Reflections on the past 5 years: The FED, Central Banks and Financial Markets

There are a vast number of analysts who proclaim that the Federal Reserve Bank, and other central banks around the world, are in control, and that had it not been for the FED's aggressive and unprecedented monetary policy in the fall of 2008, and for a period of time after, the financial system would have fallen apart and collapsed completely. Further, many bears (including myself) who were vehemently against not only FED policy, but were strongly opposed to the idea that it would even be successful in preventing a financial collapse, have now been all but discredited, and many think the risk of a financial collapse and depression has evaporated and the FED has saved the day. I want to dispel two myths in this regard:

Myth # 1: The FED saved the day and prevented the complete breakdown of the financial system:

If anything, the actions of the Federal Reserve and that of Central Banks around the world have done nothing but put off the collapse, and turned an already unprecedented condition of over leveraged "too big to fail" banks and an over-leveraged system into an even more over-leveraged system, that has set up the entire financial system for complete and utter chaos once the liquidity cycle tops out and the inevitable reversion to the mean comes and natural forces of social mood take markets down. In short, the cure for too much debt is not more debt. Trying to cure the system with more debt is like trying to cure a crack patient with heroin. Instead, these geniuses at the FED and other central planners around the world have decided to do more of the same that helped get us here in the first place, and as a result have ensured an even bigger liquidity and banking crisis down the road. What has eluded me, as well as many others who are highly knowledgeable about the situation, is time. The lesson here is that extremes in financial valuations, and over leveraged systems, can go on for a lot longer, and become even more stretched, than might seem possible from the outset. In this case, the outset was the period from 1974-1982, when the biggest credit expansion in history was in its early stages. But, I must emphasize, the fact that the system has held up as long as it has, does NOT change the ultimate outcome, and, as we will see in coming years, the added leverage and debt in an attempt to prop up an already over leveraged system will only make the ultimate outcome even worse than if nature was allowed to freely regulate the financial markets.


Myth # 2: The FED is in control and "changed" the wave count.

With respect to the Federal Reserve Bank and financial asset valuations, many so-called "analysts" believe the FED sets interest rates, and, even amongst those who practice Elliott Wave Analysis, that the FED "altered" the wave count.

First with interest rates. Contrary to popular belief, the FED does NOT control interest rates. Please see the below chart, courtesy of Elliott Wave International:

As is clearly evident, The FED's interest rate targeting follows the market for 3-month U.S. treasury bills, not leads. My point in illustrating this is to prove that the FED does not decide what interest rates will be, but the global debt market does instead. And, I assert that the fact that this stock market rally and so-called "recovery" has gone on so long, and stretched so far, is not ultimately due to the FED, but rather to fluctuations in human collective social mood. If the bond market decided not to put up with the FED's unprecedented balance sheet expansion, the majority of participants would sell their financial instruments. This would drive interest rates higher, driving the value of the underlying treasury securities down, and thus the FED's balance sheet down. At the very least, it would strip them of any remaining credibility they had left, and, also quite possibly, and I think probably, forcing FED "set" interest rates higher even amidst a fragile system and weakening economy as confidence erodes away. The rising rates for already unsustainable debt levels would make both public and private sector debt unserviceable and we would see debt defaults occur in droves. In a sense, the subprime mortgage crisis is a microcosm for the entire system. It is one giant subprime mortgage, and once interest rates spike upwards, the debt will no longer be serviceable. Except this time, we are not dealing with the subprime housing market, we are dealing with the entire debt-based monetary system, and the implications are very drastic. The point in explaining these principles is to illustrate that the only reason the system has held up as long as it has, and that financial valuations and the underlying credit structure have become as stretched as they have, is that investors, who are humans, have put up with it. This, I contend, is due purely to the natural ebb and flow of human social mood, and simply serves as evidence of how big of a peak in social mood we are truly facing. These directors, which again are human beings, cannot control social mood fluctuations, no more than any other human being or group of human beings can regulate or manipulate the growth patterns of a tree. Tree growth is a system in nature, and the natural upward progression of human consciousness and social progress is also a system in nature. Contrary to many exogenous cause belief systems inherent in human beings, I believe many if not all systems in nature are endogenously regulated, or in other words self-regulated. They do not depend, nor are affected by any outside force. Since all systems in nature are subject to vibration, frequency, and fluctuation, many of them also exhibit fractal behavior, with self-similar patterns showing up in these vibrations or fluctuations at varying scales (i.e. timeframes). If one accepts the notion that systems in nature are self-regulating, then, it also seems logical to accept that financial market valuations, a result of the relative position of human collective feeling, or social mood, move on their own accord as well. Therefore, I assert that this upward trend in financial asset prices, and accompanying reflation of the credit money supply over the past five years, while encouraged by the FED, could not have happened without the trend toward a positive extreme in human collective social mood supporting it. And, the followed logical conclusion to all this, is that when the human collective social mood reverses into a trend toward a negative extreme, financial asset valuations, economic activity, and social and political conflicts will all follow toward a negative extreme.

Additionally, the fact that we as a society, unlike the financial peak of 1929, value financial asset prices in terms of debt-money IOU's, rather than real money, necessarily creates a resulting divergence between real (inflation adjusted) asset prices and nominal (assets valued in terms of debt-money U.S. Dollars ) asset prices, as should be expected. Using logic, If A is associated with C, and B is associated with C, the relationship between A and C (or ratio numerically expressed), and B and C (or ratio numerically expressed) is going to be different for the simple reason that A is not B, and B is not A. In this case, A and B represent Real Money that doesn't fluctuate in value (Gold) and credit-money (U.S. Dollars and many other central bank monopolistic currencies around the world), respectively. Continuing with this example and its conclusion, the relationship between A and C, and B and C, represent real (inflation-adjusted) and nominal asset prices, respectively. Since we have just shown that A does not equal B, the conclusion drawn from that using deduction, is that the relationship (or ratio) between A and C and B and C, will be different. Therefore, it is logical to conclude that the addition of credit-money to the system necessarily mandates, by logic of deductive reasoning, a divergence between real and nominal prices, which we clearly see present in the financial system today.

Using endogenous cause reality, the fact that we have been on a credit money system standard for decades now, rather than being a cause of how stretched the overvaluation and optimistic extreme has become, is rather a result of a peak in optimism so large, that it is concluding an uptrend in human social progress that has lasted centuries, and, looking back in hindsight, we will be telling our grandchildren about it.

 In conclusion, endogenous cause reality suggests that the extremity present in the financial system, is NOT ultimately a result of central bank action, and, if one accepts that notion, then it is also reasonable to assume, that once the trend in human collective social mood truly turns down (it has been in a topping process the past 14 years, evident by a number of different measures I have illustrated before. See prior posts), there is nothing the central banks can do to stop it, and the resulting asset price declines across the board.