THE BERNANKE PUT AND INSTABILITY IN COMMODITY MARKETS

The Fed has not been shy about taking credit for the recent equity price increases.  They claim that this so-called “wealth effect” will spill over into the real economy and create a “virtuous cycle” where nominal wealth creation leads to real wealth creation (they have that part backwards – real wealth creation leads to nominal wealth creation, but who needs facts anymore?).  But the Fed has also been quick to claim no part in the recent commodity price spike (also no mention of the continuing house price declines, but again, who needs all the facts when you can better prove your point by leaving most of the facts out of the equation?).

I have claimed that the Bernanke Put is a direct cause of a severe psychological imbalance in the market where investors begin to act irrationally based on false promises made by the Fed.  The truth is, the Fed’s ability to influence the real fundamental economy via QE is limited (this has become abundantly clear when one actually studies the intended transmission mechanisms of QE), however, they are having a powerful impact on market psychology.  This is where many economists lose sight of the forest for the trees.  They entirely ignore the human reaction to policy measures.  And in an environment where the Fed is maintaining low rates and literally telling people that they will keep “asset prices higher than they otherwise would be” it is simply foolish to believe that they are not inducing some level of speculation in various markets.

The recent bout of inflation in China and the floods in Australia have laid the perfect foundation for a fundamentally driven rally in many commodities.  Add in the Fed’s direct message to buy risk assets and you have all the ingredients for rampant speculation.  To believe that this speculation is stopping at equities is naive at best.  The fundamental story in the emerging markets and hence the commodity markets is far superior to the modest growth story in most US equities.  So, it’s only natural so see investors pouring into the commodity markets with the expectations of higher gains on the misconception of the Fed’s “money printing” and a sound fundamental backdrop.

The problem is, investors and speculators are taking the Fed’s words to heart and they are acting on them.  This remarkable video from Bloomberg (via Ed Harrison at Credit Writedowns) proves that speculators are in fact hoarding commodities.  It’s no secret that the Chinese believe the USA is largely causing their inflation problems via QE.  They’ve responded with their own Quantitative Tightening.  And while the fundamental story behind the Fed’s actions holds little water there is a dramatic and meaningful psychological impact and we are seeing it in real-time with our own two eyes (yes, that is a pile of cotton that a Chinese speculator is hoarding in his living room).

Quantitative Easing was never necessary to begin with.  The Fed panicked over the summer of 2010 due to a few negative data points and now they are attempting to justify a severe policy mistake rather than simply admitting wrong and removing the destructive Bernanke Put.  Recent market data proves that QE is nowhere close to achieving the goals it was initially set out to meet.  And now there is clear cut evidence that it is having a disastrous impact on the marketplace by causing severe instability in commodity prices.  It’s not merely coincidence that signs of this speculation began in August when the Fed initiated its “money printing” program.

(cotton prices have more than doubled in 6 months)

It’s time for the Fed to take responsibility not only for the equity rally, but also the rise in commodity prices.  Perhaps more importantly, it is time for the Fed to admit that it is having a highly destructive impact on market psychology and is only helping to fuel a speculative frenzy that is likely to increase price instability and market disequilibrium.

QE has failed to generate any sort of job growth in the USA.  There are now signs that it is creating severe price instability in many markets.  Therefore this policy measure is counterproductive to both of the Fed’s mandates.  It’s time to reconsider Fed policy and whether this approach is appropriate in the current environment.  To me, it is clear that it is not.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. If any of you folks out there think that when the commodity markets do correct that equities will be unaffected, you need to look back only as far as the last bubble pop and observe how much good diversification did then. NONE!

    When these bubbles pop, given that margin requirements are only 3%, everything is hit at the same time.

    Keep your stops current and close.

  2. Mark.

    You are may be correct but things do not happen exactly the same way each time.

    In the late 70s inflation and commodities moved up sharply as the market moved down to new lows. We forget that Inflation is not the friend of stock markets for very long. As inflation came down in the 80s and 90s markets moved up at historic high.

  3. so where should one put money now? Maybe I. Oil stocks? Assuming a continued declining dollar, while oil demand starts to pick back up? Gold scares me, but maybe it can still go higher

  4. The government can pay bond interest directly or it can pay interest on reserves (Fed’s annual earnings refund reduced by amount of IOR payments). Without letting FFR rate drop to zero, there’s no way around that choice. Since IOR rates are set at 0.25% and Treasuries longer than a year all have rates higher than that (though 3 month T-bill are at 0.09% today), its better for the Fed to buy up all long bonds and Tsy to just eat IOR cost.

    Better yet, Tsy can stop selling long bonds and just continually roll over T-bills. Since 0.09% < 0.25%, its literally cheaper to borrow money than to just print it. At the same time, I'd permanently cap rates (WWII T-bill cap of 0.375% would do fine, its higher than 3 month, 6, or 1 year rates today). If nothing else, it would cut by more than 90% the CBO's projected $5 trillion in debt service this decade. That's one way to cut the budget deficit without raising taxes or cutting discretionary spending (debt service is an automatic mandatory appropriation).

  5. Per Steve Keen aggregate demand equals GDP plus the change in aggregate (public plus private) debt. Two years ago demand collapsed because private debt stopped increasing i.e. The change in debt was negative going from some positive amount toward zero. Per Keynes Bernanke told congress to stimulate with deficits which produced a positive change in demand per Keen’s equation (also Minsky’s). This worked in 2010 but only by kicking the economy with a “credit impulse”. This is not sustainable however because aggregate debt cannot and will not increase without limit. Treasury would have to directly inject about fourtytwo trillion dollars as deficit spending to provide the net savings needed to allow deleveraging of our enormous debt burden. In this context our current deficits are a joke. To be effective, this cash spending by govt would have to constitute purchase of goods and services made by debtors. This will be viewed by asset owners as a disaster since the price/value of labor will go up while capital will flood the system debasing the value (not the price) of fixed assets compared to labor. For this reason change will be resisted but the forces are ineluctable and so much larger deficits are in store.

  6. Despite seemingly obvious reasons for QE2, the real purpose to is to intentionally keep interest rates low. Why. Adjustable Rate Mortgage resets in 2011 are in the millions. It would be financial armageddon if ARMs would readjusted upwards of 7 to 8% in this economy and the fragile state of countless banks. Prior to the meltdown, banks were “licking their chops” waiting for this day; imagine getting 8%+ on millions of mortgages for 30 years etc. “sugar plums were dancing in the heads”. I believe this was the reason for the insanity with CMO and subprime etal, it would have been the mother of all “gravy trains,cash cows and golden geese”.

  7. Cullen, been reading this site for months. Just want to say thank you for the insight provided here by you and the contributors.