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Ambrose Evans-Pritchard: Doubts grow about Bernanke's 'super put'

Section: Daily Dispatches

By Ambrose Evans-Pritchard
The Telegraph, London
Thursday, November 4, 2010

The early verdict is in on the US Federal Reserve's $600 billion of fresh money through quantitative easing. Yields on 30-year Treasury bonds jumped 20 basis points to 4.07 percent.

It is the clearest warning shot to date that global investors will not tolerate Ben Bernanke's openly-declared policy of generating inflation for much longer.

Soaring bourses may have stolen the headlines, but equities are rising for an unhealthy reason: because they are a safer asset class than bonds at the start of an inflationary credit cycle.

Meanwhile, the price of US crude oil jumped $2.5 a barrel to $87. It is up 20 percent since markets first concluded in early September that "QE2" was a done deal.

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This amounts to a tax on US consumers, transferring US income to Mid-East petro-powers. Copper has behaved in much the same way. So have sugar, soya, and cotton.

The dollar plunged yet again. That may have been the Fed's the unstated purpose. If so, Washington has angered the world's rising powers and prompted a reaction with far-reaching strategic consequences.

Li Deshui from Beijing's Economic Commission said a string of Asian states share China's "deep bitterness" over dollar debasement and are examining ways of teaming up to insulate themselves from the tsunami of US liquidity. Thailand said its central bank is already in talks with neighbours to devise a joint protection policy.

Brazil's central bank chief Henrique Mereilles said the US move had created "excessive dollar liquidity which we are absorbing," forcing his country to restrict inflows. Mexico's finance minister warned of "more bubbles."

These countries cannot easily shield themselves from the inflationary effect of QE2 by raising interest rates since this leads to further "carry trade" inflows in search of yield. They are being forced to eye capital controls, with ominous implications for the interwoven global system.

In London and Frankfurt the verdict was just as harsh. "In our view this is one of the greatest policy mistakes in the Fed's history," said Toby Nangle from Baring Asset Management.

"The Fed is gambling that the so-called 'portfolio balance channel effect' -- pushing money out of government bonds and into other assets -- will lift risk asset prices. The gamble is that this boosts profits and wages, rather than simply prices. We remain unconvinced. How will a liquidity solution correct a solvency problem?" he said.

"A policy error," said Ulrich Leuchtmann from Commerzbank. The wording of the Fed statement is "dangerous" because it leaves the door open to a further flood of Treasury purchases if unemployment stays high. "It is a bottomless pit," he said.

Of course it is precisely this open door that has so juiced risk trades, from Australian dollar futures to silver contracts and junk bonds. Goldman Sachs thinks QE2 will ultimately reach $2 trillion, with no exit until 2015. Such moral hazard is irresistible. It is the Bernanke "super put."

Yet the reluctance of investors to leap back into the US Treasury market as they did after QE1 is revealing. The 30-year segment of the Treasury market is too small to matter, but symbolism does matter. Vigilantes sniff stealth default. "If long bond investors continue to throw their collective toys out of the cot, it risks upending the Fed's policy," said Michael Derk from FXPro.

Mr Bernanke is targeting maturities of five to 10 years with purchases of Treasuries. These bonds have behaved better: 10-year yields fell 14 points on Thursday to 2.48 percent. However, Mark Ostwald from Monument Securities said foreign funds may take advantage of QE2 to dump their holdings on the Fed, rotating the money emerging markets rather than US assets.

Bond funds are already restive. Pimco's Bill Gross says the great bull market in bonds is over, denigrating Fed policy as the greatest "ponzi scheme" in history. Warren Buffett has chimed in too, warning that anybody buying bonds at this stage is "making a big mistake."

Fed chair Ben Bernanke uses the term "credit easing" to describe his strategy because the goal is to lower borrowing costs. If he fails to achieve this over coming months -- because investors balk -- the policy will backfire.

No clear rationale for fresh QE can be found in orthodox monetarism. Data from the St. Louis Federal Reserve show that M2 money supply stopped contracting in the early summer and has since been expanding at an accelerating rate, topping 9 percent over the last four-week bloc.

The Fed has used the "Taylor Rule" on output gaps as a theoretical justification for QE, but Stanford Professor John Taylor has more or less said his theories have been hijacked. "I don't think (QE) will do much good, and I worry about the harm down the road," he said.

It has not been lost on markets that the Fed's purchases of $900 billion of Treasuries by June (with reinvested funds from mortgage debt) covers the Treasury's deficit over the same period. The slipperly slope towards "monetization" of public debt beckons.

Global investors mostly accepted that the motive for QE1 was emergency liquidity, and that stimulus would later be withdrawn. But there are growing suspicions that QE2 is Treasury funding in disguise.

If they start to act on this suspicion, they could push rates higher instead of lower, and overwhelm the Bernanke stimulus. That would precipitate an ugly chain of events for the US.

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