Soros explains his comments on gold as the ultimate bubble

Hi Edward, I’ve been ferreting through the entrails of Ben’s Jackson Hole speech, and this is broadly OT, but relevant I think;

Ben’s speech is here:
https://www.federalreserve.gov/newsevents/speech/2010speech.htm

“…Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well. …”

The whole aim is to reduce rates across the board to ease “financial conditions”, via accommodative purchases of bad debt to reduce overall market risk.

However, there was a proverbial unforeseen fly in the ointment;

“…To date, we have realized about $140 billion of repayments of principal on our holdings of agency debt and MBS, most of it prior to the end of the purchase program [i.e. to March 2010]. Continued repayments at this pace, together with the policy of not re-investing the proceeds, were expected to lead to a slight reduction in policy accommodation over time. …”

And that’s a problem, the ‘repayment’ of the securities leads to, “a slight reduction in policy accommodation over time.” i.e. it has a proportional counter-stimulatory effect that would be detrimental in a weak growth environment.

But the smooth way in which Ben delivered that news in his speech sounded innocuous, it doesn’t sound serious and is written in such a way that the implications don’t sink in. But the scale and the circumstances of it and the current US situation teetering on a contraction reveals that it is in fact a quite serious problem.

Ben has a huge problem, the US economy, but now he also has to operationally clean up the now de-flowered balance sheet. The Fed discovered it can’t unwind its swollen balance sheet back to treasuries again, without imparting a significant slowing to US GDP growth, because the stimulus effect gained by buying toxic waste turns back into a counter-stimulus, once you try to unwind it again. Exhibit 1;

“… Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed’s balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening–a perverse outcome.”

Yes. A ‘perverse’ counter-stimulus that’s especially self-amplifying during a contraction with low interest rates as refinancing is applied.

So the slowing economy actually made the MBS ‘repayment’ occur faster than the Fed thought it would, thus making the anti-stimulus effect in financial markets worse than the Fed thought it would be, and at the most detrimental time.

Hence Ben’s comment,

” …However, more recently, as the pace of economic growth has slowed somewhat, longer-term interest rates have fallen and mortgage refinancing activity has picked up. Increased refinancing has in turn led the Fed’s holding of agency MBS to run off more quickly than previously anticipated. …”

Therefore;

” …In response to these concerns, the FOMC agreed to STABILIZE the quantity of securities held by the Federal Reserve by re-investing payments of principal on agency securities into longer-term Treasury securities. …” [my caps]

‘Stabilize’ meant you don’t continue to euphemistically ‘repay’ the securities back to the market as that would weaken it, so you use another pro-active sounding euphemism (when you really intend to do nothing) via saying you will “reinvest” the debt. Which means you leave the debt on your book because you dare not clean the book up any further, due to the harm it’s causing. The quintessence of ‘toxic asset’.

Within the next paragraph Ben states the FOMC’s policy thus changed, they would now maintain the Fed’s asset book at “constant size” because reducing it would not be good for “financial conditions”, especially in a long-run weak recovery, so divesting the bad debt is out, indefinitely.

Note above that Ben said; “we have realized about $140 billion of repayments of principal on our holdings of agency debt and MBS, most of it prior to the end of the purchase program”. [i.e. end of March 2010]

Which means something less than 50%, or <$70 billion USD of security debt was 'repaid' since April 1st 2010 (I couldn't determine the amount).

Which means the Fed very recently discovered the counter-stimulus problem. Logically, it was after April 2010 but before the end of July 2010. MBS refinancing generally accelerates during deepening downturns and the Fed realized a damaging feedback had begun so it shut off the 2.5%, and is creating NET jobs of ~250,000 per quarter, or else, until mortgage rates are significantly higher than they are now. Otherwise, Ben can not divest his debt assets. Thus ‘QE-Lite’ was not market easing. It was in fact the Fed acting to choke-off a slowdown that it had accidentally created, via selling MBS faster than it had anticipated.

Note that every part of that is some sort of blowback effect of past or present Fed policy. And note that the way Ben presented it in is speech downplays what happened, and that the debts can NOT be divested from the Fed books any time soon (as I will make clear).

Ben continues;

“… By agreeing to keep constant the size of the Federal Reserve’s securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred. The decision also underscored the Committee’s intent to maintain accommodative financial conditions as needed to support the recovery. …”

Reading Ben is like pulling teeth. I’ll translate that twaddle for you; what Ben was trying to say was the FOMC realized their mistake of selling too much MBS and realized they can’t do it anymore, so they entirely stopped doing it indefinitely, because they saw that cleaning up their asset book was having a terrible effect on the market. Then he made out this was a heroic group decision to “maintain accommodative financial conditions as needed to support the recovery.”

He goes on;

“…We will continue to monitor economic developments closely and to evaluate whether additional monetary easing would be beneficial. In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly. …”

Nothing new, bit of a yawn really, but to just skip over it misses the point of this present situation. The Fed is facing a problem that it’s not seen within living memory. And now it knows it is not free to unwind its toxic securities in the way it was fairly sure it would be able to without incurring a prohibitive impact on a weak US PZ (perpetual zero) economy.

But the really big issue that the above quotes do not capture, because we have become so accustomed to it now is that we’re at the BEGINNING of the Fed’s balance sheet expansion. We are nowhere near its end, we have seen the first wave, and the Fed just discovered it can not divest bad debt in such conditions.

That’s a problem. That’s potentially very serious.

The markets and media are chomping at the bit for QE2, because QE1 apparently worked so well. But an actual GDP real-economy price will be paid for unwinding QE1 and QE2. The Fed’s balance sheet will expand for longer than the public thinks.

So does an ‘unconstrained’ ability to purchase MBS with the Fiat (‘free-lunch’) dollars, fundamentally resolve the problem of buying up toxic assets?

No. It does not.

There’s no ‘free-lunch’, we just haven’t realized what the cost is yet. Ben is mumbling something about it but it’s all being smoothed over so nicely as though its not going to be a problem. But it will be a problem, but not for a few years, so who cares.

Ben continues;

“…The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.”

Ben noticed the fly in his otherwise lovely fiat-ointment, and got a real fright so he’s signaling that next time; “…the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.”

In other words, his helicopter just threw a rotor blade.

Ben’s discovered he’s not got the control of the situation that he thought he would have at the beginning of the flight. He tried to do a right turning climb, but instead the chopper nosed over unexpectedly to the left. So he stopped trying to turn. He ‘stabilized’ because he realized he cant do what he thought he would be able to do, at this late point in his maiden solo flight. His flight plan just flew out the window as well, in his confusion.

Ben; “…the Federal Reserve has expended considerable effort in developing a suite of tools to ensure that the exit from highly accommodative policies can be smoothly accomplished when appropriate, and FOMC participants have spoken publicly about these tools on numerous occasions. …”

Translation; the FOMC can exit, “accommodative policies” “smoothly” “when appropriate”, but unfortunately the FOMC can not exit the toxic securities that came from that policy, until there is real growth.

The statements prior to this make it clear the problem is not easily resolved, the securities themselves can not be rapidly or smoothly divested without creating an accelerating counter-stimulus effect, especially if the economy is already weak, plus if long-term mortgage rates are low, and refinancing is required. All of these conditions are met in 2010, and 2011, and probably for many years to come. So the Fed’s ‘asset’ book can not be cleaned-up as easily as mere accommodative policies can be dumped, “when appropriate”. In this case, “when appropriate” equates to when the US economy has actually recovered already.

And Ben may soon have to double or triple and maybe quadruple the Fed’s agency debt and MBS on his asset book.’

—

Edward,

Given a small-‘d’ US depression option doesn’t appear to exist (in practical terms, as I pointed out in a comment in, “Galbraith: Thoughts on a Plan B”). And given the Fed can not wish-away what it’s already done given the ‘PZ’ long-term debt-induced weakness, let alone what else the Fed will still do, I’d say you’re going to see that full-system ‘reset’.

A motorbike trainer once told me, “You always brake in an emergency-stop situation in exactly the same way you normally brake, only harder, so I’m going to teach you to brake correctly in normal situations so that you will automatically brake properly in an emergency.” But the man of the year has been trained to print in a financial emergency, especially a credit deflation emergency. So I don’t believe he’ll think twice when another emergency hits, he’ll reflexively do what he was trained to do. So the Fed’s book is going to go all cosmological and expand.

But the Fed will not be able to undo it’s book when it finally must to make the USD look pretty. I’ve never accepted this before, but on thinking it through it forced me to face that the USD will lose its gloss in a big way (not to mention that the US needs devaluation, and tariffs on China’s failure to move). Undoing it when you have to is going to be the problem.

If you were a foreign company can you afford to trade in over-supplied USD when the dollar has a recent history of wild-eyed down moves, plus high uncertainty? You eventually won’t risk doing business in USD if you can avoid it, if at the end of a real-economy trade in goods the USD’s purchasing-power has fallen 5% by the time the goods have been delivered and the account is paid. So you’re going to try to steer clear of a currency like that when you can. Business people will necessarily insist on a more stable exchange transfer mechanism.

And you can not force people to trade in USD, even at the barrel of a gun, so those strange people who believe a strong US military assures oil trades in $USD and therefore the primacy of USD are going to find out this is incorrect. If I pointed a gun at you and said, “trade in $USD or else”. Aside from the insult, if you thought USD was risky and peddled by thugs would you do this? No. But you might form a producers cartel and ignore the US, or worse.

The USD is not necessarily more credible or valuable or desirable than several other currencies at this point. The best hope for the USD is that the other Sovereigns proportionally print more than the Fed has to. But I doubt this will be generally the case. The US will be able to export goods and pay national bills in USD and there won’t be any US default. But I fail to see how that’s so much better given what will still occur.

Americans will not like holding or saving a zero rate $USD as it weakens. But more significantly potential foreign lenders will shy away. So the ~72% consumer-credit economy is over if Ben can’t unwind the toxic debts reasonably quickly, without also snuffing a weak US economy.

At some point the Fed has to turn off the USD’s ugly switch, and make it look prettier. And there isn’t any money-printing policy for that, so Ben and Co would be completely lost. They’d have to actually stop printing and get the toxic securities off the books somehow. So I think the NET unwinding of the Fed’s asset book, like deficit reduction, will remain pure fantasy.

A variation on Mish; “Things that can’t be unwound won’t be unwound.”

Printing further would be like trying to fix a debt crisis via increasing the debt, and no one is that dumb. In other words, you can bet they’ll still be printing even when it would be very counterproductive. Most everything the Fed has done so far has been foreseeably counterproductive in numerous ways, so it’s not like this is an impediment to further damaging actions. ‘Pay As You Go’ tells you the Fed and Congress won’t stop printing. A $2 trillion NET increase in public debt per annum is ultimately counterproductive and unsustainable, but that’s never been considered a reasonable or acceptable argument for not making it even bigger next time.

And that’s where the Fed is. They are not going to ‘stabilize’ securities, they are going to expand, again and again. Thus; PQE (Perpetual QE) is Ying to the PZ (Perpetual-Zero) Yang.

You’ve got a PZ economy with a self-destructive financial sector, and politically and in terms of continued unemployment growth, you can not maintain a GDP stagnation to allow the necessary decade or so of orderly private delevering. Thus you try to at least stay out of contractions and grow some jobs via a low dollar, deficits and pulses of PQE. And this more-or-less fails to sustain growth, pretty quickly. Which reinforces the unfavorable conditions for the Fed to unwind its toxic securities, which therefore must keep expanding. Whilst the GSE’s bad mortgages are festering in the back of the closet until about the end of 2013.

Lastly, a rather dark thought; I can’t help but wonder what nasties are sitting on the books of scores of central banks, big and small, who did almost all the same things as Ben, so also have shallow growth and low interest and a realestate mess with wrecked banks. They likewise won’t be able to unload their toxic securities until GDP growth is healthy.

In other words, don’t hold your breath.