Vigilant Investor

Fears that central banks around the world are planning a crackdown on rising inflation saw bond and futures markets move sharply on Tuesday, with a series of interest rate rises now priced into markets in the US, the eurozone and the UK.

The shift came after Ben Bernanke, the Federal Reserve chairman, warned of growing inflationary pressures, bolstering the view that all the world’s leading central bankers are on high alert.

That’s from a FT.com article titled Markets brace for inflation crackdown.

We find the “fear the Fed” (and other CBs) when it comes to inflation a touch hard to buy into, and here’s why:

Inflation at this point is well baked into the global system, and the U.S. dollar is at the epicenter, all nations have been quite egregious at boosting their money supply.  You remember money supply, don’t you?  That old statistic most economists and fundamental analysts found useless after all declared inflation dead thanks to Alan Greenspan?  So useless, when the Fed decided to cease its calculation of M3 in early 2003, the collective yawn was deafening to those devotees of classical economics.

For the Fed to actually reel in inflation — quite literally over $100 billion accumulating in foreign reserves each month as foreign central banks relying on U.S. consumption continue to defend the dollar, compounded by $ trillion foreign reserves — they’d have to take extreme money tightening measures.  However, at the same time they’re dealing with the Wall Street shell game they sanctioned.   Wall Street banks and brokerages firms, and many hedge funds, all gorged on assets backed by overpriced things — houses, condos, cars, commercial and retail development, the consumer’s capacity pay off unsecured debt , you name it,  all floated into the stratosphere .

Now, as we’re all privy to through the mainstream news reports of the last 18 months, the prices for those real things are beginning to buckle, and that’s bad news because they were securitized into tons of Wall Street debt related instruments.  Now, that wouldn’t bed such a huge problem but for the fact that the aforementioned institutional investors borrowed upwards of 10 to 20 times their initial capital in order to get excess returns on their investment strategies.  Indeed, as easy (freshly printed) money flooded into subprime mortgages, for example, their rates of return were depressed.   But most analysts and economists, and even the ratings agencies guiding the investment strategies of these investors gave the green light on risk.  What would have otherwise been a boring rate of return was suddenly quite attractive by borrowing 10-20 times the initial collateral.

And therein lies the Fed’s dilemma.  They’ve been busy rewriting the rule book to prevent the debt instruments and derivatives that were being used as collateral and/or invested in with borrowed money from being valued at a current market price.  In other words, money was paid for California mortgages issued in 2006 at the high median home price of about $580,000 , and the same can be said for $3 million condos that were pure investment deals down in Miami, and that mortgage paper is now sitting in the aforementioned asset backed securities leveraged to the hilt.  Problem is, CA home prices have dropped some $160,000 from the high, and those empty, overpriced condos in Miami are not selling for $2,000.000. Where they’ll bottom out, nobody knows.

These circumstances would that imply the mortgage paper sitting in these investments ain’t worth their original value, or anything close.  Indeed, that’s what the market for them is telling us: nobody is willing to pay but pennies on the dollar for them, while others have absolutely no bid.   In a fit of fury to prevent that information from actually valuing the bulk of these securities, the Fed and the investors, the banks, brokerages, etc., insist the decline is just a temporary bump, and pricing the paper at their current market value is irresponsible.

Of course, you can’t make the same argument if your a small investor, or if you’re in the stock market.  But the mega institutions sure can because if the assets are marked to their market value,  the entire Wall Street system implodes immediately in a daisy chain of defaults.   And no, that’s not rhetoric.  Bear Stearns collapse situation alone threatened to set just such an armageddon in motion, hence the hurried Sunday night rescue organized by the Fed to bail out Bear and its biggest co-dependent, JP Morgan. And, so, the Fed now accepts toxic debt nobody wants and exchanges it for AAA rated treasuries.  Meanwhile, M3 down to MZM are blazing at a torrid pace, which tells us money is flooding