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How Will the Federal Reserve Untie its Gordian Knot?

By Kikuyu3 (Own work) [CC BY-SA 4.0 (http://creativecommons.org/licenses/by-sa/4.0)], via Wikimedia Commons

The Federal Reserve is telegraphing that it is going to begin its great unwind in September. It’s going to untie its own not untiable knot. In case you cannot untie what I just said, that’s a knot that cannot be untied. I’m writing the article to ask you to ponder this conundrum with me. Can the Fed undo its quantitative easing without undoing the vapid recovery it fashioned out of that quantitative easing?

I’m starting with the premise that the Fed is trying to talk up the reduction of its balance sheet, starting in September, because it actually wants to unwind and still hasn’t realized it cannot. That premise, of course, may be wrong. They could simply be lying, but strong historic precedence argues in favor of stupidity.

I believe the Fed WILL start to unwind, as they’ve said they will, and havoc will begin in stocks and bonds and housing and all kinds of markets as quickly as the Fed starts to do what it has long said it will do and people begin to see that it cannot do it. I have always suspected they have no end game, but they thought they would eventually unwind into a strong economy with a lot of resilience toward their unwinding. They probably even thought their recovery would build to where some gradual cooling might be necessary to avoid inflation. Their unwinding would cause that necessary cooling.

Instead, they find they have, at best, a nearly stagnant economy where borderline stagnation promises to be the best they can hope for throughout years to come, and they have almost no inflation (by their measure). So, they must now figure out how to unwind in a situation of borderline stagnation … or never unwind.

 

Why the knot cannot be unwound

 

Here is how I think everything falls apart: As soon as the Federal Reserve starts to unload assets (being mostly bonds and those nasty derivatives), they will have to unload their junk (for they sopped up a lot of junk) at a price that will entice others to buy their sludge. I would think it takes a pretty high price (interest) to get investors to buy up junk bonds and peculiarities that, at one time, were believed to carry risk of such size that only the Fed could handle it. Of course, they own a lot of US debt, too; so, they’ll probably start with the easy stuff. Rising interest on bonds will tend to draw money out of stocks, so stocks will fall unless they receive even more extraordinary propping than what we have learned about recently about the Swiss National Bank buying huge amounts of US stocks.

The rise of interest on bonds will also have the collateral effect of making all debts less sustainable at a time when the nation is extraordinarily top-heavy in debt. That will not only increase the United States’ rapidly rising deficit, but it will make Trump’s fiscal stimulus impossible (as if it were not already going to create its own interest increase that will undo itself) because the new debt for Trump’s stimulus plans will have to compete with the debt the Fed is trying to unload along with the debt the government already has to refinance.

Since the Fed used quantitative easing in order to lower interest rates (especially long-term interest rates, such as on mortgages) and to increase liquidity, I don’t see how they unwind their QE without causing interest rates to rise. In a robust economy, they might want interest to rise; but in the present flagging economy, a rise in mortgage rates will cause the latest housing bubble to collapse because the housing market already looks like it is turning.

Many have seen this conglomeration of collateral problems coming (or, at least, something like it), but the Fed continues to tell everyone it can manage its way through all of that. I think investors in most markets have just been covering their eyes, saying, “Well … OKaaaay….” but have no idea how the Fed will actually be able to do what it says it will do. Investors are extending blind trust in order to avoid thinking about the party ending. They are saying, “Well, the omniscient Fed gave us a recovery and made us rich on stocks and bonds all at the same time, so they will be able to do this, too.” That’s religion, not science or even math.

However, the Fed is about to attempt to reverse the cause of all of that new money in their pockets (by removing money from the system) without reversing the effect (removing money from anyone’s pocket). I don’t believe Fed omniscience or omnipotence can pull that off. The problem with central planners is that national economies always prove more complex than they can manage. Our plate spinners at the Fed are no better than the central planners in nations like China, which have a lot more experience at running rigged economies. Our economic engineers not only lack deep experience the Chinese have at central engineering of the economy, they have fewer levers of absolute control. It is, for example, seen as remiss if they kill people who resist their plans.

 

The Gordian knot

 

The Fed has maintained all along that the economy must have fiscal stimulus if it is going to fully recover. We’ve heard them say many times that they have now carried the recovery as far as it can go without fiscal stimulus. However, the Fed cannot unwind from its monetary stimulus without making fiscal stimulus impossible. That’s the Gordian knot.

The concept of the Gordian knot that cannot be untied comes from a 16th century legend that King Gordius tied an extremely complex knot and then prophesied that the only person who could untie the knot would become the emperor of all Asia (an Asian version of the story of Arthur drawing Excalibur out of the stone, which no one but the right man could do).

One solution to the Fed’s unwinding conundrum would involve something they already appear to be playing with: They appear to have arranged for other central banks to intervene in US stocks in order to keep pumping the US stock market up. If that’s where the Swiss March is going …

 

 

… the market could easily scramble another steep ascent of irrational exuberance that goes beyond the alpine heights of the present market because central banks would be joining in action never done in US stocks in history (that I am aware of). They would be fully acting in consort as central planners, just as The People’s Bank of China did a couple of years ago, to rig the market in one direction. (They’ve already started doing this through the Swiss, but I’m saying it would have to be amped up and coordinated considerably to compensate for an actual unwind of the Fed’s trillions of dollars in asset accumulation. If there are other options, I hope you’ll tell me what they are.)

There is no limit to how much money central banks can create and pump into markets through their member banks so long as their member banks do not release their ill-gotten gains into the economy — or, at least, don’t release enough of those gains to cause inflation to rise too high. New money doesn’t cause general inflation until it trickles down to the general public, which it never has during this recovery.

That means central banks can conceivably pump up stock markets in all nations to astronomical heights. Their member banks could even let a little of their vast gains slip through the air-tight seals of their vault doors to keep the masses less unhappy. That might mean tolerating, as Yellen already suggested, a little higher than usual inflation to keep the game in play. In fact, maybe that is why Yellen has already suggested the need to tolerate higher inflation, as perhaps she sees the likely need to placate the masses in carrying out the Great Unwind. (That said, letting money slip out of the vaults onto main street is not what we’ve seen actually happening. It seems to be anathema to the high priests of the banking realm that anyone but themselves should ever touch the holy riches of “recovery.”)

If central banks and their member banks all worked in precision like a well-oiled printing press to keep the masses stable, I have no idea best place to buy generic ambien where the absolute limit is on how long they could keep printing the market up with cash or how high it could go, as people are not likely to complain so long as they feel more money filling their pockets without inflation stealing it away. I suspect, however, the banks will not be able to maintain that charade for long because that kind of printing — now that the economy of the entire world is visibly starting to break up in major pieces around them — is going to make them all look as red as the central planners of China, an embarrassment they have tried to avoid because it doesn’t go over well in nations like Amerika that once considered themselves pioneering, entrepreneurial … and free.

If they do go down that road of having other central banks directly buy US stocks in order to save the US stock market in order to save their bankrupt recovery during their unwind, how does that play out when it proves the whole world has become as overtly rigged as the Chinese marketplace? Will all the market analysts and commentators still not see how rigged the game has become?

If they don’t, won’t the mainstream media lose even more clout by maintaining the party line while the alt-media becomes even more popular as it speaks the obvious truth to the oblivious public? I may underestimate the willingness of the public to keep its blinders on forever, especially if a little liquidity is finally allowed to trickle down into their dusty throats; but surely at some point the game becomes so ludicrous that nobody can stand it. Does anyone really think China saved its stock market, rather than stopped it from being a market at all?

Even though I have become pretty well convinced that the human capacity in high places and low for such stupidity and blindness is endless, I still think the game flies out of control because the center cannot hold against the centrifugal force of so much nonsense in all directions. You see, I think it is one thing for one nation to maintain that kind of solution as China did in a realm like China where the government completely controls the message anyway; but it is quite another for all central banks of the world to contain the message simultaneously in a world that is falling apart and in a part of the world where they don’t quite have a monopoly yet on speech … all in a part of the world where a fair number of people still hate the very idea of central planning.

To contemplate the difficulty of this kind of rigged unwind, consider what happened in China when it tried to stop its stimulus (not even unwinding anything) and save its stock market at the same time: China had to directly control what people could say; it had to seize control of which investors could invest (by outlawing certain investors that were doing things it didn’t like); it had to outlaw speculation (which US investors all thrive on so would not likely tolerate); it had to mandate what stocks could be bought by taking huge numbers of companies off the market entirely; and the central bank of China STILL had to force its member banks and other proxies to soak up tons of the remaining stocks to force what looked (albeit only to idiots) like a rebalanced market.

As you consider this Manchurian Solution, bear in mind that China found the solution extremely difficult in a land that has been used to such rigid controls for decades. People there are accustomed to submitting to heavy-handed, top-down control of markets because they know rebellion will leave them dead in the streets. Even so, many tried to pull their money out of the country.

How does that play out, then, in economies that are accustomed to, in the very least, thinking of themselves as free markets (even though they are less and less so) and that are not accustomed to seeing entire companies and markets nationalized? I don’t think non-communist countries will be able to tolerate the kind of central control that China found necessary in order to save its stock market when it tried to merely deflate its stimulus bubble, and its stock market popped. (In the end, even China had to return quickly to economic stimulus to prevent mass revolts. So, IF THE CHINESE CANNOT PULL OFF CENTRALLY RIGGING MARKETS DURING A STIMULUS-OFF CAMPAIGN….)

 

By Rolf Brecher from Germany (Gordian Knot / Gordischer Knoten) [CC BY-SA 2.0 (http://creativecommons.org/licenses/by-sa/2.0)], via Wikimedia CommonsUntying the Gordian knot

 

My thinking continues to be that the herculean effort required to untie this knotted pit of poisonous snakes quickly becomes unsustainable because it becomes so complicated and toxic when all central banks either buy their own nation’s stocks directly or all agree to buy each other’s covertly. I don’t see how they can avoid winding up in competition on those policies over who saves what as their own nations fall apart and as their own governments to varying degrees resist allowing direct CB purchases of stocks. And direct CB purchase of stocks does appear to be the plan.

Citizen blowback and particularly blowback from traditional investors and analysts in a world with a free (albeit highly manipulated) press also becomes hard to contain. The level of interventions will certainly become as insane as China’s market did a couple of years ago — except that it will have to be coordinated globally — in nations that are highly resistant philosophically to that kind of central management and that don’t have the kinds of government controls China has long had. So, I think the Great Unwind quickly unravels.

The only way I can see for central banks to avert that would be if all central banks have agreed they will unwind one at a time and that all the banks that are not unwinding will prop up the stock and bond markets of the one country that is unwinding. Problem with that kind of plan is that it only shifts the difficulty of unwinding onto other central banks because they end up with even more lice-ridden assets to unwind later. At the same time, the central bank that just unwound cannot return the favor without loading itself back up with the assets of other.

It’s hard to believe other central banks would accept the roll of being the dumb pigeon that agrees to shift the unwind burden to themselves for the Fed’s sake. Thus, I don’t see how the Fed can even start down that road. I’m curious as to what other options others see; but here is the one that continues to look most likely to me:

 

By VladoubidoOo (Own work) [Public domain or CC BY-SA 3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia CommonsThe Alexandrian Solution to untying the Gordian knot

 

No matter, how I try to envision their unwinding process (try to untwist their knot), it looks like a Gordian knot to me. And here is the actual solution to Gordian knots:

 

“cut the Gordian knot”:
solve or remove a problem in a direct or forceful way, rejecting gentler or more indirect methods.

 

When Alexander the Great faced the prophetic Gordian knot, which he supposedly had to untie to prove he was the rightful great emperor of Asia, he preferred a simpler solution to the unsolvable problem. He took out his sword and whacked the knot in half. Knot undone, so no knot left for anyone else to claim the title.

In this case, the forceful solution is for the Fed to cut straight to the unwind and let the knot they’ve created fall apart at a time when the Fed can use the much-hated Trump as their ready scapegoat and so as to pin the blame on all the anti-globalists who voted for him, thus killing their enemies and the champion of their enemies in one fell swoop. If the Fed isn’t already planning that escape route, I’m sure it will become obvious as soon as they see they cannot unwind without creating chaos.

If you think the Fed can unwind, I’d like to hear you spell out how that happens. Go ahead and try to untie the Gordian knot in the comments below. (Maybe there is an elegant solution I am not seeing.) If I see reasons that I think your method won’t work, I’ll comment on what additional problems your solution creates and ask how you avert those so your solution doesn’t tie itself up in knots.