Monday, February 14, 2011

Dislocations Ahead: The Ratchet Effect, Stick-Slip and QE3

The Fed has galloped into a box canyon with no escape; no matter what it does, QE3 will "disappoint" the markets.

I think we can safely predict that "Quantitative Easing 3" (the next round of fiat money creation) will "disappoint," triggering stock and bond market mayhem. Last week I noted that the U.S. economy is now addicted via the ratchet effect to unprecedented levels of Federal borrowing and Federal Reserve fiat/credit creation and manipulation.

In other words, the status quo is now completely dependent on the Federal government borrowing 40% of its expenditures ($1.5 trillion a year) and on the Federal Reserve printing fiat money and buying $1 trillion in Treasury bonds every year.

Now that Central State spending and intervention have ratcheted up to those levels, any reduction will destabilize the staus quo of zero-interest rates (ZIRP), unhindered entitlement and military/Security State spending, etc.

Thus we have politicos proposing $35 billion in "cuts" to a Federal budget ( $3.8 trillion for fiscal 2011) which has leaped up by hundreds of billions of dollars in a mere decade.

Two other concepts which I have been discussing in my "weekly musings" (also covered in the Survival+ critique) may apply here as well:

1. Stick-slip phenomena, which I have previously suggested may shed conceptual light on the housing market's phase shifts.

An earthquake is an example of this phenomenon: the pressure on two adjacent plates of the Earth's crust rises without apparent consequence until the plates suddenly "slip," triggering a devastating earthquake.

2. Punctuated equilibrium, a concept from evolutionary biology based on the observation that the stasis (stability, equilibrium) which dominates the history of most fossil species is disrupted (punctuated) by short periods of rapid evolution.

Systemic change--rapid changes in climate and ecology--pressure organisms which had adapted to other circumstances to either experiment (via mutations) and evolve to suit the new environment or go extinct.

The stock and bond markets now depend on massive injections of free money (via the Fed's POMO) into equities and the purchase of newly minted Treasury bonds.This is the ratchet effect on a large scale: any attempt to ratchet down the Fed's interventions will cause uncertainty and doubt about the consequences, for no one seriously believes that private demand is just aching to jump in and replace the Fed's trillion-dollar buying sprees in stocks, bonds and mortgages.

Beneath the surface of illusory stability, pressures are mounting. A stock market which is now entirely reliant on monthly injections of $100 billion of "free money" from the Fed's "quantitative easing 2" program is a market that is exquisitely vulnerable to any reduction in that stimulus.

The same can be said of the bond market, which globally is groaning under the demands of sovereign states borrowing trillions of dollars annually in new bonds from now until Doomsday (roughly 2021, last time we looked, though many see 2012 as the end-game).

If the Fed stops buying Treasuries, then rates--already rising on the long end--will move decisively higher, bollixing the Central State's entire game plan of rescuing the insolvent banks and goosing a "recovery" with low interest rates and unlimited liquidity.

The Fed and Treasury are now boxed in by the ratchet effect. Any reduction in the Fed's unprecedented intervention, no matter how modest, will trigger an earthquake of uncertainty: the apparently "sticky" stability will slip in a dislocation.

The problem with expectations is also a reflection of the ratchet effect: they only go up.

Rather than adapt and evolve, the Central State and its proxy the Federal Reserve simply moved into a higher state of vulnerability. The global financial crisis which finally broke through all the Central State defenses in 2008 punctuated the illusory stasis/stability of the financial status quo. The opportunity to evolve was tossed aside in favor of extend and pretend, denial, and the transfer of risk and liabilities from the now-insolvent parasitic financial Elites to the taxpayers (profits were private, losses are now public).

In effect, the Fed moved into an even more precarious ecosystem, in which the "free markets" of stocks and bonds are now totally dependent on massive Fed manipulation to maintain their current stability. Yet the levels of Fed intervention are so enormous that they are inherently unstable. the illusory stability of the present has been purchased by increasing the systemic levels of instability.

Add these factors up and predicting the Fed's next round of "Quantitative Easing" (QE3) will "disappoint" expectations is easy. The reason is straightforward: the only way the Fed can avoid disappointing lofty expectations is to ratchet up its fiat creation/market manipulations another tooth. Even keeping QE3 the same size as QE2 will "disappoint" those who fear it isn't enough to "stimulate self-sustaining growth" (i.e., an economy which doesn't depend on borrowing 11% of GDP every year and the monetiziation of 2/3 of all new Federal debt via Fed purchases).

Political resistance to the Fed's headlong gallop into the box canyon of monetization and stock market manipulation is rising. The Fed's policies have enriched the top 10%--those who directly own enough stocks to experience a "wealth effect"--and enabled Wall Street to gorge on "free money profits" unleashed by the Fed's diversion of national income to the banks via zero interest rates. But politicos are increasingly aware that the Fed's lifeboats have only saved these Elites, while the passengers in steerage--the bottom 80%--are watching the Titanic sink lower in the water from the tilting deck.

The Fed is boxed in: by expectations of continued massive intervention and by political pressure to cease or curtail these very same interventions.

Ironically, if the Fed flouts political pressure and ramps up its manipulations via a monumental QE3 program, that may well disrupt the markets as much as a policy of diminished intervention, for the markets would soon grasp that the Fed would be guaranteeing a political firestorm of resistance if the Fed's manipulations didn't spark a hiring/jobs boom by the 2012 election season.

And we all know the Fed's QE3 will not spark a hiring boom, for the Fed's policies are designed to serve one goal: preserve and enrich the financial sector's Elites. Now that they're safely in the lifeboats, the failure of the Fed's policies to "trickle down" to the steerage passengers is increasingly evident.

Recapitalizing the "too big to fail" banks has not yet been accomplished, despite the Fed's gargantuan channeling of national income into Wall Street and the TBTF banks. So the Fed is triply boxed in: its unprecedented efforts to recapitalize the TBTF banks and restore Wall Street's swollen profits are only partially complete, yet it is already encountering stiff political resistance.

Even worse, the interventions have had to be ratcheted up to maintain their effect, akin to an addiction or insulin resistance. The vulnerabilities have not been erased, they've only been masked. The pressures on the financial faults beneath our feet are increasing, and the tremors will soon give way to sudden dislocations of expectations, risk and price.

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