How Central Banks Attempt to Prop Up the Economy

The Dow Jones Industrial Average tumbled about 100 points yesterday — probably not because anyone really wanted to sell stocks, but because no one could think of any really good reason to buy them. This morning, the Dow is soaring more than 300 points — probably not because anyone really wants to buy stocks, but because no one can think of any really good reason to sell them again.

In short, the financial markets are reflecting what our friend, John Mauldin, calls a “muddle through” economy.

Notwithstanding this morning’s buoyant stock market action, the euro zone is still in crisis, the finances of most governments in the Western world are still in shambles… and Bank of America’s share price is still hovering around five dollars — just like it was in March of 2009, when then-Treasury Secretary Paulson and Federal Reserve Chairman Ben Bernanke were busy patting each other on the back for “saving” the financial system.

Toward the end of yesterday’s trading session, Bank of America’s share price actually slipped below five dollars per share for the first time since mid-March 2009. That event may or may not be significant, depending upon which rumors one chooses to believe.

One of the juiciest rumors of the moment is that the Federal Reserve is desperately trying to prop up Bank of America, under the guise of helping to “save the euro.”

For example, the last time Bank of America’s share price flirted with five dollars was November 29. The stock hit $5.03 during that trading session before closing at $5.08. The following morning, at the crack of dawn, the Federal Reserve announced its latest “coordinated intervention” with the European Central Bank and a bevy of other central banks. Stock markets around the world skyrocketed on the news. Distressed financial stocks like Bank of America’s skyrocketed most of all.

Therefore, as we noted in the December 5th edition of The Daily Reckoning, “[The King Report] speculates that problems here at home may have also spurred the cavalry into action. ‘Fed concern about Bank of America was probably a prime factor in implementing the latest scheme,’ says King. ‘If BAC had fallen below $5, there could have been an avalanche of selling because some institutions cannot buy or hold a stock that is less than $5 per share. A cascading BAC could have generated an “Emperor has no clothes” moment for BAC. (Buffett would have been chagrined). So it was imperative that someone closed BAC above $5 on Tuesday and that some scheme had to be implemented to drive the price higher on Wednesday.’

“So just as expected/hoped,” the December 5th Daily Reckoning continued, “the markets rallied sharply on Wednesday, enabling BAC and a few other troubled financial institutions to live to fight another day. But the fight is far from over…and the troubled financial institutions are unlikely to emerge victorious, no matter how many times the central bank cavalry storms into battle.”

As predicted, the central bank intervention announcement on November 30 produced a very sharp, dramatic rally. Bank of America’s shares rallied as much as 16%, while the shares of many other banks and finance companies rallied even more. Nevertheless, by the end of yesterday’s trading session, those fleeting gains had more than disappeared… and there sat a forlorn Bank of America, priced at $4.98 a share

Citigroup, Goldman Sachs and Bank of America since Central Banks' Cooridinated Intervention

Then the cavalry charged in once again!

Is it not somewhat curious, that today’s 320 rally seemed to come out of nowhere, on no major news whatsoever? Is it not also somewhat curious that the stock market happened to the soar the very next morning after Bank of America fell below $5?

These kinds of coincidences are almost enough to make me believe crazy rumors.

Oh, wait a minute, there was some bullish news out of Europe this morning. The Spanish government managed to sell a few bonds to “the public.” This announcement sparked a rally in Europe that continued into the New York trading session. But once again, if you believe some of the crazy rumors going around, the “successful” Spanish bond auction had the Fed’s fingerprints all over it.

According to the scuttlebutt, European banks snapped up the Spanish debt — these very same European banks that are already choking on life-threatening quantities of Spanish, Italian, Portuguese and Greek debt. So why would they buy even more of this stuff?

Two reasons: 1) The banks have a large, vested interest in preventing the prices of the sovereign bonds they already hold from falling even more and; 2) Thanks to the Federal Reserve, these banks now have access to extremely cheap, unlimited funding through the swap lines the Fed announced on November 30th. (The banks also have access to very cheap 3-year credit lines from the ECB).

Let’s call this whole shebang, “Backdoor Quantitative Easing.”

Even if the details of this Backdoor QE theory are somewhat off base, the substance of the theory is certainly dead on. Somehow or other, you can be sure that the Fed and the ECB are busy “fixing things”…and utilizing clandestine tactics to do so.

But so far, the troubled banks of America and Europe are still as troubled today as they were three weeks ago, and many of them are more troubled than they were three years ago, when the Fed moved full-time into the bank-rescue business.

Of course, the Fed and the ECB have financial problems of their own.

“No matter how you slice it,” observes our friend Dan Denning, editor of the Australian Daily Reckoning, “many of the world’s governments need money. If the private markets don’t give it to them, their central banks will have to do the job. This will lead inevitably to money printing and currency devaluation. The amount of money these governments require is staggering.

“Industrialized Welfare State governments will have to borrow some $10.4 trillion next year, according to the Paris-based Organisation for Economic Cooperation and Development (OECD),” Dan continue. “That’s a lot of money. The countries doing the bulk of the borrowing are in Europe. Don’t forget America. The chart below shows that nearly 60% of total US Treasury debt outstanding — or $5.6 trillion — must be refinanced in the next four years.”

Maturity Dates of Marketable Debt Held by the Public as of 9/30/11

Where is that money going to come from?

It’s hard to say where the money will come from, but it’s easy to say where it will not come from. It will not come from private citizens who are looking to park their cash in safe and secure investments. There aren’t enough folks with actual money to invest who are willing to lend that money to a bankrupt government. So in order to fill this $10 trillion funding gap, we should expect a few more quantitative easing programs and other forms of money-printing.

Meanwhile, we should also expect a lot more attempts by government powers to repel the forces of economic nature: More “coordinated central bank intervention,” more “emergency landing facilities,” and more ad-hoc, too-big-to-fail remedies.

So at least we’ve got that going for us — a lot more of the stuff that hasn’t worked… and never will.

Buy gold…some more.

Eric Fry
for The Daily Reckoning