The Fed Is Cornered and Soon It’s Checkmate

I loved to play chess as a kid. My dad started teaching me when I was only a few years old. I racked up some wins in our household. And, eventually, I even found my way into a local tournament.

I learned two things from the experience: Nothing feels better than the moment when you got to tell your opponent “checkmate.” But nothing feels worse than being cornered, knowing it’s just about time to tip your king over and having to stand up, shake your opponent’s hand and admit defeat.

I reflected on that this week after seeing the news out of the Federal Reserve. That Ben Bernanke chose to avoid “tapering” the $85 billion-a-month QE program — five long years after the emergency that prompted the policy in the first place faded into history — is unconscionable.

The securities market was prepped for at least a token move in tapering. The major banks and brokerage house economists were all expecting it.

The foreign central banks that have most closely followed or mimicked Fed policy — in New Zealand, the U.K. and several emerging economies — have all started raising short-term rates, laid the groundwork to do so in the future or otherwise taken tentative steps toward tighter monetary policy.

And, yet, Bernanke and Co. punted to at least the next meeting. Why would they possibly do that?

Ben Bernanke’s surprise shows that the Fed is boxed in a corner.

Here’s my theory: The Fed is cornered — and it knows it.

Policymakers can see the bond market countering every move they make, driving long-term rates higher despite Fed protests.

They can see their list of easy-money allies getting shorter by the day.

They know QE doesn’t work for the real economy. That’s been the message of multiple academic studies of late, including those presented at the Fed’s own landmark conference in Jackson Hole, Wyoming, in August.

And they know the endgame is inexorably approaching. The moment when they will be forced to taper and end this multiyear experiment.

So, like a cornered player in a game of chess, they’re trying to prolong the game for a few more moves. They’re trying to buy a bit more time.

But just like a player who has lost all his pawns, rooks, bishops, knights and even his queen, there is no way around it.

Checkmate is coming.

My prediction is that we now will see a tapering in October or December, the last two Fed meetings of the year. And I still believe the start of a series of short-term interest-rate hikes is coming in 2014.

The likely catalyst is a renewed sell-off in long-term bonds, the most sensitive to the inflationary threat of too much easy money. Indeed, amid the Fed’s surprise announcement Wednesday, bond prices gained back only a small percentage of the massive losses they’ve suffered over the past year from the bursting bond bubble. That alone speaks volumes about the underlying fundamental weakness in the market.

So I urge borrowers and investors like you to take advantage of this temporary respite. Pay down debt before it gets more expensive to do so. Lock in long-term rates on any loans you may need to keep outstanding. And position yourself for the next leg down in bond prices and rise in interest rates by taking protective measures — or by buying investments that rise in value along with rates.

Until next time,

Mike