Interest rates and monetary policy are the preserve of the U.S. Federal Reserve (“Fed”). They are determined by the Federal Open Markets Committee (“FOMC”) and communicated to the American people via a post-meeting statement by the Fed. The current chairman of the Fed is Dr. Ben Bernanke, a widely admired scholar. Since he took over as Chairman, he has made it his priority to make the deliberations of the Fed more transparent. But transparency also means demonstrating that the proverbial emperor has no clothes. That realization is the trigger for this article.
1. Bernanke’s Press Conference on Wednesday, June 19
The Fed statement was released at 2 pm on Wednesday. It was sort of expected and the reaction in the markets was normal. Then Bernanke began his press conference and all hell broke loose. Interest rates exploded to the upside, bonds, stocks & gold all fell hard. The carnage continued on Thursday and Friday. Markets around the world cratered. What you saw was liquidation in its purest form, investors dumping what they could regardless of price.
The interest rate on the 10-year Treasury rose by 15% in just two days. This is the rate that forms the backbone of mortgages, the foundation of America’s housing sector. The 5-year Treasury rate rose by an unbelievable 37% this week, reportedly the worst rise in 50 years. It was as if Bernanke lighted a match and threw it in a dynamite factory, a trader said on CNBC on Friday.
What Bernanke did will reverberate all over Main Street and not just in financial markets. The U.S. economy is still levered and higher interest rates will send a shudder through it. Bernanke is convinced that the rise in the U.S. stock market is an important prerequisite for steady improvement in the U.S. economy. Well, the stock market fell hard after his press conference and kept falling on Thursday & Friday.
The real problem, the utterly disturbing problem, is that Bernanke never intended to cause this reaction. He was shaken by the carnage in the markets. We know this because his favorite economic reporters came out on Friday and blamed the markets for misunderstanding or overlooking the dovish message embedded in Bernanke’s comments. So this was just a case of miscommunication or a misunderstanding?
This disturbs us greatly. Bernanke caused a great deal of damage to the U.S. economy and destroyed a large amount of wealth because he didn’t know how to communicate his message or because he couldn’t figure out how the markets will react? And that is not his fault?
We think the problem is much deeper. The problem is not miscommunication or misunderstanding. Those can be cleared up fast. The real problem, we are convinced, is that Bernanke simply doesn’t understand the Bond market, the Interest Rate market. His greater problem is he does not listen to the markets or to pros who can teach him.
2. What Bernanke Failed to Understand? What He Chose to Ignore?
The principal job of the Fed is to regulate interest rates, the Federal Funds (“FF”) rate. They lower the funds rate when they want to ease monetary policy and raise the funds rate when they want to tighten monetary policy. This is how it has been for at least the past 100 years.
But this is the era of zero interest rates. Bernanke has clearly communicated that the Fed will not raise the Federal Funds rate at least for awhile. So the Federal Funds rate has become virtually meaningless. Last year, Bernanke announced and implemented his extraordinarily bold policy of buying $85 billion of bonds from the open market per month without a defined end date. His idea was to pump money into the U.S. economy until unemployment dropped below his desired threshold.
A couple of months ago, Bernanke announced that he would either increase or decrease the monthly stimulus amount as economic conditions warrant. By doing so, Bernanke essentially established his monthly stimulus amount of $85 billion as the New Federal Funds rate. So were he to raise the $85 billion to say $95 billion a month, that would be interpreted as easing and were he to decrease or “taper” the $85 billion to $75 billion, that would be taken as tightening of monetary policy, the equivalent of the traditional hike in the old federal funds rate.
This is so elementary, isn’t it? But it became evident on Wednesday that Bernanke does not understand it. That is why he said in his press conference that if the Fed’s “forecast proves true, Fed will taper later this year, end QE next year”. And the Fed’s forecast is that the U.S. economy is getting stronger.
Once you understand that $85 billion of bond purchases per month is the new FF rate, you understand how the financial markets reacted. They heard Bernanke say that he will begin cutting the $85 billion monthly stimulus step by step to Zero by mid 2014. Meaning Bernanke will raise the new FF rate step by step until mid 2014. This is as great a tightening cycle as Greenspan hiking FF rate 6-7 times in 1994.
And what happened in 1994? The mother of all bond sell-offs, bankruptcy of Orange County and a blow up in Mexico. Now you understand why financial markets in emerging economies are being treated as Sherman treated Georgia in the American civil war. Now you understand why Gold fell off a cliff this week and why interest rates exploded.
It would have been acceptable if Bernanke intended to create this carnage to remove all traces of speculative fever from financial markets. That is what Chairman Greenspan intended and accomplished in 1994.
What is not acceptable is that Bernanke created this financial carnage inadvertently. What is not acceptable is that Bernanke created this carnage because he did not understand how financial markets function?
The biggest reality of 2013 has been the deep discomfort and fear in markets about the unprecedented financial experiment of unlimited stimulus launched by Bernanke last fall. The last two Fed Chairmen, Paul Volcker & Alan Greenspan, publicly warned about the dangers of this policy. Bernanke was unmoved and relied on the rally in financial markets as validation of his policy.
Bernanke forgot or never understood that armies get destroyed not while they are marching ahead but while they retreat. He should have read accounts of Napoleon’s & Hitler’s invasion of Russia. Russians let these armies come in deep into Russia without offering much resistance to either army. When the French & German armies began retreating, the Russian army began pouncing in small attacks and then more forcefully until retreat became a rout of French & German forces.
The financial markets are deeper than Russia. They behaved just as the Russian armies did from November 2012 to mid-May 2013. They rallied consistently without worrying about minor resistance from small events. Then the markets changed their tactics on May 22 when they saw signs of a retreat in Bernanke. Since then, the Bernanke rally has been in trouble, the rally he counted on to revive the U.S. economy. Bernanke’s press conference converted the attack into a rout this week.
Bernanke did not have to read old military history. All he had to do was to listen to some of the greatest market professionals in America. Read what Stanley Druckenmiller said on CNBC on Tuesday, March 5, 2013:
- “Do you know what guys like me are going to do when they sell the first bond out of 4 trillion?… And don’t think that letting the bonds run off isn’t selling. That debt has to be refinanced. If you do not — if you just let all the bonds run off that is still 4 trillion in selling…..what do you think the markets are going to do when they figure out the exit?”
How
clear was Druckenmiller? And he is among the absolute best of global macro traders. Why didn’t Bernanke listen when Druckenmiller spoke on CNBC? Why didn’t Bernanke invite a few first tier professionals like Druckenmiller to ask their opinion or recommendations for an orderly, tactical retreat from his unlimited stimulus?
The answer, in our humble opinion, is that Bernanke does not understand or respect bond markets.
3. Difference between an Economist & a Bond Trader?
First of all, why should anyone care about this difference? Because the Fed cannot implement its monetary policy without going through the markets. The Fed may be the engine of monetary policy but the bond market provides the transmission mechanism. And the bond market is deep and liquid. It can make or break Fed’s monetary policy. Just look at this week. Bernanke was trying to back away on Friday from what he said on Wednesday. Not because he felt he said anything wrong but because the bond market forced him to retreat.
Dr. Bernanke is a great scholar of economics. He is an expert on the deflation problems of the 1930s. His expertise in economics is probably matched by expertise in physics of at least a few Nobel Prize winning Physicists in America. But NASA would not use these physicists to build a rocket for outer space. That task requires deep knowledge & experience in technology, in understanding how much stress rivets, joints, heat shields can handle safely. Without such depth of knowledge and experience, the rockets may not take off or worse burn during reentry.
Economics is a science while Financial Markets are technology. That is a completely different skill set. It requires empirical understanding of market patterns, experience in understanding and responding to market positioning. This stuff is foreign to economists as Bernanke amply demonstrated this week.
The difference between America and the rest of the world is the difference between economics and financial markets. Other countries have superb economists but America is the world’s foremost leader in the technology of Financial markets. That is why America’s Financial Markets are the deepest, most transparent, most liquid and most innovative in the world.
4. Remember when a great Bond Trader & a great Economist worked together?
Remember 1994? The mother of all bond market sell-offs that summer, the bankruptcy of Orange County, the blow up of Mexico? Robert Rubin took over as Secretary of the Treasury in November 1994. Rubin was a superb trader and trading manager. He thoroughly understood financial markets, how they think, how they are positioned, what their stresses are, the works. Rubin knew exactly what to say to markets, when to say it and how to say it. Every time he spoke publicly, even during the 1998 long term capital crisis, the markets calmed down.
The financial success of the 1995-1998 period, we think, was due to the cooperative and mutually respectful relationship between markets pro Rubin and superb economist Greenspan. This team solved the Mexican crisis of 1994-1995 and protected America’s financial markets during the 1998 crisis.
The next such team was Henry Paulson & Ben Bernanke from 2006 to 2008. Paulson, for those who don’t remember, was the chairman of Goldman Sachs. This team blended together very well and helped solve America’s great banking crisis in 2008. Neither would have been able to construct and implement TARP working alone. Both economic science and financial markets technology were required for this herculean task as well as great stature. This team had both and we the people survived that crisis.
Now think of the intervening period from mid 1999 to mid 2006 when Greenspan and Bernanke worked alone as great economists and without a partner with similar stature & expertise in financial markets. We suffered through the technology-telecom bubble of 2000-2003, the creation of housing & credit bubble from 2004 to 2006, and a period of jobless economic growth.
Frankly, we were plain lucky to get Rubin and Paulson. President Clinton asked Rubin at the nadir of his presidency and President Bush asked Paulson at the nadir of his presidency. We got Rubin & Paulsen because the two Presidents needed great markets expertise to rescue their presidency.
Frankly, the Secretary of Treasury is supposed to fulfill the President’s objectives and the President is supposed to work mainly for Main Street. So realistically speaking, we should not expect a markets expert to be the Secretary of Treasury.
5. So what is a Realistic Solution?
The last 20 years have demonstrated that the U.S. economy is simply too important to be left merely to economists. We cannot expect to get better economists than Greenspan and Bernanke. But these two great minds have failed America when they have been left alone.
So it is time to add Financial technology expertise & demonstrated experience in financial markets to the great economic talent resident at the Fed. Not just in an advisory capacity but in a position of leadership.
Chairman Bernanke’s term expires in January 2014. So within the next few months, President Obama will have to name a new Chairman of the Federal Reserve. This transition has always been tricky. The 1987 crash happened in the first year of Greenspan’s appointment and the 2007 credit bust began in the second year of Bernanke’s appointment.
The transition from Bernanke to the next chairman could be the most difficult transition ever. The next chairman will have to manage the exit from Bernanke’s unlimited stimulus and the enormous expansion of the Fed’s balance sheet. The success of this exit and the fate of the U.S. economy will be dependent on how the Bond market reacts to it.
It is our considered opinion that the next Chairman of the Fed must be a bond market professional of exceptional stature, a professional whom the financial markets will respect and trust.
6. Our Recommendations
We recommend two professionals for the position of the Chairman of U.S. Federal Reserve. Both are absolute fits to the requirements we laid out above. Both have been supremely successful and are deeply respected. Both will be able to fit with and work well with Fed’s economic brain trust of Janet Yellin, William Dudley, Richard Fisher, James Bullard et al.
Both are genuine patriots and care deeply about the American people or Main Street. We believe both came from reasonably simple backgrounds and have built their success from the ground up with their integrity, hard work and brilliance. They both have their feet on the ground. Fortunately, one is semi-retired and the other has his successor in place. So we believe neither will be able to turn down a request from President Obama to take over the helm of the Federal Reserve during the coming period of grave uncertainty and danger.
Our two choices, in & only in alphabetically correct order, are Stanley Druckenmiller and William Gross.
Need we say more?
PS: As a second, distant second option, we would ask for Co-Chairpersons of the Fed, one of them a bond market expert like our choices and the other a traditional economist.
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