Midweek Matters

Doug French. Contributing Editor

Dont tug on Supermans cape. Dont spit into the wind. And most definitely, dont fight the Fed. Thats what they say on Wall Street. When the central bank is printing, get your money in stocks. When the PhDs at the Eccles Building take away the punchbowl, turn out the lights and sell your stocksthe partys over. Dont believe it? Google Dont fight the Fed, and youll get 468 million results.

Before the late Martin Zweig was a legendary investor who never fought the tape, he was teaching finance at Baruch College and Iona College, and his byword was, Dont fight the Fed.

Philippe Gijsels, the head of research at BNP Paribas Fortis Global Market in Brussels, told CNBC in 2011, The famous saying do not fight the Fed has worked for the last 20-odd years.

We are now entering year six of the post-Lehman Brothers era, and the Feds occupation of the market looks to be permanent. The new normal doesnt seem so normal as Ben Bernanke has desperately tried to pry everyones money out from under their mattresses and into stocks.

However, this is a market that Jim Grant describes as a hall of mirrors. The Feds looking glass makes some things tall, some things small. Objective value is nowhere to be found; instead, certain rates are scripted by a central bank that can only set a price for short-term interest rates with really little clue as to what the outcomes of that monetary command and control will be.

Now Janet Yellen takes over as Atlas, with world markets resting uncomfortably on her shoulders. Further shrugging may send nervous investors for the exits, not only in the US, but around the world. The least bit of monetary slowing, rather than a wide-open throttle, is now viewed by the worlds monetary elite as the stuff of black swans. This [tapering] is a new risk on the horizon and really needs to be watched, Christine Lagarde, the managing director of the IMF, said at Davos over the weekend.

Arent you glad youre living through, investing in, and your retirement depending upon navigating this terribly interesting, manipulated market?

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In todays article, Jeffrey Peshut gives us some idea of when to look for the next financial crack-up. While Jeffrey is a devotee of the Austrian school of economics, hes not some fuzzy-headed academic, trapped in the ivory tower. He works in the real world, putting food on his table as an institutional real estate investment manager. When he doesnt get it right, it costs him money. Hes put Dont fight the Fed to the historical test.

See what hes discovered.

Sincerely,

Doug French, Contributing Editor

Does the Fed Really Create the Boom-Bust Cycle?

By Jeffrey J. Peshut

Janet Yellen takes over as Fed chair at the end of January, stepping into Ben Bernankes big shoes. Bernanke was Time s Person of the Year in 2009, and The Atlantic magazine dubbed him The Hero.

However, those who understand Austrian business cycle theory believe the Fed causes more problems than it solves. Sure, maybe Bernankes policies averted an economic meltdown in 2008. But Austrians believe thats akin to commending an arsonist for putting out a fire he set in the first place while at the same time creating favorable conditions for the next blaze.

Austrian Business-Cycle Theory : The Basics

According to Austrian business cycle theory, if interest rates are allowed to reflect underlying market conditions and coordinate production over time, the resulting economic growth will be sustainable. There will be no boom-bust cycle.

However, if a central bank like the Federal Reserve forces interest rates down, those manipulated rates send false signals to businesses. Lower rates tell businesses that consumers are saving more today to increase consumption in the futureand so now is the time to take advantage of those low rates by investing in longer-term production projects that produce future products.

But when ultra-low rates are a result of phony credit rather than actual increased savings, businesses investing in long-term projects are acting on false signals. Since the resultant boom is not based on reality, the bust is inevitable.

Thats the story. Whats the data say?

Empirical Data

Figure 1 illustrates that the five US credit crises and four recessions since 1975 all share a common theme. Each was preceded by a period of loose monetary policy followed by tight monetary policy, as represented by the fed funds ratea boom followed by a bust.

Figure 1: Fed Funds Rate, 1975-2013

The fed funds rate and the money supply move inversely: low rates accommodate easy money, and vice versa. There are many ways to measure the money supply, but for my analysis, Ill use Murray Rothbards True Money Supply (TMS), which quantifies only the amount of money in the economy that is available for immediate use in exchange.

Overlaying the TMS growth with US crises and recessions since 1975 shows a close relationship. The Fed first sows the seeds of crisis by aggressively expanding the money supply. When the economy gets too hot, the Fed hits the brakes, and the slowing of money supply growth causes a crisis or bust. The Fed responds by opening up the money spigots once more, and the cycle begins anew. You can clearly see it in action.

Figure 2: True Money Supply (YOY%), 1975-2013

We can also see that each crisis or recession occurred shortly after the rate of growth of the TMS approached or broke below zero.

The Next Crisis

Until the most recent credit crisis and recession, the Fed was able to loosen monetary policy by simply lowering the fed funds rate. In the fall of 2008, however, the Fed ran out of room to manipulate in that manner, as the funds rate approached 0%. To continue to force down interest rates and increase the growth of the money supply, the Fed provided loans to key players and purchased Treasury securities, GSE debt, and mortgage-backed securities. This package of policy tools is commonly referred to as quantitative easing, or QE for short.

Figure 3: Fed Funds Rate and Federal Reserve Balance Sheet, 2007-2013

More recently, the Feds Operation Twist and QE3 were designed to force down long-term interest rates through the simultaneous sale of $45 billion of shorter-term Treasury securities and purchase of $45 billion of longer-term Treasury securities per month, as well as the purchase of $40 billion of agency mortgage-backed securities per month.

On December 18, 2013, the Federal Open Market Committee announced that it would reduce its aggregate bond purchases from $85 million per month to $75 million per month beginning in January of 2014. Thats notable because although the TMS has been increasing during Operation Twist and QE3, its growth rate has been slowing, which is what really matters. The Feds reduction of bond purchases will likely decelerate growth of the TMS even further, setting the stage for the next credit crisis.

When might that crisis hit? I extrapolated the TMSs current growth rate forward a few years. If the current trend holds, TMS growth should approach zero in early 2015, setting the stage for a crisis near the end of 2015 or the beginning of 2016:

Figure 4: True Money Supply (YOY%), 1975-2013 Actual, and 2014-2015 Forecast

While that trajectory could easily change, its our baseline scenario. Watch what the Feds doing to the money supply for early warning of the next crisis.

Thank you to J. Michael Pollaro, author of The Contrarian Take. for the data used to construct the charts in this article.

Jeff Peshut is a strategic institutional real estate investment manager in Denver, Colorado and is the creator of RealForecasts.com. a website that provides market forecasts and investment strategies to real estate investors. He holds a B.S. in finance and a J.D. degree, both from the University of Illinois.