By Numerian

Don’t these men know the nasty history of central banks which monetize government deficits as the Fed is now doing?

The QE2 left New York harbor yesterday, on its voyage to ports all around the globe. Captain Ben Bernanke has promised to shower the inhabitants of such diverse locales as Brazil, India, and China with up to $600 billion of free money. Following his departure, central banks in these countries announced that they did not want the money and will enact regulations to forbid the QE2 to land in their country. (Image)

Such is the bizarre state of monetary policy in the United States that the second round of Quantitative Easing by the Fed is already being feared and rejected by economists and financial analysts around the world before it is even implemented. It may be that the market has come to realize that QE1 did not perform as promised. Job creation remained anemic, economic growth declined, commodity inflation accelerated, and bubbles popped up in a variety of markets.

Pumping up the Market

A second matter of concern could be that Ben Bernanke this time around has pulled open the Fed’s cloak of secrecy to reveal a dirty secret: the Fed has been actively targeting a higher stock market as one of its monetary policy goals. In an op-ed published yesterday in the Washington Post, Bernanke wrote that a higher stock market has resulted merely from the speculation that QE2 would be implemented (this is true), and that because consumers will feel wealthier, spending will pick up (this is highly dubious not least because consumers have been ditching the stock market all year).

Then of course there is the fact that all this liquidity is supposed to wind up in the pockets of Americans, but it somehow does not. Through a mechanism called the carry trade, hedge funds and banks borrow super-cheap dollars and invest in Brazil, India, China, Australia and elsewhere because interest rates are so much higher in these countries. This is why Americans never see any of this money. The carry trade works well as long as the dollar deteriorates on the foreign exchange markets, which has been the case ever since the Fed announced it was thinking about QE2.

Bernake?

These are reasons enough to question the competence of Ben Bernanke and his fellow Fed governors and presidents who voted for QE2 (only one person dissented). Don’t these men know the nasty history of central banks which monetize government deficits as the Fed is now doing? Can’t they see the asset bubbles that are getting out of control in corn, copper, sugar, wheat and of course the precious metals? Don’t they realize a bubble is underway in the junk bond market, and the last time this occurred was right before the credit crisis of 2008? Haven’t they read the Flash Crash reports that show US stock markets are broken to the point that 70% of trades are done by computers and the average trade is now held for less than two minutes? Don’t they see that their favorite inflation indicator – the GDP price deflator – is at 2.2% and already exceeds the upper bound of their accepted range? What about the fact that real GDP itself came in during the third quarter at 2.0%, hardly a level justifying a dangerously speculative monetary policy? Is there anyone at the Fed who remembers the currency wars of the 1970s and how quickly they got out of control?

Either one of two things is going on here: the people running the Fed are grossly incompetent to the point of malfeasance, or they are fully aware of the risks they are running but are going ahead for some unstated purpose, probably having to do with the need to continue to pour capital into the Big Four American banks which are closer to collapse than the public is allowed to know. These are the banks, after all, which have been making hundreds of millions of dollars off free money and the carry trade, and these are the banks which are at risk of insolvency as the foreclosure crisis grinds on.

Different Market, Different Reaction

As of this moment, the markets continue to be schizophrenic now that QE2 is official. Some markets dread the inflationary potential of this policy, which is why gold is up, the dollar is down, and the US Treasury bond market is selling off. Some US stock markets set new highs for the year yesterday, on the belief that only a fool would stand in the way of free money being poured into stocks by the Fed. “Don’t fight the Fed” has been a hallmark of stock traders for decades now, so why not follow what has always worked in the past, especially now that the Fed has explicitly stated that its goal is to get stock prices higher.

U.S. stocks have shot higher and higher since September 1 when QE2 was first announced, and there has been no significant correction to this advance. More unusual still is the fact that corporate CEOs have been relentlessly selling their stock for months now; the ratio of insider stock sales to purchases each week has been running as high as 1,000:1, which has never been experienced before. Insider selling is always a reliable sign of a stock market at its peak. At the same time, retail Mom and Pop investors have been deserting this market every week since Spring, which is again a highly unusual circumstance and one the stock market would never have ignored in the past. There are so many other unusual circumstances to this stock market that it is hard to pick out the most alarming, but one that everyone has noticed is that we have gone the longest period on record where the stock market is rising but the bond market is falling. Always in the past, the stock market could not advance if the bond market was expressing fear about inflation or the economy, which it has been for months now.

These type of discrepancies always get rectified, and the longer they go on the worse the reaction for the stock market. We are very overdue for that reaction by almost every technical and sentiment indicator that is published, and we have gone so long now without even a modest correction that the sell-off is going to be brutal. It is going to look as if the market is rejecting QE2, or at least it will look that way temporarily if the sell-off is a short term correction rather than a new leg down in a bear market.

Things to Watch

Here are some of the things to watch for that could trigger a sell-off: a) a complete rout of the dollar leading to a currency crisis that can only be solved with higher interest rates in the U.S., b) a collapse in the U.S. bond market as traders respond to fears of hyperinflation, c) a blow-out acceleration of the price bubbles underway in commodities, d) a return to $100/bbl oil, which already crossed above the $85/bbl level yesterday, e) a major credit default affecting the junk bond market, f) a statement by the new House of Representatives leadership that Republicans will not vote for an increase in the debt ceiling, implying a possible default by the U.S., g) a massive lawsuit against a TBTF bank for tens of billions of dollars in damages due to fraudulent activity in mortgage securities transactions, h) capital controls imposed by a major country like Brazil, and possibly involving large-scale selling of Treasuries and agency securities (Fannie and Freddie) by these central banks, or i) a failure in Europe by Greece, Ireland or some other heavily-indebted country to roll over its public debt.

This list could be longer still, but you get the idea. So much could go wrong given how over-stretched these markets are around the globe. If any of these things happens, it will expose the fragility still extant in the markets and the global economy, and it will make people understand that QE2 isn’t able to solve these problems. That’s when the realization will dawn on everyone that the Federal Reserve is not simply powerless to improve the economy, it is making things much worse.