Federal Reserve

Sprott Asset Management has "pulled forward" something I intended to cover in my "year end review" Ticker but since he's put it out there I think I need to cover it now:

As a thought experiment, we separated all the various US Treasury owners and asked our readers whether each group could afford to increase their 2009 treasury purchases by 200%. In the end, we surmised that most groups couldn’t, and prepared our readers for the worst.

Almost seven months later, however, nothing particularly bad has happened on the US debt front. There have been no failed auctions, no sovereign defaults, no downgrades of debt and no significant increase in rates…not so much as a hiccup in the treasury market. Knowing what we discussed this past June, we have to ask how it all went so smoothly. After all – it was pretty obvious there wasn’t enough buying power to satisfy the auctions under ‘normal’ circumstances.

In the latest Treasury Bulletin published in December 2009, ownership data reveals that the United States increased the public debt by $1.885 trillion dollars in fiscal 2009.

....

To our surprise, the only group to actually substantially increase their purchases in 2009 is defined in the Federal Reserve Flow of Funds Report as the "Household Sector". This category of buyers bought $15 billion worth of treasuries in 2008, but by Q3 2009 had purchased a whopping $528.7 billion worth. At the end of Q3 this Household Sector category now owns more treasuries than the Federal Reserve itself.⁸

If you believe that you're more gullible than I.

Here's why.

The 2009/3Q Z1 shows an alleged annualized inbound (purchase) flow rate for "households" of $742.9 billion.  This was exceeded only by the 1Q 2009 number of 1066.5, which in the context of the stock market meltdown makes perfect sense.  Likewise, in 2008 Q2/Q3 when the market was falling apart flow rates into Treasuries by households were very heavy as well.

Before you write this off and say "oh but people still are scared and thus not willing to invest in the stock market" you better look below at the Money Market Mutual Fund holdings!  In Q1, Q3 and Q4 of last year this segment saw massive buying of Treasuries.  Not so this year - Money Market funds have been NET SELLERS all year long, and in Q4 the rate of selling has dramatically increased, mostly as a consequence of broker/dealer sales. 

This, of course, is perfectly consistent with the stock market rising - money flows out of Money Market funds and into equities, thus causing Money Markets to be net sellers.

So how is it that "Households" allegedly are (individually, via Treasury Direct?) buying Treasuries at a $700+ billion annualized rate when the other categories under which "households" transact in the markets - via money market accounts, mutual funds and similar instruments - are showing either small increases or significant net sales?

There are other oddities in the Z1 as well related to net borrowing and lending - one of the more important being the fact that GSEs suddenly became negative net borrowers to the tune of more than a half-trillion dollars in the second and third quarter!  Wait - they're paying down outstanding lending commitments?  I thought The Fed was absorbing all their net new issue and Treasury was backstopping their operating costs?  Hmmmm...... is someone trying to de-lever due to knowledge of "fun times" to come in 2010? Perhaps Timmy knows too, eh?

The two companies, the largest sources of mortgage financing in the U.S., are currently under government conservatorship and have caps of $200 billion each on backstop capital from the Treasury. Under the new agreement announced today, these limits can rise as needed to cover net worth losses through 2012.

Hint: Treasury believes those losses are going to be massive, and so do the GSEs, judging not by statements but by their behavior.

Commercial banks are neither lending OR borrowing, and after what looked to be a let-up in their divestment in the 2nd Quarter it has picked up bigtime once again in their third.  Again: What do they know that we're not being told about their losses?

I have previously opined (in October) that it is more than a bit unlikely that "Caribbean Banking Centers" have the GDP (or sovereign wealth) to support more than $200 billion in Treasury Security acquisitions:

Who is the real holder of all the Treasuries in "Caribbean Banking Centers"?  You don't actually expect me to believe that little islands like Antigua and Grand Cayman have the sovereign wealth to support holding nearly two hundred billion dollars of Treasuries, do you?  Is that a vehicle by which back-door monetization can (and has) taken place?  Germany, with a real economy and government, by contrast holds a mere $55 billion dollars, and even Russia (and Hong Kong!) have only $121 billion.

Yeah.

Now we have more than $500 billion in further discrepancies that make absolutely no sense, especially when one looks at the rest of the patterns in the Fed's most-recent Z1 release.

This, of course, begs the obvious question:

Who really "bought" that Treasury debt - and did it really "subscribe"? 

Or is the truth that there were in fact no buyers for upwards of half of the total Treasury issue in the last year and it was instead monetized - one third openly via Federal Reserve "open market" purchase, and the other two-thirds via "covert" or "stealth" means, complete with bucketing the alleged "buyers" into categories in The Fed's and Treasury's data releases?

Release Date: December 16, 2009

For immediate release

Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating.

Those of you without jobs are now rolling off the unemployment rolls, so you don't count any more.  We in Washington DC and on Wall Street have our huge bonuses back, and thus the labor market - what we see of it anyway, is doing better.

The housing sector has shown some signs of improvement over recent months. Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit.

Credit continues to contract as shown by our most-recent Z.1 (below), but we're not going to tell you that:

This, of course, means that people are spending a higher percentage of their incomes.  That in turn means that the squeeze - especially on the middle class - is getting acute.

Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales.

Walmart and others are laying off seasonal help ahead of Christmas because, surprise-surprise, sales suck!

Financial market conditions have become more supportive of economic growth.

We continue to pump the markets with every opportunity but unfortunately the effects are failing.  We are thus forced to lie lest you discern that the curtains are on fire and bolt for the door.

Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

Our stated purpose was to restart private credit expansion.  We failed.  See the above chart.  We are thus forced to lie (didn't you read it the first time?)

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

Gasoline is up 38% y/o/y, but this doesn't count as "inflation."  In point of fact, we do have deflation - and lots of it - since credit is the monetary base.  Oops.  (There's that damn chart up above again!)

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

I hear there is exceptionally strong support at zero.  For everything.

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.

We will keep illegally buying Fannie and Freddie paper.  We will also keep calling them "agencies" even though they are clearly not, as defined by The United States government itself.  Remember, we lie.

In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.

We're preparing to do this:

(That, by the way, is why there's an ammunition shortage!)

In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve’s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral. The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.

All this crap failed to work - again, as I said before, the goal was to restart private credit expansion.  It didn't - it's still contracting.  Indeed, the really bad news is that even with all the government games total credit outstanding is contracting EVEN WITH government "borrow and spend" - an unprecedented problem.

At some point you have to give up.  That point is now.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Go long gasoline and matches for this feature presentation in The New Year:

Now we got a problem.

Bernanke was named Time's "Person Of The Year"; in doing so Time has added him to their illustrious list of persons....

Whether Bernanke wants to be in the company of these individuals is another matter.  Here's the list of those who I believe have as their legacy that which most-closely approximates what Bernanke will be known for 10 or 20 years hence:

Why?  Because Bernanke's actions have singularly done more damage to the American economy - and America - than anyone in the history of this nation.  He clearly eclipses Nixon in his dissembling, while making a mockery of the free market. 

Just like those other infamous persons pictured above he has acted in the belief that he can do so without consequence on the world stage. 

This notion is not easily disabused, but in the end it always proves false.

Today's lesson in falsity is the announcement, long rumored, by the Gulf States that they will be forming a common currency, breaking the formal and informal dollar pegs that have controlled the price of oil and kept the petro-dollar recycling mill operating, allowing The United States to force our inflationary policies down the Arabs' throats.

“The Gulf monetary union pact has come into effect,” said Kuwait’s finance minister, Mustafa al-Shamali, speaking at a Gulf Co-operation Council (GCC) summit in Kuwait.

The move will give the hyper-rich club of oil exporters a petro-currency of their own, greatly increasing their influence in the global exchange and capital markets and potentially displacing the US dollar as the pricing currency for oil contracts. Between them they amount to regional superpower with a GDP of $1.2 trillion (£739bn), some 40pc of the world’s proven oil reserves, and financial clout equal to that of China.

Potentially displacing my tailfeathers.  That displacement is now assured.

Oh, and it doesn't stop with just money either:

The GCC also agreed to create a joint military strike force – akin to the EU’s rapid reaction force – to tackle threats such as the incursion of Yemeni Shiite rebels into Saudi territory earlier this year.

They nevertheless repeated on Tuesday that “any military action against Iran” by Western powers would be unacceptable.

Well there you have it.

China will be next with a Pan-Asian common currency and exchange system.  The rumblings have been coming from there too, and they'll be followed by action - if for no other reason than that with the unpegging of oil from the dollar there is no longer any reason for China to continue to maintain a dollar hegemony of its own, and in fact doing so could be extremely damaging to China's economy.

Bernanke is entirely responsible for this.  By encouraging the bubble economy during Greenspan's time in The Fed (Bernanke was the chief agitator for 1% interest rates - and holding them too low during the early part of the 2000s) and trying to restart the bubble economy this time around through both ZIRP and intentional distortions through the credit markets, shielding those who made bad decisions while cramming the inflationary pressures down the throat of trading partners, Bernanke has guaranteed the loss of global reserve currency status for The Dollar.

Our Senate is too stupid to recognize this and stop his re-nomination. 

You can take that to the (insolvent) bank. 

Yet a failure to do so - a failure to reject Bernanke for a second term - will result in the acceleration of action by China and The Gulf States.  Before Bernanke's next term expires you will see the dollar decoupled and left in the sand as the former anchor of global trade.  You will see import prices in dollar terms - especially oil and similar commodities - skyrocket.  You will see the destruction of America's way of life.

None of this was unforeseeable.  Defending the currency isn't just Treasury's problem - it is yours as well when you act as Treasury's handmaiden by giving them free license to issue Treasuries into a zero-interest-rate environment for deficit spending purposes.

Stand and take a bow Ben - your true legacy will be recognized in the fullness of time.

Mark my Ticker.

Senator Bunning sent in a written request to Bernanke following his re-confirmation hearing - and Bernanke has responded.  You can read the entirety of both; I am going to focus this Ticker on one section that I have repeatedly opined upon, as there is apparent clarity here:

The legion of misdirection and lies from The Fed continued yesterday, with this ditty from NY Fed President William Dudley:

The actions undertaken by the Federal Reserve over the past two and a half years have been critical to stabilizing the financial system and preventing the extraordinary distress in markets from causing a deeper and more protracted economic downturn.

The actions taken by The Federal Reserve were necessitated by the previous actions taken by The Federal Reserve.

Yes, that's circular.  It is also true.

That said, there is also no question that the Federal Reserve and other regulators could have done more to prevent this crisis.

Following the law would have been a good start.  You know, basic laws that say that you can't misrepresent the credit quality of things you sell (securities laws) and you can't claim to have a "hedge" against something when the counterparty to the trade has no capital (AIG anyone?), for openers.

Turning to the first issue, identifying asset bubbles in real time is difficult.

Not really.  A stock index selling at a P/E of 80 is clearly overvalued.  Likewise one that is selling with a dividend payout ratio less than half the historical average.  Both suggest valuations are so stretched as to be driven not by fundamental value, but rather by debt pyramiding.

To take one recent example, there was a tremendous increase in financial leverage in the U.S. financial system over the period from 2003 to 2007, particularly in the nonbank financial sector. This sharp rise in leverage was observable.

Let's be clear Mr. Dudley: The sharp rise in financial leverage occurred because the at-the-time head of Goldman Sachs, one Henry Paulson, went to Washington DC and lobbied the SEC to remove the leverage limits from investment banks.

He in fact went twice - in 2000 when he was rebuffed, an again in 2004 when his request was granted.  The Fed sat back and did nothing in either instance.

This suggests that limiting the overall increase in leverage throughout the system could have reduced the risk of a bubble and the consequences if the bubble were to burst.

There was a limit.  It was removed by the efforts of the aforementioned Henry Paulson.  The Fed has not demanded that the former limit for investment banks be restored. 

Nor does it stop there.  Alan Greenspan allowed gross and outrageous increases in financial leverage through his bastardization of reserve requirements via sweep accounts, and Ben Bernanke asked for and got the ability to set reserve requirements to zero - that is, to allow infinite leverage - in the EESA/TARP legislation.

On the other hand, however, there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage.

This, of course, is why we have a zero interest rate right now as a new bubble has been blown, correct?  It is why the zero interest rate has not been increased?

For example, the Federal Reserve has been singled out for criticism about the failures of supervision even though it did not have any regulatory responsibility for many of the largest U.S. financial firms that collapsed during the crisis

That's true in the case of AIG, for example.  But The Fed did have supervisory responsibility for the banks that traded in CDS positions with AIG, and as such could have prevented the establishment of positions for which AIG lacked the capital to perform. 

Bluntly, The Fed failed in discharge of its duties.

In a perfect world we would be able to prevent those individuals and institutions from benefitting; we would have a better way to penalize those who acted recklessly. But once the crisis was underway, one goal took precedence: keeping the financial system from collapsing in order to protect the nation from an even deeper and more protracted downturn that would have been more damaging to everyone.

That would be nice except that The Fed caused the bubble and subsequent collapse. 

This argument is similar to the fireman who is also an arsonist.  After setting the fire he claims he must be allowed to put it out, lest other structures burn as well.

That may be true but does not excuse his use of the gas can and matches just minutes before.

Going forward, the Federal Reserve and other regulators need to move aggressively to change the system so we don’t ever find ourselves in this position again.

You could start by taking responsibility for your blatant, outrageous and reckless disregard for risk, your mathematically-bankrupt credit support policies that are impossible to sustain and in fact illegal under the black letter of The Fed's mandate, and demand that all alleged "credit instruments" be backed with actual capital and nightly supervision - in particularly in the OTC derivative market.

Instead The Fed has made excuses for all of the above.  Profit before safety, just as with the arsonist-cum-firefighter - the firefighting salary is sufficient to make the rent but when you can also collect $10,000 per pop for setting the fires, why that's good money!

2010 is also likely to be a more moderate growth period because we still face quite a few headwinds generated by the hangover of the financial crisis. The banks are still under pressure in terms of credit losses. The shadow banking system is still impaired and securitization activity is recovering very slowly. For example, last month we saw the first commercial mortgage-backed securities (CMBS) deal in a year and a half. This means that the constraints on credit availability will take considerably more time to fully abate.

Those constraints cannot "abate" until debt levels to GDP come back into balance.  The Fed has done a horrifyingly bad job of this for the last 20 years and shows no sign of improvement:

If growth is subdued, this implies that the unemployment rate will stay high and inflation will stay low. If this outlook is broadly correct, this suggests that it will be appropriate to keep the federal funds rate target exceptionally low for an extended period.  One risk in the outlook is that inflation expectations could become less well-anchored. This could conceivably occur for several reasons. First, people may worry that the expansion of the Federal Reserve’s balance sheet and the increase in the Federal debt will prove inflationary over time. Second, some may worry that the Congress could take actions that would call into question the Fed’s independence with respect to monetary policy and that this could cause the Fed to be less willing to tighten monetary policy in a timely way in the future.

In a word: Bah.

The real risk is in the above graph.  Real rates of interest - that is, the rate charged by a willing lender of private capital - is largely determined by both inflation expectations and credit risk.

Credit risk is, to a large degree, determined by the debt-to-income ratio of the borrower.  Taken as a nation we currently have 350% of our gross income (GDP) out in debt.

Were you a certified financial planner you would likely counsel an individual coming to you with such a profile that such a debt-to-income ratio is dangerously close to the wall where a death-spiral leading to insolvency could occur.  Further, you would likely note that their continued ability to make the payments was dependent on extraordinarily low interest rates - rates that have fallen while their credit quality has deteriorated, which is an inherently unstable - and dangerous - situation.

You would counsel them to reduce their debt load immediately to something more reasonable.

But you're not doing that are you William? 

Why not?

On the issue of the size of the Fed’s balance sheet, the worry among some is that the rapid growth of the Fed’s balance sheet will ultimately lead to an inflation problem. This anxiety stems from the fact that periods of rapid growth of the monetary base (that is, currency plus bank reserves) in the past have typically been followed by rapid credit growth and inflation.

That's backwards.  Credit growth leads.  But it's immaterial.

No, the real problem is that your balance sheet is stuffed full of used toilet paper.  By becoming the market for MBS you have distorted the market price to a never-before seen degree, allowing banks to hold similar paper at marks that are entirely unrealistic.  Given the leverage in the system this has prevented them from detonating - after all, even a 5% markdown from par, when multiplied by 20:1 leverage is enough to destroy a 10% "Tier 1" ratio, leaving a smoking hole where a bank once stood.

This sort of accounting gimmickry is how ENRON blew up - literal make believe on market prices.  When the truth came it arrived fast, cold, dry and hard.  Perhaps you'd like to explain how it will be different this time?

We should think about how market participants will react to the potential politicization of the monetary policy process. Knowing that a decision to raise interest rates today might be criticized by the GAO six months later, market participants could begin to worry about the Fed’s willingness to make tough choices in terms of tightening monetary policy.

The Fed has utterly failed to hold credit aggregate growth in line with GDP for more than two decades as is clearly shown by the above chart. 

There is absolutely no reason to believe that you will begin to perform in line with your lawful mandate any time soon, and until there is, such a concern as you raise above is utterly without merit.