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The Fed's (VERY) Big Bets image

There can be little argument that the U.S. Federal Reserve saved the banking system and in the process, the global economy, during the credit crisis. In an intense time with the financial system seemingly coming apart at the seams, Bernanke & Co. pulled out all the stops in order to keep the country from an abject disaster.

Gentle Ben and his merry band of central bankers cut rates time and time again. They changed some rules and offered up an alphabet soup of new programs to keep banks solvent. And in the end, they even printed money to keep the country out of what would have surely been history's darkest days from an economic standpoint.

And once the danger of imminent collapse had passed, Bernanke's Bunch then had to turn their attention to keeping the U.S. from entering a Japanese-style deflationary cycle. Having studied every detail of the Great Depression, Bernanke knew that once deflation took hold of an economy, it was almost impossible to stop. So, after years of "fighting inflation" - as in keeping it low - the Fed decided that a little inflation would be a good thing, and set out to reflate the economy.

So, if investors are looking for someone to thank when looking at their 401K statements or the value of their home, they need look no further then Ben Bernanke and the rest of the FOMC members. It was their creative handiwork that ultimately saved the day.

But make no mistake about it; there were some VERY big gambles with VERY large stakes involved. And the Fed's latest big bet is about to come into play.

Three BIG Bets - Two Big Wins (So Far)

In essence, the Federal Reserve wound up making three ginormous bets - to the tune of about $3.2 trillion!

Yep, that's right; the Federal Reserve has spent more than $3.2 trillion since 2008 on its efforts to save the economy/banking system as the Fed's "balance sheet" went from less than $1 trillion before the crisis to over $4.2 trillion as of last week.

The good news is that two of the three big bets appear to be winners at this stage. But it's the third one that has investors worried these days!

Bet #1: We Can Save the Banking System from Collapse

First, Bernanke's Gang bet that they could find a way to keep the banking system from collapsing during the crisis. Bear Stearns was gone. Lehman had fallen. Merrill was in a world of hurt. Heck even Goldman Sachs needed Warren Buffett to ride in on his white horse to save their bacon during that tumultuous few weeks.

While it was a very close call (many believe that money market funds "breaking the buck" would have caused the financial system to buckle and break), the Fed changed some rules (anybody remember a little thing called "mark to market?"), opened up the bank's vault, made some deals, and twisted a few arms in order to ultimately get the job done.

In short, this was a very big win. But unfortunately, it was akin to simply keeping the patient from bleeding out in the Emergency Room. No, it turns out there were other large problems to contend with. On to Big Bet #2...

Bet #2: We Can Keep the Economy Out of Deflationary Cycle

Next, the Fed bet that they could keep the U.S. from entering a deflation cycle. The good news was that the banks weren't going to collapse. But with stocks cratering and the value of real estate plummeting, Bernanke and friends knew they still had a great deal of work to do.

S&P 500 Weekly During The Credit Crisis

iShare Real Estate (IYR) Weekly During The Credit Crisis

So, the Fed cut rates. And then they cut rates again. And again. And again - until there was nothing left to cut. However, the economy just couldn't seem to get up off the mat.

The problem was that beginning in 2010, new crises cropped up with regularity. And the bottom line was that each new crisis caused the economy to stop on a dime. First there was Greece. Then there was, well, Greece. Then there was Ireland, Italy, Portugal, and Spain. Then there were the self-inflicted wounds from the boys and girls in Washington. And then there was... you get the idea.

Those Darn Europeans!

Many, including your truly, contend that if the European debt crisis hadn't caused investors to freak out every 6 months, the first round of Fed stimulus would have likely done the trick. But with it looking like the bad old days of the crisis were returning every spring, the economy just couldn't gain any momentum and the threat of recession remained constant.

In response, the Bernanke crew came up with something called "Quantitative Easing." The idea was for the Fed to buy up existing bonds and other securities every week in order to pump liquidity into the system. This was intended to keep rates low and to force those freshly minted dollars to be "put to work" in the economy somewhere.

It is important to realize that although the idea of quantitative easing definitely wasn't new, employing the tactic on a mass scale was a bit of an experiment (i.e. a big bet!) for the U.S. Federal Reserve.

While analysts are likely to argue about this tactic for decades to come, the bottom line is the implementation of QE programs I, II, and III (or were there actually four, or five?) has indeed kept interest rates low and pushed asset prices (think stocks, bonds, and real estate) higher.

And as the chart below clearly illustrates, it has been a pretty good time to own stocks and real estate.

S&P 500 Weekly From 2009

One of the oldest sayings on Wall Street is "Don't fight the Fed." This is especially true when they are "on a mission." So, with the Fed clearly on a mission to reflate the economy and increase asset prices, it's been a good ride in the stock market. And owning real estate hasn't been too bad an idea either.

iShares Real Estate (IYR) Weekly From 2009

So, while the game's not quite over, it's been so far, so good on this bet.

Bet #3: We Can Return Rates to "Normalized" Levels Without Issue

And finally, the Fed is betting that with the economy looking like it is finally on a growth path (fingers crossed!), they will be able to remove the myriad of stimulative efforts without the stock or bond market tanking.

Next time we'll talk about the final, and VERY big bet the Fed is making.

Turning To This Morning

Geopolitics remain in focus this morning as U.S. allies have signed on to the President's plan to combat ISIS. Across the pond, Industrial Production numbers for the Eurozone were above expectations (+2.2% vs. consensus of +1.3% and +0.2% last month on a year-over-year basis and +1.0% vs. +0.5% and -0.3% on a monthly basis) and the latest poll shows "No" votes remain ahead of "Yes" in Scotland. In addition, Super Mario made headlines yesterday afternoon when he said in a speech that the ECB could do more in terms of stimulative action. Here at home, investors are awaiting the August Retail Sales results for the latest look at the economy. At this time, futures are pointing to a slightly higher open on Wall Street.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    - Japan: +0.25%
    - Hong Kong: -0.27%
    - Shanghai: +0.88%
    - London: +0.27%
    - Germany: -0.20%
    - France: -0.02%
    - Italy: +0.22%
    - Spain: +0.21%

Crude Oil Futures: +$1.32 to $93.15

Gold: unchanged at $1239.00

Dollar: lower against the yen and euro, higher vs. pound.

10-Year Bond Yield: Currently trading at 2.566%

Stock Indices in U.S. (relative to fair value):
- S&P 500: +0.40
- Dow Jones Industrial Average: +3
- NASDAQ Composite: -0.60

Thought For The Day:

Empty pockets never held anyone back. Only empty heads and empty hearts can do that. - Norman Vincent Peale

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Positions in securities mentioned: None

Wishing you green screens and all the best for a great day,

David D. Moenning
President, Chief Investment Officer
Heritage Capital Research
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