"1) How will Ben let the market down softly?
How will Bernanke let this market down softly with the end of QE2? Mr. Bernanke has done something that Alan Greenspan always attempted, but never made so explicit – he has kept asset prices “higher than they otherwise would be”. It’s a dangerous precedent to set. It’s a lot like giving your children a treat every time they start to cry. After awhile they become conditioned to believe they will always get their treat so long as they cry long enough. The result is a child who never actually earns the treat and instead becomes spoiled rotten. Similarly, market prices no longer have to rise on fundamentals alone. So long as the Fed is there with their safety net speculators can feel confident that they will be rewarded with a treat every time the market declines and they begin to cry.
The result has been obvious – equity investors are eager to take excessive risk by buying every dip in the market with the knowledge that the market can no longer decline. It’s a lot like walking a tightrope knowing that there is a cushion just 5 feet beneath you. There is no need to be overly careful. The problem arises when too many people start jumping on the tightrope with you and create a disequilibrium in the system. At some point the rope becomes unstable and possibly snaps. Except this time your cushion isn’t a soft padding, but someone else’s head. People get hurt. You get the picture. What Bernanke has created is not all that different. It’s an environment of spoiled tightrope walkers who are conditioned to take risk and believe they will always receive their treat when they begin to cry. It might be “working” for speculators, but is it good for the US economy?
The problem for Mr. Bernanke is that he must take the pacifier out of the baby’s mouth without causing a temper tantrum. And yes, Wall Street will throw a temper tantrum when the pacifier is removed. If I had to venture a guess I’d guess that Mr. Bernanke will end QE2, continue reinvesting interest payments, thus slowly removing the pacifier. But that’s just a guess. Either way, he will tread carefully and likely remain close at hand with the pacifier at the ready just in case the baby begins to throw a temper tantrum.
In a similar note to thought #1 – there is the potential for a very frightening market development in the coming years (work with me through this hypothetical). Let’s say the Bernanke Put continues to cause asset prices to deviate from their fundamentals – the economy continues to recover (marginally), but the Bernanke Put becomes so ingrained in market perception that the disequilibrium in markets expands. This results in an imbalance so severe that market bubbles appear (could already be occurring in the commodity space). What happens to the market if the disequilibrium Ben Bernanke causes results in some sort of serious market dislocation similar to 2000 or 2008? All it would take is a minor exogenous threat to cause a global panic. It could be surging oil, a slow-down in China, a repeat of the Euro scares….The result would not only be economic slow-down (into an already weak developed market), but potentially crashing asset prices as bubbles have a tendency to overshoot on the downside. But it’s not the recession that would scare the markets. It is the potential backlash against the Fed.
After three bubble implosions in less than 15 years (all somehow directly tied to Fed intervention), I think the public would call on Congress to revisit the Fed’s dual mandate, its impact on markets and whether their actions over the last 20 years have been appropriate. The rational response would be to reduce the Fed’s role in markets. From a societal perspective I think this is an enormous long-term positive. The sooner we get the Fed out of the market manipulation game the sooner this economy can stabilize, definancialize and get back to becoming the economic growth machine that it has been for so long. For the markets, however, this would be a traumatic event. Imagine 20 years of Greenspan/Bernanke Put being sucked out of the market…it might sound far fetched right now, but I have a feeling the Fed will be far less involved in markets at some point in my lifetime. It might be wishful thinking, but I am confident that America will wise up to the destruction this institution causes by constantly distorting our markets and economy.
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