The Fed Trap…Why The Fed Bubble Is Likely To Burst

March 11, 2014

PEAK Observation            

Forget about the liquidity trap. We’re looking at the deluxe version of that rare economic situation and, ironically, the Fed has trapped itself.

How? Through the odd combination of being too successful with its plan to reinflate risk assets everywhere and its absolute unwillingness to let the stock market go down.

Under the “normal” and, I might add, highly unusual liquidity trap – think Japan over the last roughly 15 years – we’re looking at an anemic economy that refuses to be revived by repeated rounds of central bank accommodation of various shapes, sizes and forms.

The goal of such accommodation, one would think, is to get the sluggish economy moving organically and something that Japan basically gave up on 8 years ago until, of course, Shinzo Abe “Superman” landed more recently.

One reason – probably the main reason - Japan ended its 5 year-long pursuit of pumping liquidity into a lackluster economy starting in 2001 and well ahead of the advent of Abenomics was because the money wasn’t going anywhere. It wasn’t changing hands, it wasn’t circulating and it certainly wasn’t helping the people of Japan become more prosperous. Put simply, QE didn’t work to revive the Japanese economy.

How does this relate to the U.S. now? Because it is exactly where we are today behind the gauzy veil of a stock market that has gone up 180% over the last five years as the detritus-eating GDP seems to go nowhere but sideways and along the bottom.

What makes this so interesting to me is that 4 years after publishing one of my favorite PTR notes -

M2 vs. GDP: Stuck between a Rock and A Hard Placenothing, and I do mean nothing, has changed relative to economic growth. In 2010, quarterly GDP growth was in a range between 1.6% and 3.9% with two quarters recorded at 2.8%.  Fast forward to 2013 and we’re looking at quarterly GDP growth in a range between 1.1% and 4.1% with two quarters caught in the middle of that range at 2.4% and 2.5%.

But what did change? Why the stock market, of course, and nothing – and I do mean nothinghas stopped the stock market.

Not Dubai, Greece, the Eurozone, record high bond yields on some of the PIIGs or the threat of a double dip recession around the world.

A nuclear disaster in Japan? No big deal. The U.S. loses its coveted triple A credit rating? Bring it on.

Nothing – and clearly I do mean nothing – has stopped this stock market - or – I should say nothing has stopped this Fed.

The reason I say “this Fed” is because as GDP growth feeds on the detritus of the last 20 years of economic activity, the stock market thrives, presumably, on the well north of $3.0 trillion the Fed has thrown at it.

Apparently all of that Federal Reserve accommodation has gone not to Main Street and the economy but to Wall Street and the financial markets.

But how does this relate to the liquidity trap? It is the liquidity trap only in this case it is the Fed Trap as stocks only ride higher on one of the better bull markets ever driven by all of that Fed liquidity.

The economy referenced in the chart above is not the economy as most people think of it in terms of GDP growth or corporate profits. But it’s as fundamental and important, in my view, because it represents Main Street and whether or not money is changing hands.

Specifically, shown by that severely sliding red line is the velocity of money or how quickly money circulates through the economy, and thus it is probably the single fastest way to gauge the real health of the economy.

Only in the case of our economy, a record low velocity of money tells us that money isn’t going anywhere – the liquidity is trapped - on the balance sheets of banks and corporations rather than flowing to and through the balance sheets of ordinary Americans to help make their lives better.

And so now – we sit in this odd disconnected surreal spot that most people refuse to really acknowledge and one that has me fired up in a 2010-early-2011-kind-of-a-way and something that most of you never had the opportunity to see. But it’s impossible to remain relatively muted anymore because the falsehood behind this reality is growing increasingly distorted and it will – make no mistake about this fact - correct and probably in one of two basic fashions.

Either the economy starts growing organically and something that can be proven only by decent and consistent GDP growth simultaneous to gently-rising velocity of money back toward the 1.8+ level – or - the stock market crashes.

Let’s hope for the first and okay, if the second, maybe it won’t be a crash, but it will require at least a severe correction for the gross disconnect between Main Street and Wall Street to be bridged if the healing is not done on Main Street.

And this is where my problem rests or the reason I’m especially agitated right now about the Fed

Trap. It - as in the disconnect between stocks and the velocity of money - did not need to become a chasm so wide that it will create a serious correction in the lives of most Americans who will feel the effect of a stock market crash far more than they ever felt the benefits of the virtuous wealth effect.

After all, I was a fan of the Fed far before it became popular to praise Ben Bernanke and company for being so aggressive and innovative in keeping the financial system and economy from crashing and something that I still think we should all be grateful for.

However, my fondness for the Fed started to fade in September of 2012 when the Fed made a mistake and the one showing in the chart above in a rather clear and dramatic manner in 2013.

That mistake is called QE3 and the reason we know it was a mistake is because as the Fed has pushed infinite – in perception - additional liquidity into an already reinflated financial system despite all of the evidence that the anemic U.S. economy refused to be revived by QE1, 2 or the Operation Twist, the velocity of money has only drooped down lower simultaneous to the Fed’s apparent inability to do much with what is supposed to be its most powerful tool or interest rate policy. This is probably the most dangerous trap.

This stagnate swamp of Fed liquidity is the ball to the chain of one of the Fed’s many significant problems at this time and this is, of course, the uncomfortable consequences of rising rates and something that the slack-filled system will not allow for without a truly recessionary result, in my view. 

Returning to my new favorite chart, the reason the line in red - or the velocity of money - continues to sag is because it is derived by dividing nominal GDP by M2 and so long as the Fed keeps pumping up the denominator of M2, all of the slack that’s been sitting in the system since the Great Recession becomes increasingly swamped by that accommodative typhoon.

And so why would the Fed make this decision to weigh on the real movement of the economy or money changing hands? I have to believe it was to make sure the stock market does anything but go down.

Now monetary policy is as much an art as it is a science and I am neither an artist nor a scientist – or an economist for that matter – but the dire message of a record low velocity of money stood out to me 4 years and $2.0 trillion of QE ago.

Personally I would like to think the Fed’s 2012 policy decisions were not a matter of hubris but rather for the reason of this note or the fact that the Fed is trapped and has been the moment it favored the fact that QE was an excellent elixir to reinflate the stock market but more of a placebo on the economy.

QE2 – and something I was behind along with that leg of the rally – was justifiable in the fact that the diminishing odds of QE weren’t entirely clear yet here in the U.S. and there were clear signs of a deflation threat as told by the uncomfortable narrowing of the 5-year TIPS spread and Mr. Bernanke’s own justification for that round of bond buying.

But $600 billion injected and less than a year later and it was pretty clear that QE was, in fact, a good remedy for a flailing stock market and more of a neutral on the economy. Only the latter part of that statement is not true considering the destructive drag on the velocity of money.

In fact, I think the Fed Trap chart makes a pretty decent case for harm done on the Main Street economy over the last 16 months and apparently for the benefit of Wall Street that long ago ceased to be a good justification for infinite – read the gravity of that word: infinite – Fed support.

It would be hard, I believe, for the current Fed to make a compelling argument explaining how an increasingly record low velocity of money speaks to anything but an excess of M2 in the context of a slack-filled economy that is not stronger via GDP today than it was 3 or 4 years ago. I know: it’s the weather.

Even scarier about that chart is the possibility that the velocity of money is setting up for a massive spike higher and not something that would represent money changing hands in a healthy manner on Main Street but inflation if not hyperinflation and one of the great fears of many around the Fed’s years of accommodation. This possibility has been largely forgotten at this point, but isn’t that exactly what makes a scenario ripe to happen?

And what about the current beneficiaries of the Fed Trap or the very elite institutional investors who have allowed themselves to be steered like lemmings willing to take the plunge if need be?

Well - they may actually get to take that plunge soon if they stay the course on which the Fed is steering them right now.

Yes, I know, I know. I have been calling for a stock market correction for the last two years that has simply failed to materialize – yet.

Maybe the Fed succeeds with its whack-a-mole global central bank coordination that is showing up as very troubling instability in the currency markets and if so, there will be a healthy pullback at some point soon but not the sort of 50% - now 60%+ - that I have been expecting to happen based on the charts.

Let’s hope this is the case and the Fed does succeed in not just kicking the can down the road but somehow kicking it off the road because the alternative could be devastating to millions of Americans if all of the destabilizing forces of a 30 year borrowing binge reinflated by the Fed should crest and come crashing back down.

As the rather starkly marked long-term chart of the DJIA illustrates above, 2014 may prove to be a critical time around the Fed’s ultimate success on its $4.1+ trillion balance sheet-gambit.

If the DJIA trades in a modest but steady manner above long-term ascending resistance, then perhaps the Fed’s great QE-experiment will start to pay off as GDP and the velocity of money, perhaps, start to match that five-year manic spike higher.

If the DJIA, fails to make it above long-term resistance and instead skims near the top or drops back into the girth of that massive sideways range, look out as a correction worse than 2008 likely takes the stock market – and the economy – back down.

Beware, then, the Fed Trap and a fragile financial system situation that may prove to be comprised of dangerous quicksand.

As always, thank you for taking the time to read this month’s piece.

Courtesy of http://www.peaktheories.com

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