Now Goldman Sachs Clueless as to Effects of Fed Policy

As discussed recently here and on EPJ Central, mainstream economists--even those anointed by the heavens--just don't have a handle on the enormous implications of Fed policy. Goldman Sachs' Jan Hatzius writes as follows:

Chairman Bernanke also outlined three possible tools for further easing: (1) to strengthen the commitment to keep short-term rates "exceptionally low for an extended period;" (2) to cut the interest rate on excess reserves (IOER) from its current 25-basis-point level; and (3) to resume asset purchases. He also said that the FOMC would review all of its options, including the possibility of reinvesting MBS prepayments and redemptions. Currently, these proceeds are not being reinvested, with the result that the Fed's balance sheet is set to shrink slowly over time. This amounts to a slight tightening bias in the current policy stance, albeit one that may not have much effect given the enormous volume of excess reserves in the system. With the IOER already close to zero, we see little to be gained from cutting it further, other than to signal a switch in policy orientation. The incentive for banks to make new loans would increase only marginally, while money market funds would have a tougher time eking out positive returns as yields on other short-term assets moved even closer to zero. Besides, the FOMC could send the same signal by taking up the MBS reinvestment option. Although it is a close call, we now expect this to occur at next week's meeting.

To his credit, we are in agreement with many of Hatzius' assessments, including the fact that MBS cash flows into the Fed have a slight policy-tightening bias, as we discussed the other day. However, there are several hidden and incorrect assumptions in the statement, "IOER is already close to zero". "Zero" is largely unimportant as both an absolute level and from the perspective of what is relevant to measure IOER against. As interest rates are manipulated by the Fed, we do not know what real interest rates are (that is, interest rates absent government intervention that reflect actual time preference and inflation expectations). Similar to temperature (on a non-Kelvin scale), the zero level is more important as a psychological boundary, and not the all-important inflection point it is made out to be. [And, there is really no reason why IOER could not be negative--thus no downside limit. In the topsy turvy world of quantitative easing, we have already surpassed the level once considered undoable.]

What is relevant is the spread of IOER to other short term rates on the lower end of the yield curve--namely, (1) the Federal Funds rate paid on uncollateralized overnight loans between banks and other large financial institutions and (2) short term Treasury Bill rates. As of Friday, August 5, the Fed Funds rate was 0.19%, and the 1, 3 and 6 month T-Bills were yielding between 0.15% and 0.19%. Even 1 to 2 month investment grade commercial paper has been yielding less than the IOER.

This means that banks can leave their excess money at the Fed and get paid 0.25% every night, as opposed to lending to another bank at the lower rate of 0.19% or locking the money up in Bills or commercial paper for a month or more. [It's also important to know that the reason the Fed Funds rate, which is uncollateralized, is less than the IOER is largely because the biggest lenders are Fannie and Freddie, both ineligible to park their money at the Fed because they are not banks.]

Accordingly, were the Fed to lower the IOER to say 0.10%, several investment options would immediately become more attractive to banks and a material amount would likely leave the custody of the Fed. How much and in which directions cannot be known, but the implications should not be ignored simply because the spread is seemingly small. We're talking over $1 trillion of leveragable cash held by banks. They might not loan it to businesses and consumers, as Hatzius concurs, but never underestimate the influence of vast amounts of digital zeroes suddenly searching for a new home.

The danger is that, because a change in Fed policy with respect to the interest on excess reserves is incorrectly being discounted as relatively innocuous, it has tremendous power to inflict unforeseen effects on the economy. Leave it to Ben and his sandbox of tools? No thanks.

Via ZeroHedge

Can the Fed Inflate the Money Supply at Will? My 2 Cents....

See here for the Mish/Ciovacco "debate" and RW's comments. The following is to explain the actual mechanics of what will likely happen in the near future.

James Bullard of the St. Louis Fed recently proposed via a research paper that the Fed resume quantitative easing. However, the FOMC is expected to announce next Tuesday that the Fed will merely reinvest its MBS cash flows in Treasurys. This is considered reserve-neutral (though most certainly not impact neutral).

The NY Fed's System Open Market Account, or the world's largest hedge fund as I like to call it, has $1.1 trillion in MBS outstanding. For simplicity, we'll ignore prepayments and say the average coupon is 5%. Therefore, $55 billion per year is being transferred out of the economy (and into the Fed) from people paying down their mortgages. M2 money supply as of July 26 is 8.556 trillion, so M2 is being deflated by 0.65% annually just as a result of this phenomenon, which is material when M2 growth has been anemic at under 2.5% for all of 2010.

The Federal Reserve Act allows the Fed to exchange maturing securities (Treasurys/Agencies/MBS) with the issuer (Treasury/Fannie/Freddie). However, it would be a violation to simply use MBS cash flows to purchase directly from the Treasury. Accordingly, the NY Fed will buy already issued T-Bills, Notes and Bonds from the 18 primary dealers through what are called permanent open market operations (POMO). This is where the NY Fed intentionally buys above market prices for securities to entice dealers to sell (or vice versa for POMO sales that soak up reserves).

While a dealer might acquire inventory from other institutions or the public for the specific purpose of selling to the Fed, most of the securities the Fed buys will be from the dealers' unhedged portfolios they acquired directly from the Treasury at auction. This means most of the $55 billion that was transferred by the public to the Fed will be transferred by the Fed to the dealers, who may then deploy it as they wish. This money may or may not enter the economy, as it could simply lay fallow as excess reserves at the Fed. Or, it could be funneled into proprietary trade positions, such as equities (as we saw in the second and third quarters of 2009), derivatives, precious metals, or more Treasurys.

Seldom is either deflation or inflation omnipresent in an economy. Despite the ongoing consumer and bank deleveraging, large amounts of free money will always look for a market in which to bid up prices. Will $55 billion a year be enough to inflate a particular market or sector of the economy? Maybe, maybe not. However, it is inevitable that at some point in the future we will return to crisis mode to an extent that will goad policymakers into demanding a much larger amount of printing. As there is no end in sight to mammoth deficit spending, that time will not be the last either. Accordingly, the risk of money printing overshoot with resulting across-the-board inflation is real and should not be ignored.

Did Top Bank Officials Just Admit the Fed Will Backstop All Munis?

Each quarter, representatives from the banking elite primary dealers meet with top Treasury officials to advise an optimal debt issuance strategy. The Minutes of these Treasury Borrowing Advisory Committee meetings and formal Report to the Treasury are a window into their perceptions and insider knowledge, yet they seldom receive notice--even outside the mainstream financial news outlets. Surprising, because there are often a few hidden gems, and today's release is no exception as we learn that it is now the PDs' foregone conclusion that the Fed will backstop the entire municipal bond market. Indeed, the Report offers a statement not covered in the more lengthy Minutes:

Implicit in this analysis is the Federal government's willingness to intervene in the event the municipal market ceases to function.

Also present is the typical cluelessness regarding the Fed's "accomodative" stance, covered at length here at EPJ:

The Fed has limited tools to employ should growth disappoint or inflation expectations fall precipitously.

At least they can recognize a wounded duck economy when they see it, unlike Bernanke:

[Deputy Assistant Secretary] Rutherford also suggested that the risks to the recovery have risen since the committee last met in May.

Below are the full Minutes followed by the Report. Highlights and bracketed comments were added by the author, who apologizes for the sparse annotations, which are all time allows.

http://www.treas.gov/press/releases/tg801.htm

To view or print the PDF content on this page, download the free Adobe® Acrobat® Reader®.

August 4, 2010
tg801

Minutes of the Meeting of the Treasury Borrowing Advisory Committee

Minutes of the Meeting of the Treasury Borrowing Advisory Committee

Of the Securities Industry and Financial Markets Association

August 3, 2010

The Committee convened in closed session at the Sofitel Hotel at 10:03 a.m. All Committee members were present. Assistant Secretary for Financial Markets Mary Miller, Deputy Assistant Secretary (DAS) for Federal Finance Matthew Rutherford and Director of the Office of Debt Management Colin Kim welcomed the Committee. Other members of Treasury staff included Fred Pietrangeli, Nathan Struemph, Alfred Johnson, and Veena Ramaswamy. Federal Reserve Bank of New York members Richard Dzina and Fabiola Ravazzolo were also present. The Chairman of the Committee introduced one new member, Ruth Porat.

DAS Rutherford opened the discussion with a presentation to the Committee that highlighted current fiscal conditions and financing needs. The presentation began with a review of the near term budget outlook and projections for the upcoming year. DAS Rutherford noted that the economy continues to grow at a moderate pace, with economic activity expanding at a 2.4 percent annualized pace in the second quarter.

He also stated that tax receipts continued to gradually improve, led by robust increases in the corporate figures. There was a brief discussion about the evolution of tax receipts following recessions. DAS Rutherford indicated that the recovery of the receipt base following the trough in GDP in the current recession was similar to previous downturns. However, he underscored that the economy contracted much more sharply in the current recession, leading to a lower base level of receipts. He noted that the Administration is expecting receipts to total 14.7 percent of GDP in FY 2010, below the 50-year average of approximately 18 percent.

DAS Rutherford explained that the Administration had recently released the mid-session review of the President's budget. The budget deficit for FY 2010 was revised down to $1.471 trillion, although the FY 2011 deficit was revised up to $1.416 trillion. Rutherford noted that primary dealer economists anticipate a smaller budget deficit for FY 2010 than the figures given by the Administration in July. The average deficit forecast from the primary dealers for FY 2010 is $1.351 trillion, $120 billion below OMB's forecast.

DAS Rutherford also suggested that the risks to the recovery have risen since the committee last met in May. As a result, Rutherford indicated that debt managers must remain extremely flexible to respond to changes in borrowing needs. He noted that there was still scope to continue to reduce auction sizes further, but that the reductions would likely occur at a more gradual pace. DAS Rutherford indicated that once these cuts are complete, Treasury will likely hold auction sizes constant for a period of time to assess the fiscal outlook.

Rutherford then discussed auction dynamics. Coverage ratios remain extremely high for bill, note, bond, and TIPS auctions. DAS Rutherford also highlighted that domestic funds have increasingly become more active in the Treasury market. There was a brief discussion on bank purchases of Treasuries. It was noted that banks have more than doubled their holdings of Treasuries in the past 2 years. This was largely attributed to weak loan demand, as well as potential changes surrounding liquidity requirements in upcoming bank regulation. Rutherford also noted that increased demand for duration has lead to an increase in STRIPS outstanding.

Director Kim then turned to the current state of the Treasury portfolio. Overall, the bills as a share of the total outstanding portfolio continue to fall. He noted that bills (including SFP) currently make up 22 percent of the portfolio, compared to the pre-crisis average of around 24 percent. The decline reflects the transition to coupon financing, as nominal coupons' share has risen to 71 percent. Treasury inflation-linked securities (TIPS) currently comprise 7 percent of the portfolio and issuance in this program will continue to steadily increase over the next year. For calendar year 2010, Treasury expects to issue between $80 and $85 billion in TIPS. Issuance will gradually increase again in 2011 as Treasury expects to increase the frequency of auctions.

Kim noted that the average maturity of the portfolio continues to lengthen. The average maturity of the debt currently stands at 58 months, directly in line with the average observed since 1980. Going forward, Kim indicated that the average maturity of the debt will gradually extend further, largely due to the fact that Treasury continues to hold monthly coupon auctions across the entire yield curve. However, he noted that any further extension will likely occur at a slower pace than what has been observed over the past year. Ultimately, he underscored that Treasury must retain its flexibility in order to respond to a range of financing scenarios.

Rutherford then briefly concluded with a few comments on the longer-term fiscal challenges facing Treasury. There was a discussion about the changes made to the President's 2011 budget in the mid-session review. One member asked about the macro growth assumptions underlying the Administration's forecast. Rutherford indicated that the real GDP growth assumption was approximately 4 percent over the next several years. Another member asked about assumptions regarding the extension of the 2001 tax cuts. Rutherford explained that the Administration used an assumption of eliminating tax cuts for those earners with income over $250,000, and that such an assumption added $37 billion per year to revenue. Additionally, he indicated that the bipartisan fiscal commission is currently working to identify policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run. Rutherford noted that the Administration and Congress await their recommendations, which are due at the end of the year.

The committee then discussed projected auction sizes for nominal coupon securities going forward. It was noted that given constant levels of coupon issuance, Treasury has cut a cumulative $232 billion of annualized borrowing capacity when compared to April levels.

One member began by noting that given projected financing needs and uncertainty around the economy, the Treasury would probably need to stabilize coupon issuance by January 2011. The member noted that nominal coupon issue sizes peaked in early 2010 and held steady from February through April 2010. Further marginal issue-size reductions in nominal coupons could probably continue for the remainder of the calendar year, according to this member. Such a plan would still provide Treasury with capacity and flexibility to address unexpected financing needs, and also extend the average maturity of outstanding debt further.

A lively debate followed. [LOL]

A member stated that given the fiscal and economic uncertainty going forward, it may be prudent to pause after some further gradual issuance-size reductions. The member stated that Treasury should consider making small reductions in 10-year notes and 30-year bonds. Other members agreed with the idea that 10-year notes and 30-year bonds should be cut slightly, with one member stating that the 10-to 30-year spread has widened [Yes--to record levels (113bps)] and that there is a perception by some market participants that Treasury wants to extend its duration even though term premia appears to be elevated by some metrics.

Other members challenged this notion, suggesting that small marginal cuts in 10-year notes and 30-year bonds might not be considered to have a substantive purpose and that there was nothing to be gained from doing such cuts at this point. One member stated that given the long-run fiscal forecast, uncertainty about extension of the 2001 tax cuts, and absent any sort of credible fiscal plan for reducing government borrowing, cutting 10-year notes and 30-year bonds would be imprudent.

Ultimately, the Committee thought it was important for Treasury to maintain the flexibility to cut across the curve in the future. There was general consensus around the idea of pausing issue size reductions at some point in the future until more clarity forms around the economic and fiscal outlook.

A brief discussion followed regarding the optimal size of the T-bill market. One member stated that once bills as a percentage of the overall portfolio drops below 20 percent, dislocations and poor liquidity become more problematic in the bill market. Another member stated that if the Fed starts to reinvest cash flows from their MBS portfolio in the front end of the curve, shortages in the bill markets may be further exacerbated. Another member commented that bill issuance should be skewed more toward the short end of the bill curve to accommodate the demand from 2a-7 money market funds which are under new WAM constraints; many investment vehicles that money funds used to invest in are in shorter supply, including ABS paper and SIVs.

The committee next turned to the question in the charge concerning state and municipal debt markets and the ability of municipal issuers to access the capital markets. The committee focused its response on current market dynamics, including overall financing costs and strategies, as well as implications for the Treasury market and fixed income markets more broadly.

The presenting member began by describing general municipal market conditions, noting that the municipal bond market has grown dramatically over the past few decades, totaling $2.8 trillion at the end of 2009. The member noted that the municipal bond market has a higher average credit rating than the corporate bond market, which can be attributed to municipal taxing authority, low historical default rates and conservative debt profiles. Seventy percent of municipal bond holders are retail or retail equivalent buyers, including households, mutual funds, ETFs and money market mutual funds. Life insurers are large purchasers of taxable Build America Bonds (BABs), owning over 50 percent of many BABs deals.

The presenting member then went into a discussion on the municipal credit default swap (CDS) market, noting that the market is small and relatively illiquid. The market has only a handful of actively traded issuers, including the States of California, Illinois, New Jersey, Florida and Texas. As of the end of July, only 6 out of the top 1,000 CDS reference entities were state or local governments, and only $105 million of single-name municipal CDS was traded during the last week of July. In comparison, $144 billion of CDS was traded for the top 1,000 reference entities.

The member then discussed the MCDX index, which is an index containing 50 equally weighted state and local government and revenue issuers. The MCDX has approximately $3.8 billion of net notional outstanding, significantly below the $300 billion for the investment grade corporate index. The member noted that the MCDX is a poor indicator of perceived risk in the municipal market given that the index is subject to inconsistent market making and unpredictable investor participation.

The presenting member then went into a discussion of current cash market conditions and concerns going forward. It was noted that the largest municipal issuers have had continuous access to the market. This is evidenced by municipal issuance, which is at $232 billion year-to-date, a 13 percent increase from 2009. In absolute terms, municipal rates are at multi-decade lows. However, municipal bond yields remain elevated relative to Treasury yields. The yield on the Bond Buyer 11 index is currently 110 percent of Treasuries compared to a long-term average of 86 percent.

The member then discussed overall municipal market structure changes, highlighting the BABs program, which was introduced in 2009. Under the BABs program there has been $120 billion of taxable bond new issuance. The dramatic decline in municipal bond insurance was also highlighted. Five years ago, 50 percent of issuance was insured, compared to below 10 percent today. The member noted that the use of bond insurance is unlikely to return to previous highs given increased investor focus on the underlying credit quality of issuers as well as the health of the bond insurers.

The importance of the short-term market was also highlighted. Short-term offerings are generally used by issuers to smooth cash flow timing mismatches. They are used more frequently during recessionary times when budget deficits increase.

The presenting member then went into a discussion of current municipal market investor concerns. State budget imbalances are among the top concerns for investors. Although most states have balanced budget requirements, budget solutions are often one-time in nature and credible revenue and expense solutions are not evident for the largest general-obligation issuers. In addition, liquidity access and management was highlighted as a concern given roll-over risk for letters of credit for the variable rate market. Approximately $200 billion of letters of credit are maturating in 2010 and 2011, of which $30 billion may be difficult to renew. The result will likely be more restrictive terms, higher costs and less availability for lower-rated issuers.

The member then discussed the major risks to municipal issuers, which fall into two categories: market access and new issue pricing. In terms of market access, the member noted while a state GO default seems unlikely, if it were to occur, it would result in significant dislocation in the new issuance market. However, this risk is mitigated by a number of factors, including: state taxing authority, low debt/GDP ratios, low debt servicing costs, high debt payment priority, expense reductions, alternate sources of funding (asset sales, revenue stream securitizations), as well as rainy day reserve funds.

With respect to new issue pricing, the member suggested that municipal issuers would likely face higher financing costs if the BABs program is not extended. Other concerns included worsening credit quality of issuers and regulatory reform, which could affect banks providing letters of credit for variable rate issues.

The member concluded that in the near term the likelihood of a major default is low. However, a long-term deterioration in credit fundamentals is possible and funding costs are likely to increase.

The members then discussed the dramatic increase in municipal bond issuance over the last few decades. One member wondered how GDP growth over this time period had been affected [lower, you think?] by the sharp increase in municipal debt, where proceeds are typically used to finance state and local infrastructure projects.

The committee then turned to the third question in the charge concerning the drivers of demand for long duration fixed-income assets and the corresponding implications it may have on the gradual extension of the average maturity of Treasury's debt portfolio.

The presenting member began by noting that in contrast to the recent strong price performance in many financial assets, economic fundamentals have continued to weaken. Real GDP for Q2 came in lower than expected at 2.4 percent annualized pace. Both market consensus and the FOMC's Central Tendency Forecast for real GDP and inflation have declined. The subdued economic outlook and decline in inflation expectations have pushed out expectations for policy rate increases and driven yields lower across the curve.

The presenting member next discussed how changes in the mortgage market were affecting fixed income markets more broadly. The member underscored that the Federal Reserve holds 27 percent of 30-year agency MBS, which has altered the traditional hedging activity observed by mortgage investors. [Big effect on Treas mkt] He also noted that capacity constraints are continuing to weigh on refinancing activities. It was concluded that agency MBS supply is likely to remain low for some period of time.

The member noted that one sector where supply is picking up is agency callable debt. At current rate levels, there is the potential that over $50 billion of outstanding agency debt will be called over the next two months [based on which obsolete duration model?], which would boost gross issuance and agency supply.

However, it was reiterated that Treasury still remains the dominant issuer in fixed income markets. Even if budget deficits decline in the next few years, Treasury will remain the major source of net supply in fixed-income markets.

The presenting member then discussed sources of demand in fixed income markets. It was noted that banks have been a strong source of demand for Treasuries over the past year. Corporate pensions continue to be a net buyer of fixed income despite low yield levels. Mutual Funds and ETFs have also seen significant inflows into fixed-income products throughout the crisis. It was noted that initially this was supportive of government issuance, but more recently, the low absolute level of yields has led some investors to pursue higher-yielding strategies.

The presenting member finished by noting that long-end demand continues to exceed supply. Treasury auctions continue to exhibit strong coverage ratios, and as a result, the member recommended that Treasury continue to lengthen the average maturity of outstanding debt.

The meeting adjourned at 11:45 AM.

The Committee reconvened at the Department of the Treasury at 5:35 p.m. All of the Committee members were present. The Chairman presented the Committee report to Secretary Geithner.

A brief discussion followed the Chairman's presentation but did not raise significant questions regarding the report's content.

The Committee then reviewed the financing for the remainder of the July through September quarter and the October through December quarter (see attached).

The meeting adjourned at 6:15 p.m.

_________________________________

Matthew Rutherford

Deputy Assistant Secretary for Federal Finance

United States Department of the Treasury

August 3, 2010

Certified by:

___________________________________

Matthew E. Zames, Chairman

Treasury Borrowing Advisory Committee

Of The Securities Industry and Financial Markets Association

August 3, 2010

___________________________________

Ashok Varadhan, Vice Chairman

Treasury Borrowing Advisory Committee

Of The Securities Industry and Financial Markets Association

August 3, 2010

Treasury Borrowing Advisory Committee Quarterly Meeting

Committee Charge – August 3, 2010

Fiscal Outlook

Taking into consideration Treasury's short, intermediate, and long-term financing requirements, as well as uncertainties about the economy and revenue outlook for the next few quarters, what changes to Treasury's coupon auctions do you recommend at this time, if any?

Municipal Bond Market

We would like the Committee to provide an update on state and municipal debt markets and the ability of municipal issuers to access the capital markets. Please provide detail on current market dynamics, and whether overall financing costs and strategies have changed. How have these dynamics affected the Treasury market, and fixed income markets more broadly?

Demand for Long-Duration Assets

What are the forces that are underpinning demand for long-duration fixed-income assets? What factors should Treasury consider as the average maturity of outstanding debt continues to gradually extend?

Financing this Quarter

We would like the Committee's advice on the following:

• The composition of Treasury notes and bonds to refund approximately $33 billion of privately held notes maturing on August 15, 2010.
• The composition of Treasury marketable financing for the remainder of the July - September quarter, including cash management bills.
• The composition of Treasury marketable financing for the October - December quarter, including cash management bills.

TBAC Recommended Financing Tables: Q4

TBAC Recommended Financing Tables: Q1

______________________________________________________

http://www.treas.gov/press/releases/tg800.htm

August 4, 2010
tg800

Report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee of the Securities Industry and Financial Markets Association

August 3, 2010

Dear Mr. Secretary:

When the Committee met in early May, the economy was firmly transitioning to a self-sustaining expansion. Economic releases since then suggest that this progress has slowed. Business spending and private employment rose at a solid pace last quarter but momentum appears to have slowed into midyear. Similarly, the robust gains in retail spending recorded early this year has been tempered by recent weakness. Rising uncertainty about growth prospects and the direction of policy has also weighed on consumer confidence. In all, the expansion continues to move forward but at a more modest pace than had been anticipated three months ago. This loss of momentum heightens lingering concerns about the expansion's resiliency in the face of a significant fiscal tightening planned for the quarters ahead.

The US economy has just completed a year of economic expansion in which realGDP rose 3.2%. Importantly, all components of private demand – consumption, fixed investment and inventory accumulation – contributed to growth in the first two quarters of the year. However, their relative magnitudes remain imbalanced. The latest figures show strong gains in business spending and inventory accumulation this year. In addition, exports are rising at a double-digit pace. Consumer spending, by contrast, is sluggish. Despite solid income growth, consumption rose at a 1.8% annualized rate in the first half as the household saving rate moved up to 6.2%. This mix of strong business spending and sluggish personal outlays has concentrated much of the gain in output to goods producing industries. Services GDP has increased at a meager 0.5% pace during the first year of economic expansion.

The US manufacturing sector has benefited from the lift in domestic and foreign goods demand with output rising 8.3% over the past year. This year of boom has realigned depressed levels of manufacturing activity to final demand. With inventories now rising, output growth is poised to slow. The slide in the ISM manufacturing survey to 55.5 in July suggests moderation is underway. A downshift in manufacturing following a bounce is a regular feature of the early stages of US expansions. Generally, service sector activity tends to improve as the expansion matures and the manufacturing lift fades. With the downshift in production indicators providing less of a directional signal, demand and labor market indicators will shoulder the burden of highlighting the progress of this rotation and the underlying health of the expansion.

The continued shift by cash-rich firms away from a defensive posture is likely to provide further fuel for growth in the coming quarters. Adjusted corporate profits are estimated to have increased more than 35% over the past year, the most rapid rise in more than a quarter century. Although the lift to growth from a shift away from paring inventories management is largely spent, a recovery in capital spending and hours worked from depressed levels remains in its early stages. The tentative expansion now underway should receive additional support in the coming quarters as credit availability improves and global demand continues to rise. It is encouraging that last quarter produced the expansion's first material rise in private payrolls (1.6%, saar) although momentum on hiring appears to have slowed as the quarter came to an end.

Households are expected to remain cautious in the coming quarters as they continue to adjust their balance sheets to an environment of weak labor and housing markets. With saving rates drifting higher, rising labor income will be the key for bolstering confidence and sustaining modest consumption gains. The first half of this year provided encouraging news as labor compensation rose at a 2.7% pace. More disappointing has been the sharp drop in home sales with the end of tax incentives. Household credit quality appears to be improving but an overhang of existing homes in the foreclosure process looks likely to limit any lift in home prices.

In spite of a year of growth, resource utilization remains depressed and disinflationary pressures persist. Over the past year, the core CPI rose at less than 1%, the slowest pace since the early 1960s. With trends in hourly labor costs still moving lower, inflation will likely stay low for some time to come. Faced with high unemployment and very low inflation, the recent loss of growth momentum has raised concerns that the economy could slip into deflation. The Federal Reserve has responded by balancing its discussion of exit strategies with rhetoric that signals it would consider additional monetary stimulus if needed. The Federal Reserve looks likely to remain on hold for some time to come and asset sales will wait until levels of employment and inflation are consistent with a tightening in policy.

US monetary policy will need to maintain an extremely accommodative stance in part because fiscal policy is turning restrictive. The ARRA federal stimulus is already fading and state and local spending is likely to continue to contract at its current 1.5% pace. As the economy turns towards next year, ARRA federal transfers to states will end and a number of tax cuts will expire. Although accommodative monetary policy is expected to provide an important offset to this drag, policy rates are already close to zero. The Fed has limited tools to employ should growth disappoint or inflation expectations fall precipitously. [Is this a joke?]

Against this economic backdrop, the Committee's first charge was to examine what adjustments to debt issuance, if any, Treasury should make in consideration of its financing needs. In the near term, the Committee felt a continued reduction in nominal coupon issuance was appropriate. However, coupon issuance sizes will likely stabilize at or about the end of calendar year 2010. Given the uncertain economic and fiscal backdrop, the Committee felt that maintaining maximum flexibility was necessary.

The bulk of the reduction in coupon issuance should continue to be in the two-year, three-year, five-year and seven-year maturities. Although this is broadly consistent with the Committee's desire to increase the average maturity of the outstanding debt, some felt that given the meaningful progress thus far, reductions in ten-year notes and thirty-year bonds could be justified.

The Committee discussed both the relative and absolute size of the Treasury bill market. One member commented that bills should not drop below twenty percent of marketable Treasury debt outstanding. However, the Committee concluded that more work needed to be done to better understand the evolution of Treasury bill demand dynamics. Finally, the Committee felt that growing TIPS from roughly $80 billion gross issuance in fiscal year 2010, to over $100 billion in fiscal year 2011, was still appropriate.

The second charge was an examination of the current state of the municipal bond market. The member looked at municipal market dynamics, the ability of issuers to access the markets, risk factors, and the impact of municipals on fixed income markets more broadly.

The presentation (see attached) highlights that municipal bonds outstanding rose over the last decade by $1 trillion to $2.8 trillion. Despite some of the recent headline risks and the challenging economic outlook, the member concluded the municipal market appears to be in reasonably good condition. Broadly, municipalities still have a low probability of default, historically high recoveries, low absolute cost of funds, access to a broader investor base via the Build America Bonds program, and a largely unlevered existing retail investor base. Implicit in this analysis is the Federal government's willingness to intervene in the event the municipal market ceases to function. [No discussion of this in the Minutes--where did this come from? Got that--it is presumed that the Feds will backstop the entire muni market]

The third charge was to examine the demand for long duration fixed income assets amidst the backdrop of a gradual increase in the average maturity of debt outstanding. The member focused on the impact of the Federal Reserve's asset purchase program. In particular, the presentation (see attached) highlights the absence of mortgage hedging needs as a stabilizing force underpinning long term yields. In addition, the member referenced the secular increase in demand for long duration assets from asset managers, insurance companies, and pension funds. Furthermore, cyclically, the member showed that investor confidence in the path of central bank policy rates tends to anchor long term yields.

In the final charge, the Committee considered the composition of marketable financing for the remainder of the July-September quarter and the October-December quarter. The Committee's recommendations are attached.

Respectfully,

Matthew E. Zames

Chairman

Ashok Varadhan

Vice Chairman

The Ghosts of Deflation Past & Zombies vs. Vigilantes

All too often, both "inflation" and "deflation" are used as catch-all terms, when the economy usually experiences different flavors of both concurrently. We saw this in 2009 when consumer credit outright contracted (credit deflation) in the midst of a flashy stock market rally (asset price inflation), which itself was a result of the Fed's money printing. Robert Wenzel recently posted a must-read article written by Richard Ebeling in 2003 that clarifies the different types of deflation, one of which can actually be a hallmark of a robust economy. The following will evaluate our present circumstances within his framework.

At the time (again, in 2003), Ebeling wrote, "There is nothing in recent Fed monetary policy to suggest that there has been a decline in the supply of money and credit." Indeed, what followed the easy money policy was asset price inflation from the unprecedented housing boom, which culminated in the Panic of 2007 (to use a Fed VP's preferred term). So, where are we today in terms of the supply of money?

While money supply may not be in decline as measured by M2 NSA year-over-year, it has slowed considerably to less than 2%, from over 10% at its recent peak. Prior contractions on this scale have precipitated asset price deflation, most visible in the form of stock market crashes. (Notably, the contraction in money supply in the summer of 2009 did not result in asset price deflation because the Fed's concurrent $1.75 trillion in asset purchases were redirected into risk markets.)

In contrast, after the prior recession in 2001, M2 fluctuated between 6.0% and 8.5% YoY until late 2003, facilitated by the Fed lowering the Federal Funds target rate to 1%. In the present, even other measures of money supply are not broadcasting inflation, as Money Zero Maturity (MZM) is in outright contraction. Some will point to the monetary base (M0) which, at 20% YoY, would appear inflationary. However, it is down from over 100%, and it must be noted that the Fed payment of interest on excess reserves (IOER) keeps $1 trillion of M0 parked at the Fed. Indeed, were the Fed to truly pursue a zero interest rate policy (ZIRP), it would lower the current IOER rate of 0.25% to zero (not recommended, but an interesting though experiment).

As to credit, the Fed has wound down nearly all its temporary liquidity facilities and terminated its quantitative easing programs (except for some limited MBS dollar and coupon roll activity). In addition, it has nominally increased the discount rate, the rate charged to borrow from its primary credit facility, from 0.50% to 0.75%.

From an interbank perspective, the cost of borrowing is rising as evidenced by an increasing Libor-OIS spread, though not nearly to levels reached in the post-Lehman crisis.

In addition, the Federal Funds rate, or the overnight unsecured lending rate between banks and certain other large institutions, has recently been ticking lower.

Though perhaps non-intuitive, a lower Fed Funds rate is indicative of less liquidity because of the structure of this market. The major lenders of Fed Funds are the housing related [quasi] GSEs, Fannie Mae and Freddie Mac. Because they are not banks, they are not eligible to earn interest on money the way banks do with IOER, and must find other ways to invest excess funds short term. According to the Fed, they tend to transact with a few favored banks, such that when fear is increasing, they narrow the scope of lending, and the rate decreases. (It is also normal for end of quarter bank activity to effectively shut down the Fed Funds market, so nothing significant should be inferred from a precipitous drop on the last day of each quarter.)

Finally, consumer credit has been in outright contraction for over a year, for the first time in the post-war period.

Accordingly, from the perspective of the Federal Reserve to banks, banks to banks, and banks to consumers, credit is in decline. And, as has been demonstrated, monetary policy by the Fed, while certainly not hawkish, has been less easy by several measures. While one can concede the Fed will not hesitate to become easy[er] in the future, for the time being, we are experiencing both Price-Wage Rigidity Deflation and Monetary Deflation, per Ebeling's definitions. As he wrote,

"The continuing hubris of the central banker can be seen in his failure to fully appreciate that it has been his own monetary policies that have created the unstable booms and bubbles that he complains about and criticizes. And even when he admits that central bankers have erred in the past and have produced those very consequences to which they object, he continues to believe that “next time” they will get it right."

The danger is that we are in an intervention-induced cycle of decreasing periodicity of both inflation and deflation, with the level of intervention increasing each round and shortening the cycle. The deflationary episodes choke the entire economy, while the subsequent intermittent reflation attempts front-run the necessary resource reallocation, rewarding disproportionately the non-productive sectors. Hence, the zombie economy.

Only when the zombies are buried for good (and they will be by force, if necessary, by the bond vigilantes), will the necessary adjustments be made by pure market forces to allow another era of sustained growth. Barring a collective anagnorisis on the part of the world's central planners, it will likely be the bond vigilantes that reconcile the economy with reality.

Mid-Year Sector Performance Confirms ABCT

From Bespoke Investment Group:

As we come to the end of the first half of the year, below we take a look at S&P 500 sector performance so far in 2010. At this point, no sector is up year to date. The S&P 500 as a whole is down 6.17%, while the Materials [capital goods] sector is down the most at -12.22% and the Consumer Discretionary sector is down the least at -0.31%. Four sectors are outperforming the overall index (Consumer Staples, Financials, Industrials, and Consumer Discretionary), while six sectors are underperforming (Materials, Energy, Telecom, Technology, Health Care, Utilities). When markets are down, the cyclical sectors are usually down the most, while defensive sectors are down the least. That hasn't really been the case so far at this point in the year.

In related news, the latest Twilight saga "generated record sales of more than $30 million from midnight showings in U.S. and Canadian theaters."

Why the 10 Year Yield is Dropping, and Why the 30 Isn't Catching Up

In response to RW's post yesterday on the drop in the 30 Year fixed rate mortgage to 4.375%, I commented:

Ultra-low mtg rates are why the Fed announced a coupon swap today on to-be-settled Agency MBS. On-the-run 5.5's are expensive because of low supply. Doubt these were purchased prior to the Mar 31 termination of the purchase program, but as a result of dollar rolls. Each transaction is a hidden subsidy to favored PD's.

Another unintended consequence: MBS duration models are triggering long term Treasury purchases to compensate for increased prepayment risk. These models are slow to adapt, however, and many data sources suggest refis are slowing, not growing (incl. Consumer Metrics Institute). 10's could go to 2%, but the ultimate unwind will be enhanced when the artificial demand evaporates.

Today, ZeroHedge runs with a Morgan Stanley report, part mea culpa, part defensive posturing with regard to Jim Caron's prior (and continuing) non-deflationary stance. After some hilarious predictions about 3.5% annual growth for the US in 2010 (globally 4.8%!), Caron reasons as follows:

But for now, here are some of the reasons the UST 10y has broken down below 3.00%

1. Fundamental reasons: The most common reason is that people feel the mkt is headed into a disnflationary double dip and buying UST 10s at this level is a good play for that scenario.

2. Hedging reasons: as one long/short equity manager put it to me, "USTs are big and liquid, you've gotta own them". This was in the context of owning USTs as a preferred hedge against their equity longs. They felt owning USTs was akin to owning tail risk. And at least you got paid some carry to own this hedge. If mkt conditions improved, you could exit easily.

3. Asset Allocation and Indexers - these reasons are more technical:

• people were short/underweight USTs through May. Recently, fund managers have been getting back to a neutral weighting, which implies they will need to buy USTs in the process.
• as the universe of USTs increase, indexers need to buy more and more USTs to remain at the prescribed weighting of their index.
• the Fed announced yesterday it was going to swap the 5.5% coupon mortgages it bought during QE for 4.5% coupon mortgages. This was done for liquidity to alleviate delivery fails in the 5.5%s. The impact of moving to a lower coupon is that it's duration is longer. So, if you sell the 4.5% mortgage to the Fed in exchange for a 5.5%, then you are effectively short ~$2Bn UST 10y equivalents. This means you need to BUY $2Bn 10s. This caused the mkt to drop 6bps in UST10y yields in a flash. Also, people speculated this may be a signal QE may re-start, which we think is nonsense.
• Month-end/Quarter end window dressing. Although there is not much of an extension, managers want to show investors they own nice safe USTs.
• people view the roll-off of the €442Bn 1yr LTRO in Europe on July 1 as a potential event risk. We disagree with that notion (as per Mutkin's last weekly).

4. Rumors: there have been some articles in the UK Telegraph suggesting that the Fed will enter QE again and buy over $2Tr more in assets. This has not been verified as a reliable source.

A Counter Point to the Deflationistas

If true deflation fears were at work in the market then one should expect the longest duration points on the curve to rally most and we would see a significant flattening of the yield curve, especially the UST 10s30s segment of the curve. We use this as a check against deflation fears. Instead, we see the opposite with the UST 10s30s curve right up against its 20-year highs. If deflation is truly at work in the market, then someone ought to tell the UST 10s30s curve. And for that matter, all curve segments should be much flatter. Yet the curve flattening has been slow and grudging. Thus the yield curve is more representing an overall shift to lower yields as the Fed is expected to be on hold for a long time, not that deflation is truly at work. Don't confuse the two. It's too early to conclude that deflation is truly at work in the marketplace.

His justifications for the yield drop are pretty much spot on (though the conditions will likely persist longer than he thinks); however, his observations on the 10s30s spread are leading to an erroneous conclusion. That segment will be the last to contract because (a) there is a real and rising risk of US default as evidenced by credit default swaps (30 years is 3 times as long as 10 years, after all), (b) the 30 year is not used as a primary hedge instrument against duration, nor is it materially a necessary embedded component in the half quadrillion in interest rate swaps (IRS) (whereas the 2, 5 & 7 tenors--and to a lesser degree the 10--are), and (c) the greatest demand for the 30 year will be the Fed itself when it restarts Treasury QE.

Until Gentle Ben's QE 2.0 capitulation, the 10s30s spread should not be read as a non-confirmation of deflation as there is simply not the same artificial structural demand for the 30 year as there is with the 10. This is also in line with my previous explanation of how artificial distortions in the yield curve will hinder its predictive power.

Long term, it's going to be inflationary turtles all the way down, but for the time being, Treasurys are more than likely to rally (that is, unless you think the S&P 500 puts in a quadruple bottom here).

(IL)liquidity Alert

Market liquidity, as measured by proxy through the eMini S&P 500 futures contract via a proprietary measure, had improved over the last few weeks, but just deteriorated significantly. The last time it approached these levels from the downside (greater to less liquidity) was May 6. This doesn’t mean there will necessarily be another flash crash, but that it is very easy to push prices around on low volume. Caution is warranted with all positions.

Fed VP concerned with meat supply, not money supply

NY Fed Vice President Joseph S. Tracy waxed philosophical today at the Westchester County Banker's Association, as he weighed the nomenclatural merits of "The Panic of 2007" versus "The Great Recession." While he educates us on the Knickerbocker Trust, the shadow banking system and the similarities between the recent asset bubble in housing and the bubble in copper preceding the Panic of 1907, at no time are we treated to a discussion of the Fed-induced subnaturally low interest rates in 2003 that led to an explosion in money supply--a necessary condition precedent to the greatest bid up of risk assets and relaxation of diligence standards in modern times. For that matter, the term "money supply" did not garner a single mention, though a close derivative did:

Why did the point at which house prices peaked and started to fall in some housing markets spark a run on the repo market? Additionally, why did the problems in subprime mortgage assets spread quickly to other assets? Gary Gorton uses the analogy of an E. coli breakout.12 Suppose that E. coli is thought to have infected a small quantity of the country’s meat supply. The difficulty is that no one knows which batches of meat have been infected. If eating infected meat will cause the individual to become very sick, then the natural reaction is for everyone to immediately stop eating meat altogether. This will continue until the entire meat supply has been recalled and inspected. Subprime mortgage defaults were the E. coli that infected the financial system. Some mortgage assets would lose significant value as a result, but it was difficult to know which mortgage assets were "infected" and who was holding these assets. The natural response was to pull back from these assets.

File under "your central bankers at work."

The Internet Police Are Coming: Introducing the Internet "Kill Switch"

A bill recently introduced by Joseph Lieberman in the US Senate threatens the basic tenets of a free and open internet through the creation of a new National Center for Cybersecurity and Communications (NCCC) within the Department of Homeland Security. In addition to giving the President the power to declare indefinite "National Cyber Emergencies", it would grant broad powers to the NCCC to coerce and entice key private internet infrastructure companies into compliance with new arbitrary government standards. A thorough read of the bill reveals the Feds may intend to rewrite the very structure of the internet for their own ends. ZDNet Australia covers many of the more onerous features:

A new US Senate Bill would grant the President far-reaching emergency powers to seize control of, or even shut down, portions of the internet.

The legislation says that companies such as broadband providers, search engines or software firms that the US Government selects "shall immediately comply with any emergency measure or action developed" by the Department of Homeland Security. Anyone failing to comply would be fined.

That emergency authority would allow the Federal Government to "preserve those networks and assets and our country and protect our people," Joe Lieberman, the primary sponsor of the measure and the chairman of the Homeland Security committee, told reporters on Thursday. Lieberman is an independent senator from Connecticut who meets with the Democrats.

Due to there being few limits on the US President's emergency power, which can be renewed indefinitely, the densely worded 197-page Bill (PDF) is likely to encounter stiff opposition.

According to the bill, the statutory limits on what would constitute a "National Cyber Emergency" are indeed broad:

an actual or imminent action by any individual or entity to exploit a cyber vulnerability in a manner that disrupts, attempts to disrupt, or poses a significant risk of disruption to the operation of the information infrastructure essential to the reliable operation of covered critical infrastructure;

A simple statement by the President every 30 days would maintain the state of emergency with no details required to be revealed to the public.

TechAmerica, probably the largest US technology lobby group, said it was concerned about "unintended consequences that would result from the legislation's regulatory approach" and "the potential for absolute power". And the Center for Democracy and Technology publicly worried that the Lieberman Bill's emergency powers "include authority to shut down or limit internet traffic on private systems."

The idea of an internet "kill switch" that the President could flip is not new. A draft Senate proposal that ZDNet Australia's sister site CNET obtained in August allowed the White House to "declare a cybersecurity emergency", and another from Sens. Jay Rockefeller (D-W.V.) and Olympia Snowe (R-Maine) would have explicitly given the government the power to "order the disconnection" of certain networks or websites.

On Thursday, both senators lauded Lieberman's Bill, which is formally titled Protecting Cyberspace as a National Asset Act, or PCNAA. Rockefeller said "I commend" the drafters of the PCNAA. Collins went further, signing up at a co-sponsor and saying at a press conference that "we cannot afford to wait for a cyber 9/11 before our government realises the importance of protecting our cyber resources".

Under PCNAA, the Federal Government's power to force private companies to comply with emergency decrees would become unusually broad. Any company on a list created by Homeland Security that also "relies on" the internet, the telephone system or any other component of the US "information infrastructure" would be subject to command by a new National Center for Cybersecurity and Communications (NCCC) that would be created inside Homeland Security.

The only obvious limitation on the NCCC's emergency power is one paragraph in the Lieberman Bill that appears to have grown out of the Bush-era flap over wiretapping without a warrant. That limitation says that the NCCC cannot order broadband providers or other companies to "conduct surveillance" of Americans unless it's otherwise legally authorised.

Though the limitation on wiretapping is a blatantly hollow bone thrown to counter legitimate arguments against free speech encroachment, more dangerously, the new law will institutionalize the chilling repression of online free speech. It will establish a multi-tiered internet with assets that are either within the new National Information Infrastructure or not. For those that are in, the NCCC has broad powers, both carrots and sticks, to induce compliance with what it would deem acceptable content, both here and abroad. From ZDNet:

The NCCC also would be granted the power to monitor the "security status" of private sector websites, broadband providers and other internet components. Lieberman's legislation requires the NCCC to provide "situational awareness of the security status" of the portions of the internet that are inside the United States — and also those portions in other countries that, if disrupted, could cause significant harm.

Selected private companies would be required to participate in "information sharing" with the Feds. They must "certify in writing to the director" of the NCCC whether they have "developed and implemented" federally approved security measures, which could be anything from encryption to physical security mechanisms, or programming techniques that have been "approved by the director". The NCCC director can "issue an order" in cases of non-compliance.

Incentives to private companies that are critical to national infrastructure include civil immunity and/or taxpayer indemnification from civil lawsuits arising as a result of compliance, as well as large contracts for internet security providers, such as antivirus software developers.

Not mentioned in the article are a formalized citizen cyber-snitching program (page 101) and, more troubling, the ability of the new NCCC to rewire the internet from a standards and framework standpoint. From page 66 of the bill:

"(b) ANALYSIS AND IMPROVEMENT OF STANDARDS AND GUIDELINES.—For purposes of the program established under subsection (a), the Director shall—

"(1) regularly assess and evaluate cybersecurity standards and guidelines issued by private sector organizations, recognized international and domestic standards setting organizations, and Federal agencies; and

‘‘(2) in coordination with the National Institute of Standards and Technology, encourage the development of, and recommend changes to, the standards and guidelines described in paragraph (1) for securing the national information infrastructure.

With the weight of federal resources behind it, "encourage" and "recommend" may be read as "dictate" and "police".

The incredible success of the internet is based upon its guts being mere conduits for information that is processed at the ends. As David Isenberg wrote in his seminal paper in 1997, it is a Stupid Network, one

• with nothing but dumb transport in the middle, and intelligent user-controlled endpoints,
• whose design is guided by plenty, not scarcity,
• where transport is guided by the needs of the data, not the design assumptions of the network.

Any attempts to push information processing back into the middle of the network is a step back toward the old telephone company model. It is an inherent cap on future productivity gains even in the best-intentioned administered world. In a world of suspect intentions, abuse of new control powers is guaranteed. Opponents of (the deceptively named) net neutrality proposal should be especially alarmed as this new bill will put power they were afraid to give to ISP's into bureaucrats in Homeland Security. Opponents of the (also deceptively named) Fairness Doctrine should balk as it is the Fairness Doctrine on steroids.

Though horrific and sometimes avoidable, previous national emergencies were at least visible. With no public transparency or accountability, a National Cyber Emergency could be created with the push of a button and shut down all non-sanctioned internet traffic. The level playing field created by the Internet, with its unprecedented information sharing capabilities, is under attack. Senate bill 3480 must not be allowed to pass.

(ht The Coming Economic Depression)