It’s one thing for the Austrian Economics and precious metals crowds to warn about the corner the Federal Reserve has backed itself into. Where it must either print to continue to prop up the bubbles it has inflated, or remove the liquidity and allow them to crash.
But when even bankers begin warning about the predicament the Fed finds itself in, you can only wonder if time is finally running out on this decade-long monetary experiment.
Current Credit Suisse analyst Zoltan Pozsar, acknowledged by many as the authority on repo market dynamics, shadow liquidity and Fed balance sheet strategy, warned that the U.S. central bank may soon have to make a choice between activating an overnight facility for repurchase agreements or halting its balance-sheet reduction earlier than many market participants expect.
And, as Bloomberg reported, Pozsar said that policy makers are unlikely to pursue the option of a new facility until alternatives have been exhausted, meaning a premature end to the taper is the most likely outcome.
That the Fed would eventually have to reverse course and continue adding more liquidity at some point has always seemed an inevitability to me. For the same reasons that the Fed’s expansionary monetary policy gave the appearance that things were great while the money was being printed, the opposite effect is appearing now that the money is being removed.
Given the Fed’s history, the assumption by myself and others in the precious metals community has been that as the bubbles started to pop, the Fed would respond with more monetary easing.
Yet this is hardly the mainstream Wall Street perspective. Which makes it interesting to see that the bubbles and flaws in the Fed’s policy have become so glaring that even the bankers are becoming concerned.
Which is certainly understandable.
In the past week, Turkey has joined Argentina and Venezuela on the list of countries experiencing a currency crisis. Italy (and likely many of the other Eurozone nations) still has the same debt issues that it did a few months ago. That have only been band-aided together again with more short-term measures.
Things aren’t any better at Deutsche Bank, where the markets still await the consequences of their credit rating downgrade. And whether that will trigger a credit event with their derivatives book. Add in a slowing housing market, and there are just an awful lot of factors pressuring the Fed.
Of course not making matters any easier, is that at the same time the markets are struggling in response to rising U.S. interest rates, the inflation metric the Fed uses is already well past the target level.
Meanwhile core US inflation running at 2.4%, is now well above the Fed’s target, and with tariffs threatening to push prices even higher, the Fed suddenly finds itself in a very unpleasant situation: how to tighten further without crashing the market.
The only option, as the above considerations suggest, is for the Fed to keep hiking rates in hopes of keeping inflation in check even as it gradually brings its balance sheet shrinkage. But what happens next? Well, according to BMO analyst Ian Lyngen, the Fed may have no choice but to begin expanding its balance sheet some time in the next year.
Which means the Fed has finally arrived at that point where it now has to choose between continuing to raise rates and watching the bubbles pop. Or halting the rate increases, and seeing even the distorted Fed version of inflation soar well past normal levels.
It’s also worth noting that if the market is struggling this much when rates on the U.S. 10-year treasury haven’t even hit 3%, what’s going to happen with rates at 5 or 6%?
Which still is likely miles away from any sort of true free-market determined rate. Because if Paul Volcker had to raise short-term rates to 20% to handle the inflation of 1980, what exactly would a fair market rate be today when the debt loads and monetary expansion are both exponentially greater than ever?
The rest of the world is quickly finding out what the Austrian Economists have been warning about for over a decade.
And that the prices of the alternative currencies like precious metals and cryptos have been beaten up in recent weeks and months and remain at low levels is just all the more incredible in the face of what’s happening. Amazingly the paper currency crisis has begun. While the cost of insurance remains on sale.
How much longer it takes the markets to resolve the imbalances remains unknown. But all the signs that the day of reckoning is rapidly approaching are there. With perhaps the time to take advantage of insurance at bargain prices rapidly running out.
August 17, 2018