Chairman Bernanke has placed himself in a box. It is not a box of his choosing, but rather the result of his misguided economic beliefs, use of flawed statistical data, geo-political events occurring during his watch, poor decisions and a penchant for political pandering. Some of these may be requirements for academia success but not for leading global financial markets during turbulent times.

It is time for Professor Bernanke to return to the collegial setting of Princeton University while the world still has time to correct the path he has mistakenly set us on.

I was angry during most of former Chairman Greenspan's tenure because of his persistent use of liquidity pumping to solve every problem from Y2K to the Peso crisis. Greenspan's inability to see a bubble two inches from his nose and yet still pontificate about irrational exuberance, rather than taking the punch bowl away from the party, incited me. Bernanke does not affect me that way. He simply disappoints and leaves a taste like eating dry shredded wheat, with the hope of a child, to eventually get the prize at the bottom of the box.

Character flaws show during times of stress. Honesty, integrity, value systems and beliefs are put to test and are highlighted under the public media microscope. I'm sure Chairman Bernanke is a nice guy, loved by his family but he is missing a backbone. On April 27th, 2011, that will become obvious to all.

SIGNAL MEETING

On April 27th, 2011 the Federal Open Market Committee (FOMC) issues its next decision and statement regarding the future of Quantitative Easing (QE) II. Though previously announced to officially end June 30th, 2011 there are serious questions if this is still a viable option.

This particular meeting is the 'signal' meeting that the financial community will be looking for to assess risk and strategy. Many (including myself) have already concluded what the outcome will be and are preparing accordingly.

On this date Bernanke will hold the first ever press briefing by the Federal Reserve, in addition to releasing forward forecasts which are usually held another 3 weeks. It is going to be an exciting event.

Unfortunately, Chairman Bernanke is going to disappoint!

THE BERNANKE BOX

Let's summarize the box Bernanke presently finds himself in.

REAL RATES

Interest rates have been artificially suppressed for such a long time that no matter what Bernanke does come June, interest rates will likely begin rising. Therein lies the problem for the Fed. Any further debt monetization by the central bank is now becoming counterproductive. If Bernanke enacts another iteration of Quantitative Easing, the Fed may find itself the only player in the bond market. According to my analysis this is nearly the case already.

The truth is that only a central banker can afford to own bonds that are yielding rates well below inflation, and growing even more so. The lower real interest rates become, the less participation there will be in the bond market from private sources. If you don't believe me, ask PIMCO, the world's largest Bond fund who is not only out of US Treasuries but selling short. China has been a net seller of US Treasuries since October. Besides the Fed, who is willing to buy the $1.65 Trillion in fresh new US debt paper?

So if Bernanke extends QEII we have a collapse in the US$ and a complete lockout of auction buyers. If they stop QE II, interest rates go through the roof immediately and the US government with short duration paper has an immediate and serious fiscal funding gap.

Bernanke is in a Box!

EVENT RISK & GEO-POLITCAL SHOCK

Event Shocks were unleashed on the global economy in a historic manner in Q1 2011. Whether Geo-Political issues throughout North Africa and the Middle East or Physical Natural Disasters like the earthquakes in Japan, a Tsunami, or a nuclear crisis at the Japanese Fukushima Nuclear reactors, they have impacted the global economic recovery.

These shocks are hitting an already unstable economic and financial situation. Whether Europe's worsening debt crisis as evident in Ireland, Portugal and Greece or China's aggressive policy to slow the world's largest economic engine to contain mounting inflationary pressures, we have tenets of instability.

If you couple this with corporate margin compressions due to cost push price pressures and increasing interest rates, it does not bode well for central bank monetary policy planners. It is definitely not a good recipe for an already over-extended, over-valued and over-bought stock market.

Typically bad things happen when this occurs.

What we need to appreciate is that though Mr. Bernanke is Chairman of the Federal Reserve, his night job is as Board of Director member of the Bank of International Settlements (BIS) in Basel Switzerland. Along with the other major central bankers he meets bi-monthly with them to oversee policy direction for this mysterious institution which is considered the central bank to the central bankers.

They no doubt have been meeting to discuss 'coordinated' policy - coordinated policy efforts to address such global issues as event shock risks.

They have been meeting to synchronize stopping the Yen from rising and plunging the Yen Carry Trade into an unwinding spiral. They are highly likely to be meeting to consider policies that address global inflation which is now running rampant, thanks to US Quantitative Easing.

This is a busy group with some 'heady' problems - problems that Chairman Bernanke must additionally address and secede to.

The box Bernanke was in had little wiggle room prior to the crushing disaster in Japan and the historical geo-political events in North Africa and the Middle East. The pressures to increase the value of the US dollar by reducing the money printing operations of Quantitative Easing II is a decision being shoved in Chairman Bernanke's face by other central bankers.

I fully understand that the US dollar is considered the purview of the US Treasury, but there can be little disputing the fact that the US Dollar, as the world's Reserve Currency, has become a central policy lever for the US Federal Reserve's Monetary Policy. The direction of the US dollar is a major consideration for Chairman Bernanke.

• The potential of forced unwinding of the Yen Carry Trade has trapped the G-7 into having to stop the YEN rising through repatriation pressures to finance reconstruction and recovery. To do this means pressures to increase the US-Yen cross.
• North Africa and the Middle East geo-political event means the potential of an oil shock hitting America. This additionally puts pressure on the US dollar to be stronger to alleviate some of the pressures on the trepid US recovery or it will be quickly stalled and reversed.
• The crisis in the EU as seen in Ireland and Portugal tells us the EU issues are unresolved. If Spain and potentially Italy are next, we have major global instability and fallout. Before this happens the Euro needs to be weakened to improve competitiveness. The rising Euro since QE II started must be reversed. This means the US dollar must be strengthened by slowing or stopping QEII.
• China is clearly slowing in response to public policy. A strengthening US dollar would lighten China's inflation pressures. Some would argue that QE II is at the root of China's inflation pressures and forced money printing to combat the US' premeditated Monetary Policy attack.

Bernanke is in a Box!

BANK CAPITAL RATIOS

A weakening US dollar has allowed US equity prices to rise and thereby assist in fixing the near terminally ill banking sector with their capital ratios and potential write-offs. The correlation between the increase in the Fed's balance sheet, the rise in the market, the rise in profits and the weakness in the US dollar is unmistakable. The "R2" fit suggests as close a fit and proof as this writer needs.

US financial institutions still have close to $3 Trillion of Commercial Real Estate not yet reflecting current market valuations, which must be written down. Bank capital ratios are inadequate for this, since the US recovery has not brought back commercial and residential real estate values to anywhere near their still elevated book values.

Bernanke is in a Box!

Whether he continues QE II or stops it, the situation is dire. This is what happens to those who "Extend & Pretend" and "Kick the Can Down the Road".

GLOBAL INFLATION

Inflation in food, energy and consumer staples is now a major issue that Bernanke must be seen to be addressing. This week's headlines says it all:

CHINA acts after inflation rises to 5.4%
Fresh price controls introduced and renminbi appreciation expected
EUROZONE inflation jumps to 2.7%
Revision to March figure strengthens expectations of rates increase

EMERGING MARKETS inflation surges
Inflation across the G20

WHAT IS TO BE DONE?

So what is Chairman Bernanke to do?

I believe he will resort to his old tools. Academic tools like Game Theory is likely being applied and is no doubt a good starting point for his decision making.

He needs to manage both perceptions and expectations. He needs to manage the reaction to the message he will deliver. Deciding on the reaction and degree of reaction is critical.

MANAGEMENT OF PERCEPTIONS & EXPECTATIONS (MOPE) BOX

In the above game board, I have labeled the ordinate "Y" axis to reflect a decision and communications message that would foster increased interest rates. The abscissa "X" axis reflects the same but for a potential increasing value of the US dollar.

The problem for Bernanke is that an either or decision is not optimum to balance the many diverse needs of the decision. Additionally either decision is prone to an exaggerated and dangerous reactionary move. He cannot allow the communiqué to be potentially destabilizing.

Gradualism dictates trying to move towards a midpoint on the decision game board.

DECISION

DECSION: DON'T GIVE ANY DIRECTION!

• The optimum message is one that does not confirm the ending of QE II, nor a message saying QE II it is being extended.
• The communiqué should leave the existing June termination date stand without annotation.

RESULT: LEAVE OPTIONS OPEN

• By sending no message the market will migrate towards an 'ending decision' but will be constrained because of the lack of finality.
• By not being specific the options are left open in case the expected result is unsatisfactory. May and June can be used for further adjustments.

STRATEGY: BUY TIME BEFORE QEX

• It is my opinion that the Fed has no choice but to continue the dramatic expansion of its balance sheet to offset the collapse of the Shadow Banking System.
• Money supply as measured by M3 is still dramatically shrinking.
• The Fed needs to take some pressures off financial markets by allowing a corrective/ consolidation to occur via a period of 'risk-off' adjustment.
• The negative impact of a 'risk-off' event will give the Fed the political cover to resume its QEX policy, in due course.

AN INSOLVENCY PROBLEM, NOT A LIQUIDITY PROBLEM!

The reason Central Banks are called upon to 'pump' money into an economy with policies like Quantitative Easing is because an ongoing crisis is draining liquidity in the markets and the Central Bank is the 'lender of last resort'.

We seem to have forgotten this over the last few years. There can be little doubt that the issues we are facing today are not liquidity problems despite the central banks issuing accelerating amounts of money.

What we have is a solvency problem that is presently being hidden by inflating assets or collateral values. Without this occurring, many major financial institutions are legally insolvent from mal-investment and speculative investments gone bad.

The Federal Reserve is now the 'Buyer of First Resort'. This is a completely new dynamic and shift in the structure of the country.

The game that is being played is beyond "Extend & Pretend" and "Kick the Can Down the Road". It is a game that does not allow the capitalist game to work its magic powers. It is a game that protects crony capitalism at the expense of the capitalist system.

Consider the central issue of "too big to fail'. We have laws that specifically address 'too big'. They are called anti-trust or monopoly laws. They are in place to stop unfair competitive advantage of companies using their size, to stop predatory practices from those too big to be effectively legislated and to protect the consumer from being taken advantage of. If we had used the antitrust laws that were outlined in the Sherman Act we would never have got into the predicament in the first place. We have additionally completely ignored the tenets of Control Fraud prosecution.

The second part is ".... to fail". We have bankruptcy laws specifically for the problem of corporate failure. By using government sponsored DIP (Debtor-in-Possession), break-ups, sell-offs, restructured, debt holder haircuts and debt for equity we could have addressed much of our current issues without having plunged the country into near bankruptcy so that less than two years later the banks are making historic profits and the bank owners and debt holders are completely whole and richer off. This is the epitome of crony capitalism.

The government, as represented by the US Treasury if held to the same standards as the private sector, would be criminal on many fronts. The renowned Kenneth Rogoff in a Financial Times Op-Ed referred to the US government as effectively operating a full blown Ponzi Scheme. Bernie Madoff went to prison for 150 years for this. The government calls it PAYGO. Pay as you go and go free.

We do not have a liquidity crisis. We have an Insolvency Crisis as a result of debt saturation built upon mal-investment. The government and Federal Reserve are doing everything in their powers both ethical and other to keep the whole house of cards from coming down on our heads.

Bernanke is in a box. Unfortunately it is a box of cards, cards that when played out will show it was a bad hand even though t was dealt from the bottom!

Do you really believe the Fed will end QE II in the spring?
NO it won't - BUT
The market will react differently this time no matter what the Fed does

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