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How to Profit if Bernanke's Quantitative Easing 'Exit Strategy' Fails

Interest-Rates / Quantitative Easing Jul 24, 2009 - 10:52 AM GMT

By: Money_Morning

Interest-Rates

Best Financial Markets Analysis ArticleBy Jason Simpkins writes: After more than a year of lax monetary policy and direct capital infusions, U.S. Federal Reserve Chairman Ben S. Bernanke has finally outlined an "exit strategy" that he says will lead to the "smooth and timely" withdrawal of monetary stimulus and keep inflation at bay.


However, analysts say that Bernanke's exit strategy is far from foolproof and could touch off an inflationary firestorm that hammers the U.S. economy, debases the dollar and sends prices soaring.

Indeed, analysts have long been concerned that Bernanke's unprecedented effort to boost market liquidity and expand the Fed's balance sheet would lead to a significant increase in inflation once credit markets return to normal.

The Fed has injected more than $2 trillion into the U.S. financial system, expanding credit through increased loans to banks to provide liquidity. It's also created the Commercial Paper Funding Facility - which holds $109.2 billion in short-term IOUs issued by corporations - and the Term Asset-Backed Securities Loan Facility (TALF) - which has lent $25 billion to investors to buy securities tied to auto and other consumer and business loans.

The Fed has also lowered its benchmark Federal Funds Rate to a record low range of 0.00%- 0.25%.

As a result, the U.S. monetary base has about doubled during the past two years.

Bernanke acknowledged in the Federal Reserve's Monetary Policy Report to Congress - as well as in an op-ed piece in Tuesday's Wall Street Journal and in comments made directly to the House Financial Services Committee - that inflation poses a significant threat. But he has also made it clear that the Federal Reserve has no interest in changing the course of its policy before it is certain that a recovery is underway.

"Economic policy conditions are likely to warrant accommodative monetary policy for an extended period," Bernanke said in the Fed's report to Congress.

Nevertheless, the central bank leader said he is confident that when the time comes he will have the "necessary tools" to rein in inflation in a "smooth and timely manner."

So what is the Bernanke's exit strategy? Will it work? And what should investors do if it backfires?

A Look Inside Bernanke's Toolkit

Bernanke has heard the concerns about inflation and this week he went a long way to address them. The Fed chairman not only addressed those concerns in his report to Congress, he penned an op-ed piece for The Journal.

Bernanke pointed out in each of those statements that some of the Fed's emergency lending facilities automatically wind down as the economy recovers, because they have onerous pricing and terms.

Short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion from about $1.5 trillion at the end of 2008, he noted.

Additionally, Bernanke named two key measures that the Fed could take to raise market interest rates as needed and drain the central bank's bloated balance sheet:

  • Increase the amount of interest paid on balances held at the Federal Reserve by depository institutions (banks).
  • Selling securities from the Federal Reserve's portfolio with the agreement to buy them back at a later date.

The Federal Reserve last fall was granted the authority to pay interest (currently 0.25%) on the balances maintained by banks at the central bank. Raising the amount of interest paid, Bernanke argues, will give the Fed substantial leverage over the Fed Funds Rate and other short-term rates, because banks don't typically supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve.

Basically, banks will be keener to keep their money at the central bank for a substantial, risk-free premium, than they will be to lend it out at a lower rate with a higher risk. And this can be done without draining reserve balances.

Bernanke noted that it's common practice for many foreign central banks - including the European Central Bank (ECB), Bank of Japan (BOJ), and the Bank of Canada - to use their ability to pay interest on reserves to maintain a floor under market interest rates.

"Thus, the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the Federal-Funds Rate," Bernanke argued in the The Journal. "Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed."

The second part of Bernanke's exit strategy, which will be orchestrated in concert with the first, is to unwind the Fed's balance sheet by conducting reverse repurchase agreements and outright sales of longer-term securities.

A reverse repurchase agreement is when the Fed sells securities from its portfolio with an agreement to buy them back at a later date.

"Reverse repurchase agreements, which can be executed with primary dealers, government-sponsored enterprises, and a range of other counterparties, are a traditional and well-understood method of managing the level of bank reserves," Bernanke told the House Financial Services Committee.

Additionally, the Fed could simply sell its holdings in longer-term securities, which Bernanke says would drain reserves, raise short-term interest rates, and put upward pressure on longer-term interest rates by expanding the supply of longer-term assets.

"In sum, we are very confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability," Bernanke told the House panel.

Exit Strategy or Inflationary Quagmire?

At face value, Bernanke's exit strategy is entirely plausible. But that doesn't mean it's foolproof. There are a number of lingering questions and concerns still lingering in the minds of many investors and analysts.

First, there is a question of timing. Bernanke may have described the Fed's tools, but he did not define the conditions that would lead to their use. That is, at what point does inflation become enough of a concern, and at what point does U.S. growth become sustainable enough, to warrant a change in Fed policy?

Bernanke sent a clear message to the market this week that he is aware of the potential risk of inflation, but he also made it clear that the economy is still in need of nursing. What Bernanke termed "accommodative monetary policy" - interest rates near zero and capital infusions through the purchase of government and mortgage debt - likely will remain the norm for the foreseeable future.

That seems fair considering that inflationary pressures have remained low, bank balance sheets are still in disrepair, consumer spending is weak, and unemployment is the highest it's been in decade. But as the economy improves, the central bank's policymaking Federal Open Market Committee (FOMC) will have to come to a consensus about when stimulus should be retracted and liquidity tightened. "Because there is no clear model or indicator on what tools to exit with, that is where the fuzziness is," Rudy Narvas, senior analyst with 4Cast Ltd. in New York, told Reuters. "If you don't time it right, either you dip the economy back into recession, or you will fuel the inflationary fires."

But timing isn't the only uncertainty regarding the Fed's plan. There are also questions about how effective the Fed's "tools" will be.

Raising interest payments on reserves could entice banks to keep more money with the Fed, but there's a limit as to how much money the central bank can pay out.

"There will eventually be a situation where the Fed is paying the banking system something like 5% on $700 billion of reserves," Bank of America-Merrill Lynch (NYSE: BAC) rates strategist Michael Cloherty wrote in a research note. "That would mean the Fed would be paying the banking system $35 billion per year of what is ultimately U.S. taxpayer money in order to push up interest rates."

Reverse purchase agreements could help trim the Fed's balance sheet, but the primary dealers - the "government-sponsored enterprises," and a range of other counterparties that Bernanke referred to - would have to have healthy balance sheets of their own. And so far there's no indication that they will.

Even selling longer-term securities outright carries an inherent risk. Merrill Lynch estimates that the Fed will hold $1.25 trillion in Treasury, agency, and private mortgage-backed debt.

The Federal Reserve "can't fob huge amounts of paper onto the market without having some seriously detrimental implications for long-term rates," Alan Ruskin, international strategist at RBS Securities (NYSE ADR: RBS), told Reuters.

The worst-case scenario, according to Ruskin, would be if foreign holders of U.S. debt - such as China, which held $768 billion of U.S. securities in reserve at the end of March - started dumping Treasuries and the dollar, causing a currency crisis.

What to Do if Bernanke's Exit Strategy Backfires

If the Fed is too slow in its withdrawal of "accommodative monetary policy," or if the central bank finds itself unable to unwind its balance sheet in as "smooth and timely manner" as Bernanke anticipates, a major surge in inflation will be likely the result.

In that case, one of the clear winners would be commodities - especially gold.

"Protection from inflation is a huge benefit to commodities," said Money Morning Contributing Editor Peter Krauth. "Specific investments would include gold, silver, oil, and copper, to name a few. All of these are valuable - and possess an actual value - which means that they will not go to zero. Since they are priced in U.S. dollars, as the dollar loses value through inflation, you need more dollars to buy the same quantity (not to mention increasing demand)."

If you're interested in purchasing gold, you could do so by purchasing bars, or bullion, or though the gold-linked, exchange-traded fund (ETF) SPDR Gold Shares (NYSE: GLD).

Today, SPDR itself holds more than 1,000 ounces of gold, and has a market capitalization of $33 billion. The fund's price fluctuates in concert with the price of gold, which adds a small mount of risk. However, buying this ETF is more convenient than buying gold bars directly, because the fund dispenses with the accompanying storage problems that comes with actually owning physical gold.

Similarly, there are other commodities-based ETFs that would offer a significant return should inflation take hold.

For instance, the United States Oil Fund LP (NYSE: USO), the iPath S&P GSCI Crude Oil Total Return Fund (NYSE: OIL), or the United States Gasoline Fund LP (NYSE: UGA) all offer exposure to oil and gas prices, which have surged recently on demand but are certainly responsive to inflation as well.

[Editor's Note: If it's inflation you're worried about - and commodities you want to invest in - there's no better place to look than the Global Resource Alert trading service, which ferrets out companies poised to profit from the so-called "Secular Bull Market" in commodities. If you're new to the commodities-investing arena, and are uncertain about the landscape - or even if you're an "old hand" at natural-resource stocks, but want some insights into the new profit plays and new players - consider hiring a guide: Money Morning Contributing EditorPeter Krauth, a recognized expert in metals, mining and energy stocks, who is also the editor of the Global Resource Alert. A former portfolio advisor, Krauth continues to work out of resource-rich Canada, which keeps him close to most of the companies he researches. Against the growing global financial malaise, Krauth says that commodities are among the most-profitable and least-risky investments available, and notes that this may well be the most powerful bull market for commodities We'll see in our lifetimes. He makes a strong case. To read more about his strategies, and the sector plays he likes the most, Please click here. ]

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