The Fed's Tightening Pipe Dream

Testifying before the US Senate this past Tuesday, Fed Chairman Ben Bernanke made an extraordinary claim about its bloated balance sheet: "We could exit without ever selling by letting it run off." What Bernanke means here is that the Fed could simply hold its Treasuries and agency bonds until they mature, at which point the government would then be forced to pay the Fed back the principal amount. Through this process, the Fed's unprecedented and inflationary position will be gradually and placidly unwound.

Growing rumors last month of a potential "tightening" of monetary policy - seemingly confirmed by the Fed minutes released on Feb. 20th - have spooked the precious metals markets, leading to a 5.8% correction in gold and 10.2% in silver.

First, the Fed just spent the past year and a half extending the maturities of its entire portfolio. That was the entire purpose of Operation Twist. The average maturity of the entire portfolio is now over 10 years. That means any wind-down using the strategy Bernanke outlined would play out over the course of decades - not months or years.

The second reason these fears are unfounded is that there is no exit strategy. Listening to Bernanke's testimony, it was clear that here was a man simply speculating about when an exit might be undertaken - or perhaps if it would ever be taken. Senator Corker from Tennessee accused Bernanke during the hearing of being "the biggest dove since World War II." "I think it's something you're rather proud of," the Senator continued. The Chairman's response to the charge of recklessly endangering the nation's currency? "In some respects, I am."

The Fed Chairman has been talking about tightening for some time. In 2010, he said, "As the expansion matures, the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures."

Back then, the same mainstream analysts were predicting recovery and a reversal of quantitative easing (QE). Instead, we have subsequently seen QE2, Operation Twist, and now QE3 to eternity.

While these mainstream commentators are at best guessing as to why or when the Fed might reverse course, I understand that it is extremely unlikely to do so for the foreseeable future. In fact, I've bet my net worth on it.

There is no exit strategy because the results of the Fed withdrawing its artificial support would be disastrous for the US Treasury and in the short-term, the US economy.

The Fed is expected to buy nearly 90% of new Treasury bonds in 2013, according to Bloomberg. This is a tremendous subsidy that has kept 10-year Treasury yields below 1.95% on average this year so far. Last year, with 10-year yields averaging 1.8%, the Treasury spent $360 billion on interest payments alone. That represented nearly 10% of all expenditures.

Let's assume a Fed tightening causes these rates to triple - not unreasonable for a government facing over 100% debt-to-GDP. If these rates triple by 2015, and another $2 trillion or so is added to the debt, then interest would make up over 30% of annual federal expenditures. Just interest. Then, there are principal repayments, Medicare/Medicaid, Social Security, the Armed Forces, and all the other entitlements for which the Treasury is responsible. Is Washington going to default on our creditors, our seniors, or our men and women in uniform?

I believe these assumptions are still rosy compared to what might actually happen if the Fed were to withdraw support. As I outlined in my January Gold Letter, the US sovereign debt market is a house of cards in which the Fed, foreign creditors, and domestic investors each play a part. If the Fed were to signal that creditors might face haircuts, then the reaction could be swift to the downside. If rates went above 10%, as they have in Greece, then over half of the federal budget would be committed to interest payments alone.

But that's not all. Higher interest rates would cause the shaky housing market to take another nosedive. Few Americans are in a position to buy a $300K house at 10+% interest. Rather, prices would have to decline to levels affordable for cash buyers and those willing and able to take out high-interest mortgages. That might mean another 50% decline or more, in real terms.

With housing taking a second bath, we can expect the banks not to be far behind. That sector remains bloated and dependent on various subsidies from the Fed. With loan rates higher than their customers can afford, banks would fail at a rate higher than 2007-8. This would trigger another round of bailouts from the Treasury; but without Fed assistance, where will the funds come from?

If there isn't a bailout, the major money-center banks would collapse, crippling Wall Street's reputation as the global financial center. The US dollar's reserve status might then be abandoned once and for all.

Quickly, one can see how the Fed's money-printing is the mask holding this charade together.

To see in real time what happens when the mask is pulled off, look to the Mediterranean. Greece has seen the Golden Dawn neo-nazi party win 7% of seats in the last two elections. Italy, meanwhile, just saw a comedian with no political background grab 25% of its parliament in a satirical candidacy. Street protests, unemployment, and other signs of instability are rampant. The protestors are not learning a tough lesson about the consequences of profligate spending; instead, they're simply angry that the money has stopped flowing.

No one in Washington - not least Ben Bernanke - has any intention of setting off a similar episode in the US. Yet, that's exactly what a tightening of monetary policy would do. So, at least as long as the CPI numbers can be fudged to make inflation appear "contained," the Fed is going to keep filling the punch bowl.

Returning to the latest Fed minutes that have hard asset investors so upset, it is telling that while there was some discussion of the dangers of money-printing, only one of twelve governors actually voted against continuing current policies. With no concrete actions being taken and an overwhelming majority still in favor of current policies, it seems gold bears are making much ado about nothing.

As investors realize this, they will once again put their pedals to the precious metals.

Todays dollar is worth nothing in actuality.

Much like the Confederate dollars printed during the CW.

As long as people accept them for value they will be fine, when people wake up and say hey, What is this thing actually worth we will find they ar eworth nothing.

The Bonds bought by the feds are worthless, They just printed money and then printed a Bond which they so called bought.

On day this house of cards will come falling down and the Feds will use the ammunition they have been buying.

Bernacke is the worst individual ever appointed to high office in the history of the United States. The harm he has done and is doing is incalcuable. One day this foolish man will be blamed for the failure of the Obama administration.

So, the Fed will continue ZIRP and QE to infinity unless there`s some miraculous economic rebound. An economic rebound based on what I do not know.

Banks won`t lend. Why make risky loans when the Fed will give you free money and they flee to the relative safety of bonds. Free profits with no risk.

Inflation will continue. The official CPI is not real and doesn`t reflect actual inflation. Go to your grocery store and see the prices going up every month.

Cheap loans will push up home prices. Hardly what cash strapped families need but great for private equity and institutions like as they scoop up foreclosures and re-list at nearly 100% purchase price.

QE pumps up the DOW. Why invest in anything but the DOW being a sure bet. Most equity shares in America are owned by the wealthiest 10 %. Bernanke and Obama favor not only crony socialism.

A dead in the water, 0.1% GDP is what you get and worse as more and more paper currency is pumped into the economy .

But, what the hell - we never hold any one responsible. They just have a banquet and give themselves awards.

Much like today's infantile "everyone is a winner" culture; rolling along seemingly defying gravity until reality bitch slaps it.

“Italy, meanwhile, just saw a comedian with no political background grab 25% of its parliament”

The US already has a Minnesotan comedian with no political background in the Senate, a halfwit comedian for vice-president, and a whole slew of unwitting comedians in Congress.

And most voters under 30 get their news from comedians on cable shows like The Daily Show and The Colbert Report.

“One day this foolish man will be blamed for the failure of the Obama administration.”

GW Bush appointed Bernanke. Maybe “blame Bush” would be appropriate in this case.

Inflation frightens me a lot. I have a few dollars saved and I would hate to see it truend into nothing. I only wish I had enough to invest in land or something substantial.I would get it out of the bank tomorrow.

Inflation frightens me a lot. I have a few dollars saved and I would hate to see it turned into nothing. I only wish I had enough to invest in land or something substantial.I would get it out of the bank tomorrow.

“GW Bush appointed Bernanke. Maybe “blame Bush” would be appropriate in this case.”
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My guess is that the same thing would be happening even if Mike Huckabee had become fed chairman.

"I only wish I had enough to invest in land or something substantial."

There is still plenty of affordable land in Idaho and that might be one of the safest places to live if Obama carries on unabated for a few more years. I don't know what you might do for a living, but I'd seriously consider getting off the east coast.

"I only wish I had enough to invest in land or something substantial."

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