The Bernanke Put

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We are now only a week away from finding out how much money Federal Reserve Chairman Ben Bernanke is planning to print. This is the most important news we have seen in a long time.

Since Bernanke’s speech on the 27th of August in which he said he was planning to embark on another round of Quantitative Easing (QE2) the markets have spiked nearly 15%.

Have a look at this chart showing the date of Bernanke’s speech and it is quite clear that he managed to change the short term trend.

S+P 500 daily chart


S+P 500 daily chart
Click here to enlarge
ource: Slipstream Trader

There is a huge amount of conjecture at the moment about how big QE2 will be. I have seen figures ranging from $500 Billion to $4 Trillion. It appears that there is plenty of room for the market to be either happily surprised or bitterly disappointed by the outcome.

My own view is that the Fed would prefer to disappoint the market slightly than to continue feeding what has become a massive rally on the back of QE2. There is no doubt that they are eyeing the reactions in the commodity market with some trepidation.

They know that feeding a commodity bubble is not going to help their cause. That is unless you believe their cause is actually to recapitalise the zombie banks via huge trading profits on the back of limitless amounts of cheap money.

When you look at the Feds actions from this point of view, it all starts to make sense. They are not really concerned about lowering unemployment. They are more concerned with giving the banks a free kick to use the carry trade to book huge profits that will help to fix their sick balance sheets.

Ultimately a commodity bubble will knee cap what little recovery there is. Because of this, the Fed will have to tread very carefully while playing this dangerous game.

The market seems convinced that QE2 will help GDP growth. I do not believe this is the case and I would like to strain your brain a little to drive the point home that an increase in money supply will not lift GDP growth.

John Hussman wrote a very interesting article recently on the fact that the Fed had now entered a liquidity trap. In it he quotes John Maynard Keynes who said that: “There is the possibility… that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control.”

He goes on to say that,

The hallmark of a liquidity trap is that holdings of money become “infinitely elastic.” As the monetary base is increased, banks, corporations and individuals simply choose to hold onto those additional money balances, with no effect on the real economy.
A related way to think about a liquidity trap is in terms of monetary velocity: nominal GDP divided by the monetary base. (The identity, which is true by definition, is M * V = P * Y. The monetary base times velocity is equal to the price level times real output).

Velocity is just the dollar value of GDP that the economy produces per dollar of monetary base. You can also think of velocity as the number of times that one dollar “turns over” each year to purchase goods and services in the economy. Rising velocity implies that money is “turning over” more rapidly, so that nominal GDP is increasing faster than the stock of money. If velocity rises, holding the quantity of money constant, you’ll observe either growth in real output or inflation. Falling velocity implies that a given stock of money is being hoarded, so that nominal GDP is growing slower than the stock of money. If velocity falls, holding the quantity of money constant, you’ll observe either a decline in real GDP or deflation.

The belief that an increase in the money supply will result in an increase in GDP relies on the assumption that velocity will not decline in proportion to the increase in money. Unfortunately for the proponents of “quantitative easing,” this assumption fails spectacularly in the data – both in the U.S. and internationally – particularly at zero interest rates.

Velocity of Monetary Base
Source: Hussman Funds

Likewise, real economic growth has no observable correlation with growth in the monetary base (the correlation is actually slightly negative but insignificant). Rather, economic growth is the result of hundreds of millions of individual decision-makers, each acting in their best interests to shift their consumption plans, saving, and investment in response to desirable opportunities that they face. Their behaviour cannot simply be induced by changes in the money supply or in interest rates, absent those desirable opportunities.

You can see why monetary base manipulations have so little effect on GDP by examining U.S. data since 1947. Expand the quantity of base money, and it turns out that velocity falls in nearly direct proportion. The cluster of points at the bottom right reflect the most recent data.

Change in Monetary Base
Source: Hussman Funds

Simply put, monetary policy is far less effective in affecting real (or even nominal) economic activity than investors seem to believe. The main effect of a change in the monetary base is to change monetary velocity and short term interest rates. Once short term interest rates drop to zero, further expansions in base money simply induce a proportional collapse in velocity.

I think the above charts are damning evidence that Bernanke is now officially pushing on a string. The stock market is priced for perfection and will need to see a big number announced next week to stay afloat.

If I was one of the banks that had made a killing over the past few months by borrowing cheap money and investing it abroad, I would be seriously considering cashing in some chips before next week’s announcement.

If the Fed has any ounce of credibility it will err on the side of caution rather than stoking the fire that it has ignited in the commodity markets. Therefore I would bet that they will announce a figure that is less than the market wants but they will keep the door open to act more aggressively if the situation deteriorates.

Basically it will be a new version of the Greenspan/Bernanke put. If the economy continues to deteriorate then the market will have to wake up one day and sell-off regardless of what games the Fed is playing.

The Japanese experience is a perfect example of what our markets may look like going forward. They have been using QE for years and even though it has inspired some large rallies in the equity market over that time the Nikkei is still down 75% over the past 20 years.

Nikkei daily chart 1990-2010

Nikkei daily chart 1990-2010
Click here to enlarge

Murray Dawes
For The Daily Reckoning Australia

Murray Dawes
Murray began his career on the Sydney Futures Exchange trading floor in 1993 with Swiss Banking Corporation (SBC). He spent a couple of years in the 3 and 10 year bond and option pits before moving on to the Share Price Index (SPI) futures and options pit. From there he became a broker with SBC specialising in SPI futures and options to institutional clients. After leaving SBC Murray continued his career in broking at Bankers Trust Australia. Then in 2001 Murray moved to Melbourne to work as a hedge fund trader for one of Australia’s wealthiest families. In 2003 he was ready to set up his own firm providing the same proprietary technical trading system to some of Australia’s boutique hedge funds. The success of Murray’s system led to him trading a $10 million account for a high net worth individual. This involved trading Australian and US futures and Australian stocks. Now Murray heads up the technical analysis desk for us passing on to readers some of his experience from 16 years of trading.
Murray Dawes

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