So Much for the Exit Strategy - By Doug Noland

<blockquote>'Today, extreme activist fiscal and monetary policies inflate the Global Government Finance Bubble. After the 2008 fiasco, I have a difficult time comprehending how analysts can remain dismissive of Bubble risks. And with an increasingly conspicuous Bubble at the heart of our monetary system, our central bank should not be reinforcing the market perception that the Fed is there to backstop the markets and economic recovery with open-ended Treasury purchases. Instead of a well-functioning marketplace (and central bank) working to discipline a profligate Washington, dysfunctional monetary and market environments continue to accommodate perilous Credit excess.'</blockquote>


So Much for the Exit Strategy

By Doug Noland
August 13, 2010
Source

I had limited time to write today, but I’m hoping a few paragraphs will be better than nothing. The environment beckons for more thorough analysis.

Ten-year Treasury yields dropped another 14 bps this week to 2.68%. Benchmark Fannie MBS yields sank 13 bps to a record low 3.43%. Tuesday’s announcement from the Federal Open Market Committee (FOMC) further emboldened a highly-speculative fixed-income marketplace.

Some analysts argue that the Fed’s move to reinvest cash receipts from its MBS portfolio into Treasurys is no big deal; the decision will not involve sums of Treasury purchases sufficient to move market and economic needles. A former Federal Reserve Governor – and noted “Fed watcher” – commented on CNBC that this amounts to “neutral” monetary policy. It is his view that it would be a case of “tight” policy if the Fed’s balance sheet were allowed to shrink with a drawing down of its MBS portfolio. Conversely, Federal Reserve holdings would need to expand for monetary policy to remain loose. The size of the Fed’s balance sheet is now viewed as a key policy tool.

I see things differently - and view this week’s decision by the Bernanke Federal Reserve as yet another dangerous leap into experimental monetary management. Market perceptions remain the key facet of Bubble analysis – and not week-to-week changes in Fed holdings.

Not many weeks ago the focus was on the Fed’s “exit strategy.” Apparently, policymakers now recognize that there is no way out. It was suppose to have been a case of the Federal Reserve having used its balance sheet as an extraordinary policy tool in response to the 2008 Credit seizure, with the Fed dedicated to unwinding this unprecedented stimulus as the system stabilized. Today, not only is the Fed unwilling to normalize its securities holdings, it has signaled to the markets that it is able and willing to expand its balance sheet on an as needed basis. At least that’s the way the markets will see things: the Fed is there ready to act quickly and forcefully as a reliable system backstop. No more worries about “exit” issues; and as the debt markets turn increasingly overheated, it’s sure comforting the markets know the Fed is there to ensure marketplace liquidity. This is a very big deal.

There were many crosscurrents in the markets this week. The dollar rallied sharply, immediately reinstituting pressure on various global risk markets. Euro weakness quickly translated into widening risk premiums in periphery European debt markets – that then tend to feed further euro vulnerability. The dollar pop also slammed crude prices and pressured some of the other commodities. And reminiscent of the Greek debt crisis period, dollar strength pressured global equities markets more generally. The global “reflation trade” seems these days to hinge day-to-day on the direction of the dollar – especially versus the euro.

Market pundits pointed to the Federal Reserve’s downbeat economic assessment as the main reason behind the equity sell-off, although the currency markets continue to be the driving force behind wildly volatile global markets. Perhaps the Fed’s downbeat assessment and announcement of Treasury purchases was somehow behind the dollar’s rally; or perhaps it was instead that traders had become sufficiently bearish on the dollar to ensure that Mr. Market did an about face - with a “rip their faces off!” rally.

Stocks were weak and the dollar was generally strong. But the real show was provided – once again - in fixed income. Prices continued their melt-up – yield meltdown – with Bubble Dynamics becoming only more conspicuous each passing week. And I know that most dismiss the Bubble thesis and view prices as reflecting poor economic prospects and the deflationary backdrop. I would respond that the environment remains extraordinarily conducive to Bubble expansion.

Barron’s Jonathan R. Laing captured the current mood with his article, “Time to Print, Print, Print.” With inflation risks so low and the scourge of deflation so potentially devastating, many believe it would be a dereliction of the Federal Reserve’s duty not to aggressively expand its securities holdings (“print money”). Similar reasoning was used to justify the ultra-loose monetary policies earlier this decade that inflated the mortgage/Wall Street finance Bubble.

Today, extreme activist fiscal and monetary policies inflate the Global Government Finance Bubble. After the 2008 fiasco, I have a difficult time comprehending how analysts can remain dismissive of Bubble risks. And with an increasingly conspicuous Bubble at the heart of our monetary system, our central bank should not be reinforcing the market perception that the Fed is there to backstop the markets and economic recovery with open-ended Treasury purchases. Instead of a well-functioning marketplace (and central bank) working to discipline a profligate Washington, dysfunctional monetary and market environments continue to accommodate perilous Credit excess.