by Mike Whitney
November 4, 2009
Interest rates. The Fed does not need slinky
women in plunging necklines to peddle money. All it needs is low interest
rates. When rates are pushed lower than the rate of inflation, the Fed
provides a subsidy for borrowing.
This is not as hard to grasp as it sounds.
If I offered to give you $1.00 for very 90 cents
you gave me in return, you would buy as many dollars from me as you could.
Fed operates the same way. It generates market activity by
creating incentives for borrowing. Borrowing leads to speculation, and
speculation leads to steadily rising asset prices. This is how the game is
The Fed is not an unbiased observer of free
market activity. The Fed drives the market. It fuels speculation and
controls behavior by fixing interest rates.
When Lehman Bros flopped last year, markets went into freefall. A sharp
correction turned into a full-blown panic. The bubble burst and trillions of
dollars in credit vanished in a flash. Trading in exotic debt-instruments
stopped overnight. A global sell-off ensued. Markets crashed. For a while,
it looked like the whole system might collapse.
The Fed's emergency intervention pulled the system back from the brink, but
the economy is still wracked with deflation. Billions in toxic waste now
clog the Fed's balance sheet. The dollar has fallen like a stone.
When the financial system blows up and credit is sucked down a capital-hole,
the economy goes into a downward spiral. Businesses slash inventory and lay
off workers, workers have to cut back on spending and credit. That creates
less demand for products, which leads to more lay offs.
This is the vicious circle policymakers try to
That's why Fed chair Ben Bernanke wheeled
out the heavy artillery and launched the most aggressive central bank
intervention in history.
The Fed dropped rates to zero, but its Quantitative Easing (QE)
program (which monetizes the debt) actually pushes rates even lower to
roughly negative 2 percent.
Bernanke has underwritten every sector of the financial system with
government guarantees. He has provided full-value loans for dodgy collateral
which is worth only a fraction of its original value. The market can no
longer operate without the Fed. The Fed IS the market, which is why
it is foolish to talk about a "recovery".
The idea of recovery implies a
free-standing system based on supply and demand. But, for now, the
government provides the demand, which is why there is no market and no
Analysts at Goldman Sachs sum it up like
"How much of the rebound in real GDP was due
to the fiscal stimulus, and where do we stand in terms of the effects of
stimulus thus far? Although precise answers are impossible at this
juncture, several aspects of the report are consistent with our
estimates that the fiscal package enacted in mid-February as the
American Recovery and Reinvestment Act (ARRA)
would have accounted for virtually all of the growth reported for the
Positive growth is an illusion
created by government spending.
The economy is still flat on its back. Consumer
spending and credit are in sharp decline. Unemployment is steadily rising
(although at a slower pace) and wages are flatlining with a chance of
falling for the first time in 30 years. Deflationary pressures are building.
The talk of a "jobless recovery" is intentionally misleading.
Jobs ARE recovery; therefore a jobless recovery
merely points to asset-inflation brought on by erratic monetary policy.
Surging stocks shouldn't be confused with a genuine recovery.
The Fed faces stiff headwinds ahead. Low interest rates can have unintended
The "cheapness" of the greenback has made the
dollar the funding currency for the carry trade. Investors are borrowing low
cost dollars and using them to purchase higher interest assets
The process, which is rapidly escalating, is
fraught with peril as economist Nouriel Roubini points out in an
article in the Financial Times:
"Since March there has been a massive rally
in all sorts of risky assets... and an even bigger rally in emerging
market asset classes (their stocks, bonds and currencies). At the same
time, the dollar has weakened sharply, while government bond yields have
gently increased but stayed low and stable...
But while the US and global economy have begun a modest recovery, asset
prices have gone through the roof since March in a major and
synchronized rally... Risky asset prices have risen too much, too soon
and too fast compared with macroeconomic fundamentals.
So what is behind this massive rally?
Certainly it has been helped by a wave of
liquidity from near-zero interest rates and quantitative easing. But a
more important factor fueling this asset bubble is the weakness of the
US dollar, driven by the mother of all carry trades.
The US dollar has become the major funding
currency of carry trades as the Fed has kept interest rates on hold and
is expected to do so for a long time. Investors who are shorting the US
dollar to buy on a highly leveraged basis higher-yielding assets and
other global assets are not just borrowing at zero interest rates in
dollar terms; they are borrowing at very negative interest rates...
Every investor who plays this risky game looks like a genius – even if
they are just riding a huge bubble financed by a large negative
cost of borrowing...
...This policy feeds the global asset bubble
it is also feeding a new US asset bubble...
The reckless US policy that is feeding these
carry trades is forcing other countries to follow its easy monetary
policy... This is keeping short-term rates lower than is desirable... So
the perfectly correlated bubble across all global asset classes gets
bigger by the day.
But one day this bubble will burst, leading to the biggest
coordinated asset bust ever: if factors lead the dollar to reverse and
suddenly appreciate... the leveraged carry trade will have to be
suddenly closed as investors cover their dollar shorts.
A stampede will occur as closing long
leveraged risky asset positions across all asset classes funded by
dollar shorts triggers a coordinated collapse of all those risky assets
– equities, commodities, emerging market asset classes and credit
Mother of all Carry Trades Faces an Inevitable Bust", Nouriel
Roubini, Financial Times
Everyone who watches the market has noticed the
inverse correlation of stocks to the dollar.
When the dollar fades, stocks soar. And when the
dollar strengthens, stocks plunge. Eventually, the dollar will
reverse-course and stage a comeback, probably when Bernanke stops his
That will trigger the next severe correction
which will burst bubbles across all asset classes.
Bernanke's success in reflating sagging asset prices has depended
entirely on interest rate manipulation and liquidity injections. There's
been no effort to patch household balance sheets, increase production, or
strengthen overall demand.
It's a clever trick by a master illusionist,
but it has its costs. When the dollar rallies, markets will crash.
And Bernanke will be responsible.