In Ben We Trust

On Sunday evening, Federal Reserve Chairman Ben Bernanke appeared on “60 Minutes” to defend the controversial second round of quantitative easing, known as “QE2,” which involves the purchase of $600 billion in bonds. The program has been widely criticized by opponents, but Bernanke claims the policy will not lead to inflation, and told the country that he is not ruling out additional quantitative easing.

Bernanke and the Fed have been vilified by critics, and there are plenty of them. Not me. I love him, and here’s why:

 #1 Lehman Brothers

Bernanke let Lehman Brothers fail. With the U.S. financial system on the brink of collapse, not every incompetent institution could be saved, and I think if you had to pick a bank to fail it should be the one run by Dick Fuld. Yes, the refusal to bail out Lehman caused the market to crash, but that was going to happen anyway.

By letting Lehman fail, Bernanke was essentially saying the following:

1. To the nation: “We live in a capitalist country.”
2. To the other backs: “Get your act together.”
3. To Congress: “We need money to save the banking system, and we need it now.”

For a great read on this topic, check out David Wessel’s “In Fed We Trust.”

Next: What Does This Mean for Traders? 

Buy Puts on a Financial ETF

Allowing Lehman to fail showed that Bernanke is not afraid of Wall Street, and in 2011 and 2012, he will demand the banks raise more capital and begin to return to pre-financial-meltdown accounting standards.

By these standards, most large banks today are insolvent. This will create some great short opportunities in individual banks, and traders should consider long-term put options on the Financial Select Sector SPDR (NYSE: XLF). 

#2 TARP

The fall of Lehman led to Congress passing the Troubled Asset Relief Program (TARP). Under TARP, the U.S. Treasury was allotted $700 billion to buy mortgage-backed securities from institutions in an effort to create liquidity and un-seize the money markets.

TARP – the creation of Bernanke, former Treasury Secretary Hank Paulson, and current Treasury Secretary Tim Geithner, who at the time was president of the Federal Reserve Bank of New York – saved us. Despite its many critics, TARP was absolutely necessary to keep the U.S. financial system from collapsing and keep the country from succumbing to another Great Depression, the repercussions of which would have rippled through the rest of the already teetering global financial system.

Just two years after TARP was passed by Congress, most of the bailout money has been repaid, and in some cases, the U.S. Treasury even made a profit. For example, at the beginning of December, it was announced that the $45 billion bailout of Citigroup Inc. (NYSE: C) actually produced a $12 billion profit for taxpayers.

Next: What Does This Mean for Traders? 

Short Bank Stocks

The American public will not tolerate another bank bailout for both good reasons (the banks are still terribly managed) and bad ones (Senator Rand Paul and other economically illiterate Tea Party types). This means that it is now up to the banks to fix their own problems, which will result in lower profits in 2011 and 2012, as they boost loan loss reserves.

The banks with the greatest downside risk due to “surprise” loan loss provisions are Wells Fargo & Company (NYSE: WFC) and Citigroup Inc. (NYSE: C). The safest way to play this is with long-term put options. 

#3 Quantitative Easing

With the end of TARP, and public bailouts no longer a viable option, there was a need for more liquidity from another source, namely quantitative easing. Quantitative easing is a means to stimulate the economy by increasing the supply of money in the system and increasing the excess reserves of banks, i.e., printing money.

The second round of quantitative easing, QE2, is already under way, and Bernanke has made it clear that the Fed will embark on QE3 if necessary. Many are up in arms over this policy, but the thing that I love most about it is that it makes for very predictable ways to profit.

Next: What Does This Mean for Traders? 

How to Profit From Quantitative Easing

There are two obvious ways:

1. The Inflation Trade: Unfounded fears of inflation are driving traders to precious metals, especially gold and silver. Buy call options on the SPDR Gold Trust (NYSE: GLD) and iShares Silver Trust (NYSE: SLV).

2. Currency Debasement: Unfounded fears that the Fed is destroying the value of the U.S. dollar mean more purchases of not only precious metals, but other commodities as well. Buy calls on the United States Oil Fund LP (NYSE: USO) and selected oil drillers.

You’ve all heard the saying, “Don’t fight the Fed.” When the Fed prints more money, it creates liquidity, which fuels purchases of stocks and other assets, and this pushes up (or at least sustains) equity markets. Why is Bernanke so concerned about supporting the markets? A fear of further deflation in assets. And that leads me to the fourth reason I love Big Ben … 

#4 Deflation

Ignore the pundits and politicians who have read a few chapters by Milton Friedman and think they know something (or anything) about monetary theory. These economic illiterates believe the expansion of the Fed balance sheet means more inflation and debasement of the U.S. dollar. They do not understand that classical monetary theory was developed in a bygone era of fixed exchange rates and the gold standard.

What we have today are radically reduced asset prices, and when you combine that with price measures for goods and services, it is clear that deflation has been the real issue for more than two years. And there is only one way to fight deflation: forcing more liquidity into the financial system. Even Friedman would have said so. The Fed will continue to increase liquidity as long as asset prices are under pressure.

Next: What Does This Mean for Traders? 

The Deflation Trade

As long as deflation remains a chief concern, more quantitative easing is practically inevitable.

The best way to trade this is to go long Treasurys, which you can do with call options on the iShares Barclays 20+ Year Treasury Bond Fund (NYSE: TLT) or puts on the ProShares UltraShort 20+ Year Treasury Fund (NYSE: TBT). You can also go long the U.S. dollar with calls on the PowerShares DB US Dollar Index Bullish Fund (NYSE: UUP). 

#5 Independence

The final reason that I love Ben Bernanke is the simplest: The man is independent. He reports to no one. He listens to, but does not have to obey politicians.

Capitalism requires an independent central bank, because as the greatest financial and economic crisis since the Great Depression has shown us, when desperate CEOs and politicians lose their minds, the Federal Reserve does not.

Michael Shulman is the editor of Short-Side Trader. Contact him at mshulman@investormedia.com.