August 15, 2011

Fed's ZIRP Could Lead To A Japan-Style Deflation (Guest Post)

By Ilene

After an amazing week of whipsawing market action, we explore why trading was so erratic and conclude that the days of fearless dip-buying and trust that "The Powers That Be" can support the markets may be coming to a messy end.

(Excerpts from Stock World Weekly)

Standard & Poor’s downgrading U.S. debt from AAA to AA+ after the market close on Aug. 5 contributed to the following Monday’s steep selloff. But instead of the downgrade of U.S. debt leading to lower Treasury prices and higher yields, as might be expected, the reverse occurred.

Investors feel confident that they will be repaid with interest. They are not the least bit worried about a credit downgrade. Nor should they be in the short run. There simply is no alternative to the Treasury market to absorb investable funds. Everything in this world is relative and in that respect, investors still believe that the US is a better bet than anywhere else.”   ~ Lee Adler of the Wall Street Examiner
ZIRP & Deflation

Trading was wild on Tuesday, with the afternoon release of the FOMC minutes, and the anticipation that the Fed would announce a third round of quantitative easing (QE3).
Instead of bestowing QE3 on the stock market gods, the Fed took an unprecedented step of explicitly stating a specific duration for keeping the federal funds rate at 0 to 0.25%--essentially ZIRP (Zero Interest Rate Policy) till 2013. 

Lee Adler of the Wall Street Examiner noted,
“....Keeping rates at zero will not prevent crashes, and will cause other dislocations. For every dollar in interest that someone does not have to pay, that's a dollar that someone isn't receiving and consequently can't spend. It can also force a liquidation of principal. Zero interest rates are deflationary without offsetting money printing."
It's very bearish. Case in point, Japan. They've been doing it for 20 years and their economy refuses to grow, and people are even refusing to procreate. People who cannot earn a fair return on their assets behave rationally. They stop producing assets, and they stop having children.”
Volatility Feeds HFT

Lack of an explicit promise for QE3 initially pulled the rug out from under the market, but the drop almost instantly reversed as a strong wave of buying lifted the Dow about 600 points off the low.

During the turmoil of the last two weeks, the stock market’s fastest electronic firms boosted trading threefold, stepping up strategies designed to profit from volatility, according to one of the electronic firms’ biggest brokers.

Wedbush Securities is the largest broker supplying bids and offers on the Nasdaq Stock Market. In a telephone interview with Bloomberg, Wedbush indicated that high-frequency trading (HFT) made up more of the market during the recent stock market selloff. Dave Fry, publisher of ETF Digest, shared his thoughts on High-Frequency Trading:
“In the end this volatility and manic behavior is a massive turnoff to Main Street. "The powers that be" are pulling out all the stops to thwart action they don't like. Margin requirements were raised on gold because rising gold prices are a Bronx Cheer to the Fed, Treasury and Administration... "
The European Black Debt

The European “Black Debt” crisis is now spreading beyond the smaller member countries and beginning to affect pillars of the Eurozone such as Italy and Spain. France, too, is worrying investors even though its AAA rating was reaffirmed.

Dr. Michael Hudson writes,

“The bonds in question are held largely in German and French banks in Europe, and by U.S. banks. Germans are especially angry by reports that U.S. Treasury Secretary Timothy Geithner intervened in opposition to the insistence of Germany’s chancellor, Angela Merkel, that bondholders should take a loss on their irresponsible investments."
"News reports say that as many as half the troubled securities are held by U.S. money market funds or subject to derivatives gambles. So it is not only European banks that are being bailed out, but also risk-taking U.S. speculators...Banks bought these bonds to earn high rates of interest; they took a risk, and now the taxpayers will pay. This is morally repugnant.”
Looking ahead, Lee Adler writes,
"Weak economic data will keep investors in a panic and they just may continue to opt for Treasuries at the expense of the stock market. That’s the rationale for a return of the stock market plunge, if not next week, then around the end of the month when a massive amount of new government paper will settle."
We anticipate more turmoil in the Eurozone.  Phil is heading into next week “cashy and cautious.” For more, including several trade ideas for next week, take a FREE trial to Stock World Weekly here >

[Note: This is an edited version by EconMatters from author's original post.]

About The Author - Ilene is the editor and affiliate director at Phil's Stock World with a fascination with the markets.  She also maintains a blog at Phil's Favorites.  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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