The Fed "IS" The Problem!

October 21, 2014

As I wrote yesterday, markets have become schizophrenic and volatility has exploded.  It is obvious the uncertainty regarding "QE"  (monetization) is at the heart of this renewed volatility.  I do want to mention and remind you of past crashes and vicious bear markets, they ALL have seen big volatility (in both directions) prior to the collapse.  1929, 1987, 2000, 2008 ...they all experienced big swings in the market prior to the big declines, this is what I believe we are experiencing now.

Before getting to my topic "the Fed IS the problem", I want to remind you how we have gotten here.  Back in 2008, we had both fiscal and monetary stimulus as the policy response to dysfunctional markets and a shrinking economy.  You might remember Hank Paulson talking about his "bazooka" TARP plan while the Fed was lowering rates furiously and even lending $16 trillion secretly.  They threw the proverbial kitchen sink at the problems.  The problems did not go away nor were they fixed, they were only postponed.  The postponement date now seems to be upon us as the end of another QE nears ...or another round must begin.  Can the U.S. Treasury pump more fiscal stimulus without spooking the bond market and exposing insolvency?  Who will buy another "1 off" stimulus plan?  If the answer is "no one" then it will fall solely on the shoulders of the Fed.  Do you see where this goes?

The Fed is literally backed into a corner.  They have to reflate the system yet they themselves are stretched more than any monetary entity in history.  They are levered at nearly 80 to 1.  This means the Fed can only withstand a 1.25% loss on total assets before their capital is wiped out.  I have a question for you, do you really believe the Fed has not ALREADY lost 1.25% on total assets?  Please remember, they "absorbed" the "crappy" assets after the 2008 debacle.  They were buying bonds from banks in order to get the assets off of the books of the banking system that the system itself could pretend to still be solvent.  Do you remember when some of these assets were offered for sale and the auctions immediately pulled because the bids were coming in UNDER .20 cents on the dollar?  Do you suppose on their entire book of business there actually is any equity left? 

The answer of course is no, the Fed is most probably already insolvent and has been since their last white knight, "lender of last resort" exercise.  What I am trying to point at here is there cannot be another crisis like 2008 because there is no longer anything left big enough to reflate the system.  The Treasury doesn't have the power and neither does the Fed.  Herein lies the problem, everyone has looked to the Fed since 2008 to save the system.  Everyone has relied on the Fed to create "the bid" so to speak, the saying "the Fed's got your back" comes to mind.  But here they are with a severely crippled balance sheet, a history of 4 rounds of QE (plus the secretive $16 trillion) and ...the markets are beginning to test them again.

Understand what I mean by "testing".  The markets are throwing a temper tantrum and want "more" liquidity, can the Fed really do it?  Yes, technically yes they can but only by wrecking an already wrecked balance sheet.  The next question is what happens if it doesn't work?  What happens if the selling does not abate?  What happens if the markets actually realize that QE has done very little to reflate the real economy and all of the accounting tricks have been used up?  What happens if speculators go on the attack and call the Fed's bluff?  Who will step up and save the Fed? 

No one of course will or is able to rescue the Fed.  Possibly the Chinese "could" rescue the Fed, but would they?  I believe you already have your answer by Chinese actions over the last 5 years.  They have set up currency swaps all over the world and signed trade deals directly with U.S. friends and foes alike, they have been preparing for this for a very long time.  There are of course even bigger problems for the Fed than just what happens here in the U.S., they must support all banks far and wide within the "dollar system".  Immediately, 4 German banks currently come to mind.  The European stress test out at the end of this week will be an interesting whitewash.

I mentioned above that there cannot be another crisis like 2008 ...which is why you have seen markets do things over the last 3 years they have never before done in history.  The entire game has been rigged and the charts painted to preach the picture of "control".  This is now changing, "something" is and already has obviously changed.  "Control" is definitely beginning to slip away, otherwise you would not see this much volatility.  You see, volatility is now a very VERY bad thing because of the amount of derivatives outstanding.  Outsized volatility can very easily turn a (so called) solvent bank today ...insolvent by tomorrow morning.

The main point I am trying to make here is that the solvency of the Fed itself will be questioned during the next crisis ...which looks to already have begun.  Either the Fed gets these markets calmed down and "under control" ...or, I believe the markets will begin to question the Fed's "all encompassing power".  The Fed "IS" the problem, my only question is when will speculators take them on?  Another announcement of further QE will probably do the trick. 


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