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The Ex Ante Factor: What has this got to do with monetary policy?

"What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation." ~ Ben Bernanke 11/21/2002 http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

Will the "helicopter" speech forever haunt Bernanke?

Consider the performance of the following assets since the 8/17 announcement of a 50bps cut in the discount rate and subsequent 50bps ease at the FOMC meeting this past week:















Thanks to the Fed easing, our equity appreciated 8%. But we lost 4% in purchasing power, our cost of raw materials rose 12% and cost of debt widened 30bps. According to my math, we're still in the hole. This is obviously not a desirable outcome and proves the Fed is not omnipotent as many suggest.

When Bernanke delivered the infamous "helicopter" speech the SPX had lost 40% of its value from the 2000 highs and he was clearly trying to send a message to the markets that if prices continue to fall the Fed could and presumably would inflate the currency to stimulate prices. That is precisely what they did, capitulating at the low, as M2 growth in relation to GDP growth exploded and the dollar lost over 30% of its purchasing power the following 2 years. Bernanke said the Fed could print as many US dollars as it wishes at essentially no cost. This is completely illogical and frightening to think that our central bankers believe it to be true. This inflation campaign the Fed waged cost them at least 30% in purchasing power and 250-300bps in inflation premium (yield curve) on debt capital before they finally reversed course and tightened. The current dislocations we are experiencing are a direct result of this inflation and now it looks like the markets are sending Bernanke the tab.

Below are only 4 commodity markets that clearly show they have been in solid uptrends, some now in parabolic moves.

Pundits and strategists continue to remind us of the Wall Street saying, "don't fight the Fed," implying the central bank can simply wield a wand and move markets and the economy. How can we claim to operate in a freely traded market society if one economist and his board of bureaucrats can direct asset valuation at their leisure? This is a ridiculous assertion and the past few weeks have been a perfect example as to why we shouldn't be watching the Fed but watching the markets.

Sub-prime mortgages get all the blame for the current credit market debacle but they are scapegoats and really just one of many symptoms of the larger problem of excessive leverage of assets that are artificially inflated. The reversal of the collateral appreciation and thus credit expansion is at the root of the current disruption and the outcome will depend on how the market absorbs this de-leveraging and liquidation of declining collateral and how much equity is destroyed in the process.

CDOs, hedge funds, broker/dealers, banks, thrifts, mortgage REITS, conduits, SIVs, structured products, real estate speculation and debt funded stock buy-backs all play the same game. Leveraging cash flow to increase return on equity. This game works as long as cash flow yields more than your cost of capital and the collateral values for the leverage remain stable. Now we are seeing the triple whammy of declining cash flows, rising cost of credit and declining collateral values. The magnitude of the leverage is compounding the situation as the feedback of declining collateral values and rising cost of capital are driving margin calls from lenders which are in turn driving liquidation of collateral which of course drives prices even lower. As the collateral is sold at discounts, equity is eliminated. Consider the predicament facing banks on the hook for LBO debt, making loans at par and selling them at .95 or a hedge fund that is 10-1 levered and sells it's assets in a fire sale or a home that was financed at 100% LTV and is sold at less than cost. Billions of dollars are evaporating everywhere. The trick for the Fed is whether they can print enough dollars faster than the market removes them. We think the Fed will be unsuccessful and the result will show up in the value of the dollar, price of commodities and the yield curve.

For that reason, this week we largely ignored the stock market and kept a close eye on these market indicators which we recommend investors monitor and not what is the next Fed move. Bernanke thinks he can sufficiently stimulate the monetary system to absorb the collateral liquidation. He thinks he can inflate without a cost. Maybe he can, but the past few weeks proved that the markets are quick to discount his actions and counteract his intentions.

In previous editions we have pointed to price action in the dollar, bonds, commodities and material stocks and the implications of their chart patterns and potential for a reversal in asset valuations. As we expected with a Fed ease, we are seeing the dollar fall apart, massive curve steepening, blow offs in commodities and subsequent rallies in material stocks (BHP +40%). This is exactly how they draw it up in grade school and on CNBC, so naturally we are skeptical that the consensus opinion will continue to trade correctly. It also strikes us as ironic that just as we finally get back to those old 2000 highs, the Fed has to come back in with easier money just to maintain prices. This is not the sign of a healthy market but one dependent on ever expansion of credit. We do not believe the Fed will ultimately be able to expand credit at a rate sufficient to offset the contraction of balance sheets without massively increasing the money supply which has dire consequences for the dollar and interest rates. Let the games begin.

Bottom Line: We stand at the crossroads where the integrity of free capital markets is staring down government intervention. We likely won't maintain the status quo for long but rather will be breaking out in a new trend. Is this the beginning of a new leg higher in asset prices driven by an inflated currency or are we in the late stages of this cycle that is keeping suckers in the game prior to a trend reversal? Stay tuned. The markets will let us know in due time.


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