Defaulting banks - where will it stop?

[Jan Klimkowski]

So, the Fed pledges low US interest rates for two years:

Federal Reserve pledges to keep interest rates low for two years

America's central bank pledged to peg interest rates at their ultra-low level for a further two years to boost growth in the world's biggest economy.

The US Federal Reserve said it was prepared to use a range of policy tools should growth and unemployment continue to weaken over the coming months.

But the US Federal Reserve made no commitment to begin a third round of quantitative easing, the process of electronic money creation that has pumped $2tn (£1.2tn) into the US banking system over the past two and a half years.

(snip)

In a statement, the Fed said it expected "a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting" and anticipated that a jobless rate of about 9% would decline only gradually towards the level judged by the central bank to be consistent with keeping inflation low and employment high.

It added that economic conditions were "likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013", and had looked at a range of policy tools to promote a stronger low-inflation recovery. These would be employed "as appropriate" in the light of fresh information on the economy.

Previously, the Fed had said it would keep borrowing costs low for an "extended period" but the commitment to maintain them at an exceptionally low level led to three members of the policymaking open market committee dissenting from the decision, the first time this has happened for almost 20 years.

The Dow Jones industrial average of US blue chip stocks had been up 100 points before the Fed's statement but was 150 points lower half an hour later.

Cary Leahey, managing director and senior economist at Decision Economics in New York, said: "This is a lame way for the Fed to try to help the marketplace. They redefined extended period to mean at least mid-2013. But to today's marketplace, what difference does it make if they tighten in 2012 or 2013?"

Prompting Market Ticker's Karl Denninger to write (with charts here):

Bernanke Calls Deflationary Depression

The bond market figured it out immediately, pricing it in.

(chart)

That's the 10 year Treasury on a weekly chart. It is now back to effectively where it was in the depths of the crash.

(chart)

The 5-year yield is below that of the crash.

And the 2-year has basically been turned into a T-bill.

The bond market is telling you that there will be no material economic growth for the next two years and that a deflationary depression is the economic path that will be followed.

This is effectively what happened in Japan, although the worst of the economic impacts have been muted as they had tremendous internal surpluses to expend (those, incidentally, are now pretty-much "used up" - two decades later.) We do not have those internal surpluses - to the contrary.

The stock market has been doing plenty of "up and down" and it will probably rally for a bit yet, as stock traders tend to be the short bus riders. But make no mistake - the bond market's response to the FOMC announcement is entirely rational and consistent with only one outcome - a sustained economic slowdown coupled with deflation, not inflation.

What will cause this? The debt bubble collapsing. Maybe kicked off by Congress failing to reach agreement or doing a "nothing" with the so-called "commission." Maybe kicked off by collapsing net interest spreads for the banks and then their collapse from the weight of their bad loans and inability to earn their way out of the box they've painted themselves into. Or maybe Unicredit blows up and the tsunami comes from Europe. There are plenty of things ticking out there, and it only takes one big one that goes off to set the next move in motion.

The bottom line is that either the bond market is wrong or stocks are wrong. Given that Bernanke just provided you his pronouncement and expectations, I wouldn't bet against the bond market, and if the bond market is right then the modest "mini-crash" we just saw is a warning and not a buying opportunity, just as Pompeii's Vesuvius rumbled many times before it blew its stack.

When this is priced into the equity markets - and others - it is likely to be in the form of a nasty dislocation. This also fits with the technical picture; assuming the low today of 1103 holds for the moment and is a localized low then the most-likely retrace is up around 1220, all in the S&P 500.

The next move down, unfortunately, should comprise almost four hundred S&P points and close to four thousand DOW points, and is likely to be more violent than what we just experienced. It could be worse too - it's possible that we see an S&P decline of more than six hundred points, basically cutting the indices in half, more-or-less "all at once."

Enjoy the rally today (and likely for a bit yet on a forward basis) but beware - if I have to choose between the stock market and bond market as to who's right the bond market is almost always both the leader and the correct choice