Wednesday, February 23, 2011

"THE BERNANKE PUT AND INSTABILITY IN COMMODITY MARKETS"

From Pragmatic Capitalism:
The Fed has not been shy about taking credit for the recent equity price increases.  They claim that this so-called “wealth effect” will spill over into the real economy and create a “virtuous cycle” where nominal wealth creation leads to real wealth creation (they have that part backwards – real wealth creation leads to nominal wealth creation, but who needs facts anymore?).  But the Fed has also been quick to claim no part in the recent commodity price spike (also no mention of the continuing house price declines, but again, who needs all the facts when you can better prove your point by leaving most of the facts out of the equation?).

I have claimed that the Bernanke Put is a direct cause of a severe psychological imbalance in the market where investors begin to act irrationally based on false promises made by the Fed.  The truth is, the Fed’s ability to influence the real fundamental economy via QE is limited (this has become abundantly clear when one actually studies the intended transmission mechanisms of QE), however, they are having a powerful impact on market psychology.  This is where many economists lose sight of the forest for the trees.  They entirely ignore the human reaction to policy measures.  And in an environment where the Fed is maintaining low rates and literally telling people that they will keep “asset prices higher than they otherwise would be” it is simply foolish to believe that they are not inducing some level of speculation in various markets.

The recent bout of inflation in China and the floods in Australia have laid the perfect foundation for a fundamentally driven rally in many commodities.  Add in the Fed’s direct message to buy risk assets and you have all the ingredients for rampant speculation.  To believe that this speculation is stopping at equities is naive at best.  The fundamental story in the emerging markets and hence the commodity markets is far superior to the modest growth story in most US equities.  So, it’s only natural so see investors pouring into the commodity markets with the expectations of higher gains on the misconception of the Fed’s “money printing” and a sound fundamental backdrop.

The problem is, investors and speculators are taking the Fed’s words to heart and they are acting on them....MORE