremendous public service.

  6. fred | March 29, 2013

    "However, he also explained that the recent string of good unemployment data (five months above 200,000 new jobs) "
    I read somewhere, that due to population growth, more than 200,000 jobs a month are needed just maintain stus quo.

  7. frank olalde | April 2, 2013

    My sister in law gave us what she & her husband think is great news, she's buying a 330K new home, she already has a home with 10 yrs. left on THAT note. paying 3.75% on each, on 30 yr. notes.
    I cant bear to think that dumping 330K on a home that will probably never gain value & worse yet will probably loose much of It's worth in the future bubble, is nothing short of madness.
    I sort of hinted that paying a 30 yr. note on a highly risky venture wasn't a wise move, she replied that if it went bad, they could just sell off and still keep the smaller older home.
    No thought given to maybe the house will loose much of it's worth? and if they do sell they still get stiffed holding a note on a loosing venture.
    I'd buy me 330K work of Silver bars or Gold, Platinum & or Palladium, at least I know they will at least retain face value but given the very dark clouds & thunder off in the not to distant horizon, they are probably more certain to increase in value.

    The sad part is that ALL banks are giving ignorant advise to home buyers and are trying to dissuade precious metals buyers, they give us the creeps by telling us the metals market is far more dangerous and vulnerable then any home investment. Are they saying so cause Mr. W.Buffett keeps telling us that the value of metals is only measured by the value it's buyers give it?
    My guess is that the Banks & bankers are simply trying to maintain their jobs cause if everybody goes to metal and avoid housing then there isn't much need for bankers is there?

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