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John Mauldin - Chekhov's Gun

October 15, 2013 | About:

During my recent hiatus a number of things happened which I suspect will be the subject of feverish debate amongst the chattering classes (myself included) for months if not years to come.

Amidst it all was a bald, bearded man of a certain age, who had transformed himself from a lifelong academic into a feared and almost mythical leader, becoming in the process the focus of the world as he stared down all kinds of trouble in the name of protecting his "family".

This man did whatever he felt was necessary in order to further his agenda; and though it meant making many enemies, he dared look straight into the eyes of both his detractors and those who would defy him, and he never blinked.

He did what had to be done.

But lately he had been trying to find a way out. He didn't want the responsibility anymore, and he felt as though it was time to quit and leave the empire to whoever was bold enough to seize it.

Sure, he tried to quit, but that wasn't something he could just do on a whim. Loose ends needed to be tied up, and promises had to be made good and powerful people placated.

For anyone who doesn't know the outcome of this tale, don't worry that I might ruin the ending ... because that outcome hasn't been written yet. The best we can do is just guess at how it all plays out.

Wait? What? Oh... Breaking Bad? Nooooo... I wasn't talking about Walter White, I was talking about Ben Bernanke. Except, he DID blink...


Yes, whilst I was away the Fed announced to the world that, although they had done all the hard work to convince the world that the Dreaded Taper was a done deal that allowed both bond and equity markets to price in a reduction in the amount of asset purchases being made every month by Bernanke (or, as he has become known in financial circles, "Buysenberg"), when it came to crunch time, the Fed didn't have the guts to pull the trigger. To use the English phrase, "they bottled it".

Now, any self-respecting drug lord central bank head (hell, any parent) knows that, in order to maintain respect, in order to continue to be feared, you MUST be prepared to follow through with your threats, even if you don't necessarily want to. That's just how the world works. You don't threaten to rain down badness on people and then shy away. If you do that, your credibility is gone and your reputation is in tatters.

In this world, reputation is everything.

In the months leading up to the September FOMC meeting, the world was put on standby for a change in Fed policy, a process that had been innocuously labelled a "taper" by the Fed (check out the video interview with Elliot Management's Paul Singer in this week's videos section for an erudite — and I am willing to bet 100% accurate — assessment of how that phrase came to be chosen); and, as the Fed have come to expect in recent years, their preparatory jawboning was working its customary magic.


Source: NY Times

Between May 22, when Bernanke first uttered the T-word, to September 12th, on the eve of the FOMC decision, confidence in the Fed's beginning their taper climbed relentlessly higher, reaching 67% right before the hammer was supposed to fall.

But a funny thing happened on the way to the forum: the Fed pulled a Cassius Clay and shook up the world.

When the Taper was tossed on the table in late May, a couple of turbulent months followed; but immediately before the decision was due on September 12, markets were sanguine:

(WSJ, September 18, 2013): If investors are concerned about the imminent end to the Federal Reserve's monetary stimulus, the markets haven't noticed.

Despite widespread expectations that the Fed will announce a trimming of a bond-buying program aimed at pushing down interest rates and propping up the economic recovery, fund managers have been in a buying mood lately.

The blue-chip Dow Jones Industrial Average on Tuesday advanced for the 11th time in 14 trading sessions, and U.S. Treasury prices rose for the fifth straight day.

Many investors expect the Fed to decide to cut its $85 billion monthly purchases of bonds by about $10 billion to $15 billion. Markets were roiled in May and June after Fed chief Ben Bernanke said the U.S. central bank would consider reducing purchases in a process dubbed "tapering."

Some investors dismiss the prospect of much turbulence this time. They say players in stock, bond and commodity markets have had time to prepare for potential Fed action, assuming the Fed acts largely within market expectations, and that a selloff in bonds since Mr. Bernanke's comments means there is less potential for a large price decline now.

It's important to realize that this was absolutely the environment the Fed had sought to create in the preceding months: a market that had priced in a reduction in stimulus without falling apart. There had been juuuuuust enough uncertainty to keep people on their toes, but not so much as to cause panic.

The central banker's holy grail.

So imagine the market's surprise when the FOMC decision was announced. Actually, don't bother imagining it; I'll save you the trouble of taxing your imagination:

(UK Daily Telegraph, September 19, 2013): The Fed shocked markets across the world by leaving its $85bn-a-month asset purchase scheme unchanged on Wednesday, despite guiding traders to believe that so-called “tapering” would begin this month. Most Fed followers had expected the stimulus programme to be reduced by between $5bn and $15bn a month.

Markets soared on the promise of more stimulus...

Shook up the world, shocked markets... whatever; the point is this: surely, having done all the hard work to prepare the market for the onset of a reduction in stimulus, and having gotten it comfortable with less free money, it was almost foolish of the Fed to not go through with it, right? Well, it seems I'm not the only one who thinks so:

(UK Daily Telegraph): The US Federal Reserve has damaged its credibility and sown confusion about central banks’ communication strategies by surprising markets with its decision to keep quantitative easing on hold, economists have warned.

(AP): Stocks, bonds and precious metals are rallying following the Fed’s decision to keep its stimulus measures in place. But a slew of market watchers are concerned about the long-term ramifications of such a move.

Eric Green, global head of rates, FX and commodity research at TD Securities, says the Fed’s latest announcement shows the central bank is “running scared”.

“This FOMC edition feels less dovish than it does outright scared,” Mr. Green says. “Confidence in the outlook has dimmed. That Bernanke had a free pass to begin that tapering process and chose not to follow is telling. The Fed had the market precisely where it needed to be. The delay today has the effect of raising the benchmark to tapering and ultimately makes that first step harder to achieve.”

(Peter Boockvar): “The grand monetary experiment now going on 5 years continues full speed ahead … Bottom line, while the economic data over the past few months did not call for a taper according to the Fed’s econometric models, I believe they are making a massive mistake as this QE policy does nothing but manipulate and distort asset prices with no lasting positive impact on the economy. Rip this band aid off already I say. I will repeat again to the Fed, there will NEVER be the right time to cut back, and today was the perfect opportunity to do so because the market was ready for it. Playing games now over this with the market will not smooth the eventual ease. Either way, the US bond market has already started the tightening process, and that is what participants should be focused on.

Now, nobody will convince me that the collective brains at the Federal Reserve wouldn't have figured out that, after all the talk, failing to taper would damage their credibility enormously. So one has to wonder, how bad must things really be in order that they would sacrifice their credibility so willingly? After all, they could have gone ahead with the Taper and then found another way to throw the market a bone later if they had to, but instead they chose to blink in the face of their toughest moment since the tarp was pulled off the printing press in the Fed basement back in 2008.

But before we go any farther, let's remind ourselves what sort of beast the Taper actually is.

Remember, the Taper is NOT the withdrawal of stimulus, it's simply a slowing of the existing stimulus. The way the press talks about the Taper, it is easy to forget that, once the Fed begin their program, all they will be doing is printing slightly less free money every month than they currently are.

Leave it to my friends at Zerohedge to lay this concept out in an easy-to-understand chart:


Source: Zerohedge

Yes, folks, that's right, the Taper (assuming it was as much as $20 billion a month) would mean a difference of just $300 billion by the end of 2014.

Now, I'll admit that $300 billion USED to be an awful lot of money. But now? Not so much.

In 1995, $1.3 billion was enough to bring down Barings Bank, the oldest merchant bank in London, amidst warnings that unless something was done the global financial system would be brought to its knees.

In 1998, Long Term Capital Management required a $3.6 billion bailout from 14 financial institutions after losing $4.6 billion in less than four months when the Russian debt crisis played havoc with its models. At the time, dire warnings were issued about the global financial system being brought to its knees unless action was taken immediately.

In March of 2008, Bear Stearns received a 28-day, $25 billion loan from the Federal Reserve in order to avert its collapse (and the global financial system being brought to its knees), and just days later that $25 billion loan to Bear Stearns morphed into a $30 billion loan to JP Morgan, who in absorbing Bear Stearns kept the global financial system from being brought to its knees.

Six months later, on September 15th, Lehman Brothers went belly-up; and in order to stop the global financial system from becoming the global financial system being brought to its knees, Buysenberg and then-Treasury Secretary Hank Paulson (or, as they were known back in those days, "Los Pollos Hermanos"), crafted a $787 billion bailout package (the Fabled TARP), which, thankfully, prevented the global financial system being brought to its knees.

Los%20Pollos_fmt.jpegNow, a mere five years on, we find ourselves in the position of requiring roughly three Bear Stearns bailouts every month just to keep things humming.

Put another way, we require 23.6 LTCM bailouts or 65.38 Baring Brothers bailouts every month, just to keep the global financial system from being brought to its knees.

"How does that stack up against CPI?", I hear you say. Well, I'm glad you asked.

The $1.3 billion tab for Barings in 1995, when adjusted for CPI, equates to $2 billion in 2013 dollars.

But the Fed is spending 42.5x that amount. Every. Single. Month.

No inflation, you say? Well some things are increasing in price at an annualised rate that belies the 1.8% core rate published by the BLS. We've already looked at bailouts, and there's never any shortage of press about wine auctions or fine-art sales breaking record after record, but what about... oh I don't know, diamonds, perhaps?

(Sky News): A "flawless" white diamond which is the size of a small egg has been sold at auction for a record $30.6m (£19m).

The 118-carat oval gem is the largest and most significant such diamond graded by the Gemological Institute of America.

It weighed 299 carats when it was mined in southern Africa in 2011 but Sotheby's will not name the country because the seller wishes to remain anonymous.

Two phone bidders competed for the diamond in six minutes of bidding until one dropped out.

It was bought for $27.3m at the jewellery auction in Hong Kong, but the total price including commission came to $30.6m.

That was more than the previous record of $26.7m (£16.6m) for a white diamond set in May at Christie's in Geneva, Switzerland.

Or maybe racehorses?

(Yahoo): A world record fee has been paid for a one-year-old filly which became the most expensive horse in history.

Qatari Sheikh Joann Al Thani successfully bid five million guineas (£5.25 million) for the yearling filly at the Tattersalls bloodstock auction in Newmarket.

The as-yet-unnamed filly is the daughter of the most sought-after stallion on the planet, 2001 Derby winner Galileo, and Alluring Park, and became the most expensive horse of any age sold at public auction in Europe, beating a record set in 2006 by Magical Romance (4.6m guineas).

But... tuna fish?

Last January, a world record was set for the most expensive bluefin tuna fish ever sold, when Kiyoshi Kimura, president of the Japanese chain Sushi Zanmai, bought a 593-pound fish for US$736,000. The previous record? $416,000.

This year, Kimura-san outdid himself:

(Eater.com): Kiyoshi Kimura, a businessman who owns the Sushi Zanmai chain of restaurants in Japan, has once again set the record for purchasing the most expensive bluefin tuna ever. According to the New York Times, Kimura paid 155.4 million yen (US $1.76 million) for the 488 pound fish. That's around $3,600 per pound. Kimura also set the same record about a year ago when he paid $736,000 for a 593 pound bluefin.

For those of you at home doing the math on a cost-per-pound basis, that's an increase of 290% in 12 months.

Inflation goes where the money goes — and the money is going to the wealthy, so is it any wonder we read pieces like this?

(UK Daily Telegraph): The second bi-annual Candy GPS Report, produced by Candy & Candy, Savills World Research and Deutsche Asset & Wealth Management, revealed that there was a 34pc jump in individuals worth more than $30m (£18.7m) between 2009 and 2012.

A 34% jump in the number of individuals worth more than $30m? In three years?


My great friend Simon Mikhailovich pointed out to me the last time we met that nowadays you can be worth $85 million and not be able to afford a penthouse apartment overlooking New York's Central Park; and he's right, this is the extreme inflation we have all suspected but couldn't find because we were looking in the wrong places.

But I digress... Back to Buysenberg and the weapon that gives this edition of Things That Make You Go Hmmm... its title.


Russian playwright Anton Chekhov, renowned as one of the greatest authors of short stories in history, fathered what has become a key dramatic principle when he stated:

"Remove everything that has no relevance to the story. If you say in the first chapter that there is a rifle hanging on the wall, in the second or third chapter it absolutely must go off. If it's not going to be fired, it shouldn't be hanging there."

Chekhov believed that every element in a narrative should be both necessary and irreplaceable and that everything else that is in any way extraneous to the story should be removed.

Nowhere should that principle be applied more diligently than in central bank communications to the markets, but it appears that the opposite tack is adopted more often than not.

Alan Greenspan was famous for introducing "Fedspeak" to the markets during his tenure. Described by Alan Blinder as "a turgid dialect of English", Fedspeak had many critics:

"Known as Fed Speak, the convoluted rhetoric has befuddled even the wisest of interpreters."

— Wealth Building Strategies in Energy, Metals and Other Markets:

(Wikipedia): The deliberately confusing and carefully rehearsed cryptic language described as an "indecipherable, Delphic dialect" is meant to "give people a sense that there's no way they could understand economics and finance" and thus allow the Federal Reserve and government to manage the economy with less interference from the general public...

The notion of fed speak originated from the fact that financial markets placed a heavy value on the statements made by Federal Reserve governors, which could in turn lead to a self-fulfilling prophecy. To prevent this, the governors developed a language, termed fedspeak, in which ambiguous and cautious statements were made to purposefully obscure and detract meaning from the statement.

As recently as July of this year, in a conversation with the NBER, Bernanke explained his own feelings about clear communication:

(WSJ): Well, as I said in my remarks, I’m a very big believer, the Fed Reserve is a very big believer, in transparency and communication. I think transparency in central banking is kind of like truth-telling in everyday life.

You got to be consistent about it. You can’t be opportunistic about it.


Now, in Breaking Bad, at the opening of the final season, creator Vince Gilligan begins with a scene in which a dishevelled Walter White opens the trunk of a 1977 Cadillac Sedan de Ville to find an M60 and a couple of hundred rounds of ammunition sitting there, plain as day.


No spoilers here — but you'd better believe the M60 gets used.

So why, having set the stage for the Taper, did the Fed not pull their own trigger? What did they see in the data that made them feel that buying "only", say, $65 billion every month would mean the "recovery" would falter?

Was it inflation?

“Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable...”

Guess not.


“The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall...”


Well that's the dual mandate taken care of. What else could it be, then?


Source: Bloomberg

Ahhhh...... of course.

The Fed has painted itself into an almighty corner with QE, and it looks as though we are finally getting to the point in the process where that fact begins to (a) occur to people and (b) matter.

Bill Fleckenstein has often spoken about the Fed's reaching the point where it "loses control of the bond market", and it is quite possible that we are rapidly approaching that point (the signs have certainly been strong in Japan). We may be there already. We won't know until we can look in the rearview mirror, I'm afraid; but the nonvirtuous circle the Fed has created is extremely clear:


Source: TTMYGH

The simple truth, as you can see from the diagram above, is that the economy and the markets are now 100% dependent on the largesse of the Federal Reserve to sustain them.

What you CAN'T see from the diagram is the scary proposition that the Federal Reserve in turn is entirely dependent upon hope to get itself out of this unholy cycle.

The Fed is hoping (as are the ECB, BoE, and BoJ) that the economy recovers sufficiently through massive stimulus so that the recovery will be "self-sustaining"; but, as can clearly be seen by the action of the markets in recent weeks and months, that strategy (such as it is) appears doomed to failure.


Fortunately, Obama has finally been left with just nominated Janet Yellen as the new Fed chair, and she can be relied upon to continue Greenspan & Bernanke's work in conjuring unlimited free money out of thin air:

(Zerohedge): Now that Janet Yellen has been named to lead the Federal Reserve the global financial markets should factor out any possibility that the Fed will diminish their Quantitative easing program anytime during her tenure. In fact, financial forecasts should assume that not only is a taper off the table, but that the QE program is now more likely to be perpetuated and expanded.

Unlike her predecessors, Janet Yellen has never had a youthful dalliance with hawkish monetary ideas. Before taking charge of the Fed both Alan Greenspan, and to a lesser extent Ben Bernanke, had advocated for the benefits of a strong currency and low inflation and had warned of the dangers of overly accommodative policy and unnecessary stimulus. (Both largely abandoned these ideals once they took the reins of power, but their urge to stimulate may have been restrained by a vestigial bias against the excesses of Keynesianism.) Janet Yellen, who has been on the liberal/dovish end of the monetary spectrum for her entire professional career, has no such baggage. As a result, we can expect her to never waver in her belief that stimulus is the answer to every economic question.

Which is great for the status quo, but if we take another look at that chart of the US 10-year Treasury yield again, we see something that ought to set alarm bells ringing:

The retracement of interest rates AFTER the Fed's refusal to follow up their tough talk with a Taper has been far less marked than the rout that ensued after the subject was first tabled; and that spells trouble, because the housing market — the engine of the US "recovery" — cannot stand higher rates without being choked off.

23889.pngAlready, we have seen the average rate for a 30-year mortgage ratcheting higher.

In September 2012 that average rate stood at around 3.60%, but a year later it was 4.5%. Now I know that doesn't sound like much, but a 25% increase in the cost of a mortgage will most definitely crimp activity.

If you don't believe me, then check out the chart below, which shows the average 30-year mortgage rate in the USA as calculated by Bankrate.com.

As you can see, we have come a long, long way from the levels before the housing "recovery" took hold. And we are definitely not in Kansas anymore:


Source: Bankrate.com

As for how the higher rates translate into activity in the housing market, well, there's an easy way to take a look at that, too, courtesy of the Mortgage Bankers Association's monthly Mortgage Refinance Index:

(MBA): Mortgage applications decreased 13.5 percent from one week earlier, according to data from the Mortgage Bankers Association’s (MBA) Weekly Mortgage Applications Survey for the week ending September 6, 2013. This week’s results included an adjustment for the Labor Day holiday....

The Refinance Index decreased 20 percent from the previous week. The Refinance Index has fallen 71 percent from its recent peak the week of May 3, 2013 and is at the lowest level since June 2009. The seasonally adjusted Purchase Index decreased 3 percent from one week earlier.


Source: MBA/Calculated Risk

Bill McBride of Calculated Risk chips in with his own 2c:

(Calculated Risk): The refinance index is down 71% since early May.

The last time the index declined like this was in late 2010 and early 2011 when mortgages increased sharply with the Ten Year Treasury rising from 2.5% to 3.5%. We've seen an even larger increase over the last few months with the Ten Year Treasury yield up from 1.6% to over 2.96% today. We will probably see the refinance index back to 2000 levels soon.

A return to 2000 levels in refinance activity is NOT conducive to a strong housing market, and a weak housing market is not conducive to a strong economy. What's more, a weak economy is not conducive to any kind of tapering, yet a lack of tapering is most assuredly not conducive to the Federal Reserve's credibility.

So what next?

Well, Janet Yellen might well confound everybody and launch the Taper as her first order of business. Or Buysenberg may even begin it as his last act in power; but either way, the market will now likely call the Fed's bluff, because it knows that the gun hanging on the wall in the shape of the Taper is not guaranteed to be fired. It may even turn out to be completely superfluous to the narrative; and if that is the case, then chances are it will never be fired.

Just as Walter White's honest intentions in trying to protect his family ended up trapping him in an ever-worsening spiral where countless millions of dollars only made his situation worse, Ben Bernanke is in a similar prison of his own making.


Eventually, this pile of dollars is going to be the thing that sinks Bernanke... or Yellen... or whoever has the helm on the fateful day when reality reasserts itself. That may not be tomorrow or next week; but, based on recent events, that day is a lot nearer to hand than most people thought just a few short months ago.

The Fed realizes the truth of that — hence the abandonment of both the Taper and their own credibility — but their chances of averting catastrophe are receding daily.

The ending of Breaking Bad has been hailed by many critics as perhaps the most perfect, most satisfying denouement in television history, and in large part that praise is due to Vince Gilligan's masterful ability to follow the principle of Chekhov's gun and make sure that every dramatic device employed throughout the series had a reason and a purpose. No misdirection, no unnecessary devices, just brilliant, honest storytelling.

That is the vital difference between Breaking Bad and a Freaking Fed.

Rather than write the story and end it in a manner of their own choosing, they are now prisoners of the narrative.

I fear the worst.


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