Is the appointment of Mr. Bernanke favorable for equity and bond markets?
In the intermediate term, Mr. Bernanke - in order to improve his reputation as a money printing advocate and gain some credibility - may tighten monetary conditions a tad more than Mr. Greenspan might have done. The growth of foreign official dollar reserves is still declining, which is negative for global economic growth, emerging stock markets, industrial commodity prices, but favorable for the US dollar (see figure 1)
Figure 1: Foreign Official Dollar Reserves and Crude Oil Demand
Source: Ed Yardeni, www.yardeni.com
Therefore, when it will become more obvious - even to the eternally optimistic Fed - that the US economy is slowing down, as a consequence of tighter money, bonds could rally from the current somewhat oversold position (see figure 2)
Figure 2: US 20-year Government Bond Prices
But make no mistake! Once Mr. Bernanke realizes that the world's most productive economy is not as sound as he believed and sees that rising interest rates depress asset markets - in particular home prices and stocks- he will print money like there was no tomorrow. Certainly, recent weak auto sales and collapsing consumer confidence indices would argue that the US economy is already far weaker than is generally perceived by the investment community (see figure 3)
Figure 3: Consumer Confidence Indices
Source: Ed Yardeni, www.yardeni.com
So, at latest by the middle of next year, I would expect the Bernanke money printing press to shift into high gear. This should lead to more consumer price inflation, a weakening US dollar and tumbling bond prices. From a longer term perspective, I expect Mr. Bernanke will be the greatest disaster that has ever hit the US bond market in the 200 years of capitalistic history.
So, how should investors adjust their portfolios, in light of Mr. Bernanke's nomination?
I am usually asked what the best investment opportunities are. Sometimes, it might be more useful to ask what the worst investment will be. I believe that the worst long term investment will be to own a 30-year US treasury bond with the view to hold it for 30 years. Granted, long term treasuries could rally somewhat from here for the next few months for reasons explained above, but new interest rates lows are most unlikely. With Mr. Bernanke at the Fed disaster will strike sooner or later and long term bonds will plunge precipitously once the market realizes Mr. Bernanke propensity to print money and if extraordinary conditions warrant it, to drop dollar bills from a helicopter onto the US in order to keep the by Mr.Greenspan initiated irresponsible and by ultra easy money and credit policies driven asset inflation party going. After all it was the by excessive credit growth driven asset inflation, which, since 2001, fueled the consumption related economic recovery. By shorting long term US government bonds an investor is shorting a fixed interest security that will lose value as the purchasing power of the US dollar declines, in a - due to the country's external deficits - structurally very weak currency, and in a country whose government must be regarded as a living disaster in every respect. What better short could one expect to find???
Depending on the quantity of money that the Fed will print, equities will in the long term rally, but as will be the case for home prices, decline in real terms. So, should the forecasters be right, who in 1999 predicted the Dow to rise to 36,000, 40,000 or 100,000 it is almost certain that the Dow will decline against gold. So, if we were to assume that the Dow will rise to say 36,000 thanks to the money printing press, we could also expect the gold price to rise to $ 3,600 or even higher.
What about Mr. Bernanke "formal inflation target" as a monetary policy tool?
Mr. Bernanke is the epitome of US economic thinking. He is like a navigator in the 16th century who did not believe the earth to be round. There is no such a thing as an "inflation target" except the increase in the annual supply of money, which the Fed does control. The increase in the quantity of money is inflation and not the consumer price index, which in the case of the US is doctored anyway. So, how would the good Dr. Bernanke wish to target inflation? Are rising oil and commodity prices, which are conveniently excluded from the core CPI, not inflation???
Mr. Bernanke "targeting of inflation" centers in my opinion around a flawed theory and is one of economic theory's greatest sophism.
Will Mr. Bernanke try harder than Mr. Greenspan to address global financial imbalances via US monetary policy?
This is wishful thinking. Since the formation of the US Federal Reserve Board in 1913, the US dollar has lost 92% of its purchasing power. This after the US dollar maintained its purchasing power between 1792, when the Mint Act was passed, and 1913, when the Fed was formed. Since 1980, US household wealth, driven by easy money and credit has risen from US dollar 7 trillion to US dollar 49.8 trillion while total credit market debt has exploded from 120% of GDP, in 1980, to now over 320% of GDP. The US has no other option but to print money. Otherwise their illusionary wealth collapses and drags down the economy in a deflationary apocalypse. So, Mr. Bernanke will print money. That aside, Mr. Bernanke has expressed the view that deficits do not matter or are related to a global savings glut.
Will Mr. Bernanke and the US government clash over fiscal policy as a result of Mr. Bush huge increase in spending and tax cuts?
Not at all! Last June, Mr Bush removed Mr. Bernanke from the Board of Governors at the Fed to become the Chairman of the White House Council of Economic Advisors. This brought Mr. Bernanke inside the White House for a while so that the President could become comfortable with him and be certain that he was serious about printing money to finance the administration's ill fated military follies and alarmingly rising debts that are fueling asset inflation and financing the excessive US consumption. Mr. Bernanke obviously passed his test and will now become Fed Chairman.
Will Mr. Bernanke adopt more pre-emptive monetary policies in order to ward off asset inflation?
I regard this assumption as wishful thinking. Mr. Bernanke has himself expressed the opinion that the Fed should not try to target asset price increases. Moreover, never over-estimate the intellect of central bankers. Here we have a group of people who could have sold gold in 1980 at more than US$ 800 and bought bonds yielding 14%. But no, instead they waited for almost 20 years before selling gold below US$ 300 to buy bonds at less than 4.5% yields. At the same time we had asset inflation for the last 24 years and bingo, suddenly, at Jackson Hole - having through easy monetary policies and by tolerating declining lending standards fueled the asset inflation like nobody before him, and this on a world wide scale - Mr. Greenspan touches on the subject of asset inflation. It would be comical, if not tragic, because the consequences of paper money becoming worthless will be politically and socially dire. In fact, if it were a crime for central bankers to destroy the value of money, Mr. Greenspan and all the Board Members of the Fed would be sentenced to death.
Any assets worthwhile buying???
As expressed over the last two years, I think that the Japanese stock market will significantly outperform US equities in the next five to ten years. And, whereas rising consumer prices will be negative for US financial assets, a whiff of inflation will be favorable for Japanese equities, as individuals and financial institutions will be forced to move out of bonds into equities. In fact, there seems to be a close correlation between the Nikkei Index and both Japanese and US interest rates. The Japanese stock market bottomed out in April 2003 at less than 8,000 and both US and Japanese interest rates bottomed out in June 2003. Since then the Nikkei and interest rates have been in a rising trend (see figure 4). We expect this trend to continue whereby near-term the Japanese stock market appears to be over-bought. So, we advise investors to wait for a correction to buy Japanese shares.
Figure 4: 10-year US Treasury Bond Yield and Nikkei Index, 1990-2005
Source: Ned Davis and Cumberland Associates