The Coming Rout

There's a scenario that could play out between May and September in which commodities (including my beloved silver) and the stock and bond markets could all sell off between 20% and 40%.  The trigger will be the cessation of QE II and a multi-month pause before QE III.

This is a reversal in my thinking from the outright inflationary 'buy with both hands' bent that I have held for the past two years.  Even though it's quite a speculative analysis at this early stage, it is a possibility that we must consider. 

Important note: This is a short-term scenario that stems from my trading days, so if you are a long-term holder of a core position in gold and silver, as am I, nothing has changed in my extended outlook for these metals.  The fiscal and monetary path we are on has a very high likelihood of failure over the coming decade, and I see nothing that shakes that view.

But over the next 3-6 months, I have a few specific concerns.

It's time to build on the idea I planted in the Insider article entitled Blame the Victim (February 28, 2011) where I speculated on the idea that the Fed might be forced to end its quantitative easing programs, almost certainly because of behind-the-scenes pressure.  

Here's what I said:

How I read [the Fed's recent propaganda tour] is that the Fed is taking some heat for its inflationary policies, mainly behind closed doors, and it is trying to do what it can -- with words -- to soothe the situation. Perhaps China is making noises, or perhaps Brazil's finance minister is making the phone lines feeding the Eccles building smoke ominously, or perhaps it is internal pressure coming from politicians with restless voters. Or all three.

The big risk here is that the Fed will be forced by this rising pressure to discontinue the QE program in June at the normal ending of the QE II efforts. Couple that with a possible federal showdown over the debt ceiling right at the same time, and you have the makings for a massive fireworks display, possibly involving derivative mortars bursting in air.

At the time, I speculated that all of the Fed's pronouncements about inflation being almost nonexistent were actually signs that the Fed was taking some behind-the-scenes heat for the inflation its policies was creating.  And I worried about what would happen if the Fed were to end the QE program in June.

Let's just say it won't be pretty.

Everything would tank.  Stocks, bonds, and commodities.  All of the risk assets that have been unnaturally supported by a flood of liquidity, too-low interest rates, and thin-air base money would give up those ill-gotten gains.  Gold might behave a bit differently, because along with these market declines will come an enormous amount of uncertainty about the financial system itself, usually a condition for higher gold prices.  So I expect gold to correct somewhat, but not nearly as much as everything else, and it could even gain.

The story is, admittedly, getting more confusing by the week, with some calling for hyperinflation and some calling for massive, outright deflation.  I am trying to surf the probabilities and stay one step ahead of whatever curve balls are coming our way. 

The basic idea is this:  The Fed has been dumping roughly $4 billion of thin-air money into the US markets each trading day since November 2010.  The markets, all of them, are higher than they would be without this money.  $4 billion per trading day is an enormous amount of money.  It's gigantic by historical standards.  As soon as the QE program ends, the markets will have to subsist on a lot less money and liquidity, and the result is almost perfectly predictable.

Hello, downdraft.

The markets are quite substantially elevated due to the efforts of the Fed.  T, and then some, is quite likely to be rapidly eliminated as soon as the QE program has ended. 

It's really that simple.

To make the story even more difficult to follow, the Fed has been sending out teams of PR agents in an effort to guide the markets with their words. 

First, on March 2, 2011 Bernanke said this:

Bernanke Signals No Rush to Tighten When Asset-Buying Ends

March 2, 2011

Federal Reserve Chairman Ben S. Bernanke signaled he’s in no rush to tighten credit after the Fed finishes an expansion of record monetary stimulus, seeing little inflation risk and still-slow job growth.

A surge in the prices of oil and other commodities probably won’t generate a lasting rise in inflation, Bernanke told lawmakers yesterday in semiannual testimony on monetary policy. A “sustained period of stronger job creation” is needed to ensure a solid recovery, and the Fed’s benchmark rate will stay low for an “extended period,” he said.

The "no rush to tighten credit" statement is a signal that the Fed will neither raise rates at the end of the QE program nor perform reverse POMOs where it reels cash back in and pushes MBS and/or Treasury paper back out. 

Upon the cessation of the QE efforts, and the cessation of $4 billion a day in Treasury buying pressure, it's a safe bet that market interest rates will rise.  Bernanke is at least on record as saying that if this happens, it won't be because the Fed has taken the lead. 

Bernanke was being a little bit sloppy in his statements, because stopping QE will serve to tighten credit simply because there will be a lot less liquidity sloshing around the system.  It's a situation where the absence of excess is the same as the presence of tightness, if that makes any sense. 

Then on March 5th, a much stronger and clearer signal was given, confirming my worries:

Fed Policy Makers Signal Abrupt End to Bond Purchases in June

March 4, 2011

Federal Reserve policy makers are signaling they favor an abrupt end to $600 billion in Treasury purchases in June, jettisoning their prior strategy of gradually pulling back on intervention in bond markets.

“I don’t see a lot of gain to reverting to a tapering approach,” Atlanta Fed President Dennis Lockhart told reporters yesterday. “I don’t think that is necessary,” Philadelphia Fed President Charles Plosser said last month. 

Whoa.  This is important news.  Not only a cessation of QE, but the possibility of a sudden stop is being telegraphed.  This will change everything.

The old saying 'sell in May and go away' might never be truer than this year, although with this sort of a warning, the cautious investor may want to get a head start on things and sell in March or April.

For some time there have been rumors that the Fed has been splitting into factions, with some of the inner team becoming increasingly uncomfortable with the QE program and its effects.  But so far they've either spoken in code to reveal their displeasure or quietly resigned.  So we're pretty sure there's an admirable level of support within the Fed for ending QE, and it has now bubbled to the surface and reached the public arena.

Of course, there's some form of gobbledy-gook reasoning being floated to justify the plan for a sudden stop rather than a gentle wind-down, and it involves the distinction between 'stocks and flows' (from the same article as above):

Fed staff members, such as Brian Sack, the New York Fed official in charge of carrying out the bond buying, have argued the total amount, or stock, of securities the Fed has announced it will make has more impact on longer-term interest rates than the timing of those purchases. That’s a view now held by several members on the Federal Open Market Committee, including the chairman.

“We learned in the first quarter of last year, when we ended our previous program, that the markets had anticipated that adequately, and we didn’t see any major impact on interest rates,” Fed Chairman Ben S. Bernanke told the Senate Banking Committee during his March 1 semiannual monetary-policy testimony. “It’s really the total amount of holdings, rather than the flow of new purchases, that affects the level of interest rates.”

Fed Vice Chairman Janet Yellen supported that perspective, saying at a monetary policy forum in New York last week that “the stock view won out over the flow view.”

The idea that Brian Sack, a 40-year-old economist with a PhD from MIT, is winning the day in the argument of "stocks over flows" is somewhat troubling to me.  MIT is a quantitative shop, home to some very brilliant people, but how markets will actually respond is another specialty altogether, one that requires a bit of on-the-street experience.  Markets have a bad habit of not being logical, not fitting neatly into tidy formulas, and ignoring things like 'stocks and flows.'

I'll go even further. I'll take the other side of that bet and opine that the flows are much more important than the stocks, because it is the flows that support the continued budget deficits of the US government — which, it should be noted, will still be with us each and every month long after June 2011.  Those deficits are baked into the cake and will require in excess of $125 billion in new Treasury sales each and every month.

Who will buy all the Treasury bonds after the Fed steps aside?  That is unclear.  If there are not enough buyers at these artificially inflated prices, then the price will have to fall until sufficient buyers can be found.  Falling bond prices are at the other side of the financial see-saw from rising bond yields; one goes down while the other goes up, and the Fed has been pressing firmly down on yields for a while via the QE II program.  When that's over, pressure will be reduced and yields will rise.

So what to do? For those concerned enough about this possible scenario to consider taking action, please see Part II of this article (free executive summary; paid enrollment required to access). In it, I predict the extent to which stocks, commodities, Treasury bonds and precious metals prices may be impacted in the near term.  I also detail the key indicators to look out for in order to determine if and when this scenario is unfolding - as well as recommended strategies to preserve capital during this corrective phase.

Click here to access Part II.