UTSanDiego.com

The Bernanke Strangle

Tickers in this article: GLD SPY
NEW YORK ( TheStreet) -- By now everybody knows the Bernanke Put, and it's been the best thing since sliced bread.

Of course, nobody with any self-esteem would think the Federal Reserve can solve all the problems. But whenever there's any problem, everybody remembers the Bernanke Put is there and the problem disappears. If it doesn't, Fed Chairman Ben Bernanke can double down until it does.


However, as the Fed balance sheet stands at $3 trillion and is set to increase by about $1 trillion a year (plus a few percent of interest payment and minus an unknown and varying amount of maturing debt), the risk associated with the inevitable and eventual shrinking of the balance sheet increases.

Even before economic strength approaches the Fed limits outlined in QE3/QE4, all bond yields would start to increase in anticipation of the end of quantitative easing. Borrowing costs would increase for everybody, from governments to businesses to home buyers to consumers. This would put the brake on economic recovery and, depending on severity of the bond bubble bursting, may very well kill it.

This is the flip side of Bernanke Put -- the Bernanke Call. The two combined makes the Bernanke Strangle because it literally strangles the economy in limbo.

The unprecedented Fed transparency in publicizing clear and fixed targets for QE has the unfortunate consequence of telegraphing the end to the world. Ambiguity can be a beautiful thing, as Bernanke will one day learn. It's the golden rule of all central banking.

Of course, transparency has its merits, too. But losing flexibility is too big a price to pay, unless one buys into the thinking that the health of economy can be sufficiently defined by two numbers.

Perhaps the Fed thinking is that such transparency allows the bond bubble sufficient time to deflate in a manageable way rather than going bust in a hurry.

This is, at the least, a huge gamble. Nobody can predict how bubbles behave with any responsible certainty. But even if it does deflate slowly, it will damp or possibly kill the recovery. Then the Fed would be forced to delay the bond unwinding.

Hence my prediction that the Fed can only unwind too late and, in the end calculation, inflation risk is certain.

I found the worry back at the beginning of January over the Fed unwinding quite laughable. But such market anticipation, however wrong in the end, is rational and necessary.

It is exactly through such fear that the Fed will be forced to delay the unwind. If the market sees through this and goes on with its blissful recovery, then the Fed would be forced to unwind in a well-publicized yet totally surprising move -- thus killing that recovery. It's a delicious play of game theory resulting in an unintended Catch-22.

Why does the Fed have to unwind? After all, the Bank of Japan bought a huge amount of its own sovereign debt and kept it or 20 years. The difference is that Japan can rely on its massive domestic savings while the U.S. must rely on foreign investors.