Federal Reserve to Markets: You’re On Your Own Now

Traders like patterns in the markets. Creatures of comfort, they like their sense of reassurance, they like any Garmin driving system pointing a roadmap forward out of this mess.

Thats why the markets have operated nicely in an air pocket since 2009, blown comfortably wider on Federal Reserve Chairman Ben Bernankes soothing promises the Fed will be there to lead them, as his calm demeanor slows down a market whose inner core increasingly spins faster than its outer core.

But in this skittish climate the market can rapidly swing into emotionally wide trading ranges when the Fed lets go of its hand.

Which the central bank did today, and the market swung in violent triple digits before and after Bernanke spoke.

The markets retraced 429 points higher, even though Bernanke  wasnt so reassuring today, as the Fed again slashed its economic outlook, and said it would keep rates low through 2013, indicating it may cut back its massive balance sheet at that time, an easing which expanded its balance sheet with Treasury purchases in a bid to keep rates low.

No more Fed stimulus, which helped stocks rise 30% after it last enacted easing.

Thats because the Fed is now not pushing on a string, it's pushing on thread, given its three-year long battle to stop the downturn, which saw it take on an unofficial third mandate, reflating asset prices, the other two being employment and stable prices.

Although the Fed has shot in the foot fiscal rectitude, given it recent hints at possibly more Fed stimulus, which could involve rolling over existing Treasury holdings into mortgage-backed securities to deice this frozen market and keep the loan conveyor belt moving.

Or cutting the interest on excess reserves banks keep at the Fed to zero, to incentivize them to lend the money instead.

Or the Fed could re-enact another version of Operation Twist, launched in 1961 and nicknamed after the dance move made famous by Chubby Checker, to keep the long note pancaked down, now at around 2.2%.

To battle a recession and outflow of gold back then, President John F. Kennedy convinced the central bank to sell short-term Treasuries and use the money to buy long term bonds. The move sought to ramp up yields on shorter bills, which would attract capital from overseas and backstop the dollar.

And buying longer-term bonds would hopefully lower long-term rates to stimulate long-term investments, which it did, by 15 basis points, says San Francisco Federal Reserve Bank economist Eric Swanson.

Bernanke mentioned Operation Twist in a famous 2002 speech about the dangers of deflation, where he famously cited the benefits of a money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money. In that speech he said he preferred capping yields on longer Treasury maturities to help stop deflation, noting the Fed has historically been successful doing so, notably in the '40s, where the Fed bought bonds to help the war effort.

With another Operation Twist, the Fed could keep the long note at a 2% yield, to then lower mortgage rates dramatically and stop the housing market's long, careening slide down--especially as housing is largely causing fears of another double dip recession looms.

Trouble is, knocking the ten-year back on its heels will hurt returns for ravaged public sector pension funds.

Course, it's unclear if any of this will work now, given the state of the bust. Its best now to turn to economists like Carmen Reinhart and Ken Rogoff, who rely on economic history, which shows a coterminous credit and a housing crack up which the U.S. just endured are exceedingly rare economic events.

They lead to bank, then household, then government balance sheet meltdowns.

Love for the comfort of patterns is why you hear talk of the current market meltdown as a Lehman 2008 meltdown redux. But it is not. Were in a slow motion recovery, not an immaculate recovery as some in D.C. had applauded. Thats the perspective needed now.

The markets fell through the looking glass and lost its footing in a 635-point sickening plunge on Monday on Standard & Poors downgrades of the U.S to AA+, and downgrades of Fannie Mae, Freddie Mac, (which could stall privatization efforts), as well as 10 Federal Home Loan Banks and 10 insurers to AA+.

It also lowered the AAA ratings of thousands of bonds in the $2.9 trillion municipal bond market tied to the federal government, including housing securities and debt backed by leases. More than six dozen bond funds, exchange-traded funds and hedge funds were also hurt by downgrades.

But S&Ps downgrade of the U.S. to AA+ did not break the buck at any money funds, because S&P kept the U.S.s short-term debt at its top-notch level. Money funds hold short-term debt, thats why they held fast after the downgrade.

Thats unlike September 2008, when the $64.8 billion fund Primary Reserve Fund broke the buck because it held $785 million in short-term IOUs, called commercial paper, issued by Lehman Bros., which filed for bankruptcy protection. Investors lost on paper about $1.8 trillion in equity value in the recent downdraft, versus the $9 trillion in equity value vaporized in the 2007-2009 downturn.

Still rushing for political cover, theres now talk in Washington that the Senate Banking Committee plans to investigate S&P's downgrade of the U.S.'s credit rating--even though all the credit-rating companies were the subject of major hearings just a month ago.

State and local governments could get into the act too, particularly as S&P cuts ratings on a broad swath of municipal bonds in the wake of the federal downgrade.

So could officials from the Federal Home Loan Bank system, the low-cost lending pipelines into local banks for mortgages and small business loans. S&P downgraded to AA+ ten of the FHLBs, two having already been downgraded, Chicago and Seattle.

Even so, its not clear whether the downgrade will have any impact on Fannie and Freddie's borrowing costs, or mortgage rates, since investors are flooding into Treasuries and even their securities. The flight from Euro-chaos to Treasuries drove 10-year yields down towards 2.5%, historically low levels.

With unfair talk of the Downgrade President, the Administration is now slamming the S&P for a $2 trillion math error, when it really is not an error but a difference of opinion, making U.S. politicians sound more like elected officials in Portugal and Italy every day, blaming the messenger for stating the self-evident.

Meantime, S&Ps downgrade doesnt fully take into account the fiscal ramifications of health reform, Social Security, and Medicare, all set to blow out the balance sheet.

The Administration has pumped talking points into the Beltway echo chamber, ineptly rebranding S&Ps move a Tea Party downgrade, when the Securities and Exchange Commission says it has not yet registered the Tea Party as a credit ratings agency. Ignoring the fact that historically, rampant government spending either leads to money printing, or higher taxes to pay the interest costs on this debt, to avoid default.

S&P says it used a conservative 5% spending growth rate on government discretionary programs. It also said government borrowing costs will be higher by 2015, estimating the ten-year note yield could rise to 6.25% by 2015, as a worldwide bond glut vies for a dwindling pool of savings.

Higher rates make a world of difference, because borrowing costs will rise as government spending soars, since politicians can now get the Treasury Dept. to borrow at teaser rates.

But the government hollered back at S&P that it should use the lower rate CBO reckons for 10-year yields, a lower 5.5% by 2015.

Isn't that an admission that rampant government spending has worsened a worldwide bond glut, with a flood of bonds searching for dwindling savings, so naturally yields will spike higher in just about three-years' time?

The Administration also stamped its feet that S&P should instead use a 2.5% growth rate for spending over ten-years.

And it waved in S&Ps face the caps in the debt ceiling deal on spending, and the cuts from the new debt super committee.

But a new supersonic intergalactic Marvel Comics Justice League supercommittee wont work. It is essentially a way for Congress to pass along more gridlock, when weve already had a Biden Commission and a Simpson-Bowles Commission to come up with cuts that everyone, including the President, ignored.

Knowing all that, and more, S&P then came back and said, forget it, political gridlock and your history of poor cash management wont get you to at least $4 trillion in cuts over ten years which will bring the government to fiscal health.

It said the government is on course to have debt at a dangerous 79% of GDP by just 2015. And it said we will still drop you to double A in six months- to two-years time if you dont get on the stick.

First, consider that discretionary spending has grown at rates higher than the conservative 5% S&P used.

S&P effectively didnt believe Congress would adhere to the debt ceiling deals spending caps, and why should it, given Congress has hiked the debt ceiling 106 times since 1940, the government has balanced its budget only five times in the last half a century, the Senate hasnt submitted a budget in 825 days, and the presidents budget in February asked for hundreds of billions dollars in more spending, a budget which the nonpartisan Congressional Budget Office couldnt even score.

Meanwhile, even all of the Senate Democrats voted against President Obamas budget. Just as all of the Senate Democrats voted against the House-passed budget authored by Rep. Paul Ryan (R-Wisc.).

And the House only could only muster votes for a cut-cap-balance bill that came in less than the full two thirds Congressional majority required to send a balanced budget constitutional amendment to states for ratification (which is really an open door to a European-style VAT anyway, in this environment).

And while S&P said no backloading in the latest debt reduction deal, the White House went ahead and signed off on a bill that backloads spending cuts and tax hikes until after the next election--knowing that the President has already signed into law large tax hikes in health reform, $438 billion, many of them hitting the middle class.

A big two-thirds of promised cuts are back loaded to 2017 and 2021, just a third are scheduled for the next five years.

Do you trust Congress to act on cuts in 2016--especially to big programs like Medicare, when politicians feel they cant cut, survive, and live to tell about it even now?

Meanwhile, the White House and Congressional Democrats promise tax reform to fix the deficit.

But do you trust Harry Reid or Charlie Rangel to fix the tax code?

All this, as the Administration had pushed for raising the debt ceiling once again as re-election approaches, as U.S. GDP growth has ground to a halt, at an annual 2% stall speed, as current stimulus vanishes and joblessness sticks stubbornly high at 9.1%.

Economic policy is now consistent with the re-election schedule, the Administration still wants more stimulus spending, which is like raising blood alcohol levels to stop drunk driving, as a cartoonist recently wrote.

When the better stimulus for the President is to stop with the Jimmy Carter defeatist rhetoric, stop with the Presidents bear market hug to investors, where chief executives fear that he thinks every businessman is hot molten evil.

The trouble is this Administration and this Congress fail to acknowledge in the first instance the severity of an historic housing and credit crackup, as they instead barreled ahead reforming three huge sectors of the U.S. economy, health care, financial, and energy sectors, stranding businesses in traffic.

When jobs in this rare economic crackup should be the number one priority.

Would you build a factory today or hire workers if you knew taxes and regulatory costs will eventually rise, but had no idea by how much and which ones?

Yes health reform.

But you cant have health insurance without jobs. You cant have welfare without wealth creation to pay for it.

Yes energy reform. But you cant have energy reform if it crushes job growth, jobs which create tax revenue to pay for new energy endeavors.

Yes financial reform. But you cant have jobs without bank lending.

Yes Wall Street has players more crooked than a bag of corkscrews.

Yes they got bailouts they didnt deserve.

But the DNA of the financial markets, of bank lending, is confidence. The DNA of the economy is business and consumer confidence, consumer spending comprising more than two-thirds of GDP. Theyre not feeling it now.

Lack of confidence is why $2 trillion sits parked on bank balance sheets, and why $8 trillion sits waiting in savings and money funds.

Listen to the farewell warnings from former Secretary of Defense Robert Gates in the May 28 issue of the Wall Street Journal, that America cannot be both a superpower or a welfare state.

Especially when the economy is in a slow motion recovery from this historic credit crackup.

Yes, profits will cushion whatever stock corrections are out there for now. But the government keeps throwing banana peels in front of job creators, and not knowing whats in health reform or Dodd-Frank financial reform is bad, especially when capital moves at the speed of a mouse click. President George W Bushs Administration was just as bad, it created an additional $60 billion in additional regulatory burdens

When it comes to the job creators, keep in mind Democrat Congresswoman Nancy Pelosis statement that Congress should pass health reform, it ought "to pass the bill so you can find out what's in it.

Keep in mind the Pelosi-like statement Democrat Senator Chris Dodd made about the financial reform billno one will know until this is actually in place how it works.

Dodd Frank is a 2,319 page bill versus health reforms 2,409 page bill. After the accounting scandals at the turn of the millennium, Congress passed Sarbanes-Oxley in 2002, which had 16 formal rulemakings.

Dodd Frank has an estimated 400. Health reform has untold rules. So do new rules coming out of the Environmental Protection Agency.

The U.S. is not a centrally planned economy, much as some try. No one can force the banks to lend unless the banks see demand.

Just as the government cannot create purchasing power on its own.

But that is government policy now.

Tax rebates, stimulus spending, and extended unemployment checks are simply removing water from one end of the swimming pool and pouring it into the other, as the Heritage Foundation has noted.

Again, all of that spending must eventually be paid for with higher taxes, borrowing on debt markets (more taxes to pay interest costs there) or inflation via the Fed printing press (taxation without legislation, says economist Milton Friedman.

But despite heeding its warning, S&P and the other ratings agencies, Moodys Investors Service and Fitch Ratings, are getting slammed now for enabling this crisis.

Keeping triple-A ratings on what were really junk subprime mortgage-backed securities enabled the government and Fannie and Freddie to continue to live in magical fantasy land thinking.

It enabled the government to borrow trillions of dollars more in the open markets, and Fannie and Freddie to blow out their own balance sheets to more than $5 trillion.

All to enable a dangerous government policy that tries to fix income inequality via housing, instead of via jobs and economic growth.

The ratings agencies have been doing a lot of talking to Congress, where many dont listen anyway.

So has Fed chairman Ben Bernanke, who has consistently warned about spending, and wants to see the U.S. economy, and its markets walk without government crutches.

The U.S. financial markets have gotten ahead of the economic recovery. The central nervous system of the market, the financial sector, is still reeling around in a hospital gown.

Even the most unreconstructed bull cant ignore the technical, fire engine red flashing lights.

All of this matters to you, because it affects your standard of living in retirement.

Remember, this is not an immaculate recovery. This is a slo-mo recovery from an historic crackup.

And as you know, the governments control of your money is not state of the art.