The article below is one I recently wrote for my DJ Education service, but I thought I would share this one with all. There are some “fun” facts and warnings.
Crowded House
Last week’s big event was Ben Bernanke’s press conference, the first post-FOMC meeting press event by a Fed Chairman. For those currency traders betting against the dollar and commodity traders betting on rising prices, it was a tour de force. Bernanke started with the Fed’s latest forecast, which calls for moderate economic growth and slightly higher inflation. Then the Chairman responded to questions regarding the dollar and rising commodity prices. His responses were music to the speculators’ ears.
Bernanke said rising commodity prices were related to demand and fears of supply shortages and nothing to do with the Fed’s policy or the dollar. He termed the price moves as “transitory.” I would have liked to have had a follow-up question that would have gone something like “By transitory, do you mean prices will go from very high to excruciatingly high?” But the reporters acted like they were on a first date and didn’t ask any meaningful follow-up questions. Regarding the dollar, Mr. Bernanke said the dollar was under the purview of the Treasury Department. Technically, he is correct. But in the real world, monetary policy has by far and away the biggest impact on the value of a currency.
Bernanke has never been involved in markets, but he isn’t dumb. Additionally he has a massive staff at the Fed of economists, other staff professionals who have dealt in the markets, and instant access to any big investment bank in the world. He also has access to data bases that would put Goldman Sachs to shame. Bernanke knows very well that his adherence to a crisis monetary policy, when there isn’t one, has caused the value of the dollar to plunge and commodity prices to rise. His Quantitative Easing programs have flooded the markets with dollars. In the academic world the textbooks say that, when the Fed adds massive reserves to the system, those reserves go to providing money for loans and help grow the economy. Maybe that’s the way it once was, but no longer. Today, that money has gone into the hands of speculators to leverage (borrow) money near 0% and buy risk assets. The latest Barron’s Magazine cited a study that estimated that 85% of the reserves Bernanke has provided has gone toward speculation, not domestic loans to businesses.
Bernanke knows this, and this must mean he is really okay with this. He was so intent on avoiding deflation, he wanted to see commodity prices rise. He also likely felt that if speculators drove up global equity prices, businesses would have more confidence to expand. In that case he was somewhat correct. But the level to which he has allowed this to reach unchecked has put the U.S. on a dangerous path. Not only did he promise 0% money for as far as the eye can see, he did not take off the table more QE money if he sees fit. He stood there and coolly told the press that when it comes to the dollar “it’s not my job” or words to that effect. The markets immediately told the real story. The dollar fell to close at a new three-year low, gold soared to a new record high, silver just barely missed $50 an ounce, and oil closed at almost $114 a barrel.
So, are we doomed to an inflationary future and sharply interest higher rates? Not necessarily. There is hope, although none of that hope centers around Bernanke. He’s a lost cause. The hope is that the markets themselves will correct the excesses. The commodity market has reached extreme sentiment and trading levels that match the dot com bubble. Investors of all shapes and sizes have poured into this market. The last group in has been individuals. Volume in the silver ETF (exchange traded fund), which mirrors the movement in silver, exceeded the volume of the ETF that mirrors the S&P stock index. Silver is a tiny market compared to the value and diversity of the stock market, yet interest was greater for silver than in anything else. In the meantime, speculators are ramping up their bets.
Margin debt (borrowing) for commodities has blown past any previous records. Also remember that as the value of an asset rises and provides a bigger “equity” cushion, owners can borrow more against that same asset to buy even more of that or other assets. Does this sound familiar? It should. Think in terms of the housing bubble. Once home values started to rise above the original mortgage, home owners were able to take out more loans against that very same asset to spend elsewhere. If that doesn’t send chills down your spine, it should.
Remember how taking money out of your home was “riskless” because a sustained decline in home prices had never happened? The same mentality has gripped the commodities markets. Traders and investors believe that commodity prices could never fall far, nor would stay low. Part of this belief stems from the thought that Bernanke would just pour money on the fire. But markets can do funny things. I speak from over thirty years of just watching how these events can play out.
The dollar-bear and commodity markets are very “crowded.” This means that all the players are in the same room, drinking from the same bar. Imagine what would happen if someone shouted “fire!” The “fire” could come from some unexpected event, or it could simply come from some of the very big speculators deciding to cash in some and head out the door early. Sophisticated speculators know they are in a risky trade. They have huge profit cushions of protection, but they are also savvy enough to know how quickly those cushions can evaporate in a stampede. In the hedge fund world, word spread very quickly about the big trades from the big traders. All it would take to trigger a mass exodus would be word that some of the big boys are leaving the building.
The next three months are probably the most critical. Since we know we can’t count on Bernanke to do anything, we will wait to see if some other event triggers an end to this potentially devastating run. Yes, the stock market will fall along with commodity prices. But the stock market’s room is not as crowded as the others. Leverage is also a bit less of a problem, and the stock market is a very deep with diverse asset classes. A plunge in commodities would hit the stock market very hard in the short-term, but this would be the very best thing that could happen for the long-term. If something along these lines doesn’t happen, I’m afraid the inflation doomsayers might have it right.
dwightjohnston.com
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