Ex-Goldmanite Gary Gensler "Tickled Pink" as CFTC Ramps Up for Price Fixing

Here again the government spenders have the better of the argument with all those who cannot see beyond the immediate range of their physical eyes. They can see the bridge. But if they have taught themselves to look for indirect as well as direct consequences they can once more see in the eye of imagination the possibilities that have never been allowed to come into existence. They can see the unbuilt homes, the unmade cars and radios, the unmade dresses and coats, perhaps the unsold and ungrown foodstuffs. To see these uncreated things requires a kind of imagination that not many people have. We can think of these non-existent objects once, perhaps, hut we cannot keep them before our minds as we can the bridge that we pass every working day. What has happened is merely that one thing has been created instead of others.

Henry Hazlitt, Economics in One Lesson, 1948

On November 3, 2010, while the FOMC chaired by Benjamin Bernanke was putting the finishing touches on its latest money printing scheme in Washington DC, fifty global financial regulators met at the OTC Derivatives Regulators Forum, hosted by no less than the New York Fed. Front and center among the group were representatives of the US Commodity Futures Trading Commission (CFTC), fresh off the Frank-Dodd coup that gave them authority to regulate derivatives, the world's largest market in notional amounts. While many have lauded the coming "reforms" as a necessary step to reigning in financial fraud, what is being created is simply a massive new power center from which those at the top will vainly attempt to manipulate market prices and entrench favored institutions within the new framework. Inasmuch as the central banks' precious metals suppression schemes have become increasingly ineffective, a new venue is opening through which a last ditch effort may be mounted to beat back the commodity safe havens of purchasing power, as the central banks continue to wage their competitive currency devaluation arms race.

Will the CFTC, at the direction of ex-Goldman Sachs Managing Director, Gary Gensler, use its newly minted authority to cause massive price dislocations in the commodities and other markets through position limit changes and the regulation of swaps used by exchange traded funds (ETFs)? Whether or not Chairman Gensler will aid his banker cronies in this fashion remains to be seen, but history reveals that such absolute power is seldom left untapped.

As Bloomberg writes:

The Dodd-Frank financial overhaul, which became law in July, gave the Commodity Futures Trading Commission a year to establish rules governing the $615 trillion over-the-counter derivatives market, including which companies will be categorized as swap dealers or major swap participants. Those are designations that entail higher capital requirements and increased scrutiny.

With numbers that big, the regulators are salivating. Indeed, Chairman Gensler said as much:

"This is like the 1930s for the Securities and Exchange Commission. I mean, I am just tickled pink," he said.

...

He proudly displays a dog-earned copy of the Dodd-Frank law on his desk, its cover signed by a who's who of U.S. regulation: Ben Bernanke, Paul Volcker, Tim Geithner, Sheila Bair, Mary Schapiro and Elizabeth Warren, among others.

"It's like my high school yearbook!" Gensler exclaimed.

And he's not shy about asking for money, as the Reuters article continues:

The problem is getting the $261 million annual budget he needs from Congress where sceptical Republicans are expected to gain power in the Nov. 2 elections, and may even win control of the House of Representatives.

"I'm still hopeful," Gensler said.

He warned of delays in registering 300 new swaps dealers, trading venues, and data facilities.

"We've got ... to do something more than just 'robo-sign' them," Gensler said.

Cute. However, whatever the size of the new budget, it will be a drop in the bucket compared to the profits that will be reaped by those who already have inside access to the new rules and their timing.

Speculative Position Limits

A major issue that will soon be decided regards speculative position limits, or how much of the open interest of a given market one entity and its affiliates may control. Generally, speculators are limited in the futures positions they are allowed to maintain, while bona fide hedgers are not. There are various loopholes used to get around these limits, and they generally involve swaps. If an institutional investor wants to establish a large futures positions, it can enter a swap agreement with another entity (think JP Morgan and the silver ETF, SLV), wherein they agree to make payments depending upon the price movements of an underlying instrument, such as a commodity. The very existence of this swap then allows the entities to consider any futures positions as hedges, and voila--they are bona fide hedgers with no position limits.

Some of these loopholes have been closed, but most remain. With the CFTC's newly mandated purview over the OTC derivatives market, which includes swaps, it will have unprecedented influence over commodities prices on short to intermediate term horizons. This is not to say that long term fundamentals do not matter, or that speculators are the sole reason (or to blame) for large price movements. However, a large shift in speculative interest can and has snowballed into large price movements.

How to Kill an Energy Rally

A prime example is the rebalancing of the Goldman Sachs Commodity Index (GSCI) that took place in the summer of 2006. At the time, about $60 billion tracked the index, including some large pension funds, which would allocate a portion of their assets to purchasing commodity futures contracts in the exact weightings prescribed by the index. A change in the index composition would trigger buying or selling in the days and weeks that followed. There are several such commodity indexes, and they are periodically rebalanced pursuant to announced schedules, usually annually. However, according to the New York Times, on August 9, 2006, Goldman announced it would not roll over certain gasoline futures contracts into newly reformulated contracts. The result:

Unleaded gasoline made up 8.72 percent of Goldman’s commodity index as of June 30, but it is just 2.3 percent now, representing a sell-off of more than $6 billion in futures contract weighting.

...

Wholesale prices for New York Harbor unleaded gasoline, the major gasoline contract traded on the New York Mercantile Exchange, dropped 18 cents a gallon on Aug. 10, to $1.9889 a gallon, a decline of more than 8 percent, and they have dropped further since then.

Rob Kirby quoted Bill King, who had taken notice at the time:

Goldman's changes probably induced arbs, commercial hedgers, and other traders to sell September and October unleaded gasoline future contracts to avoid possible (settlement, delivery, etc.) problems.

September futures expired in August; October contracts expire September 29. So unleaded gasoline prices collapsed in August and September.

For the conspiracy minded, note that ex-Goldman Sachs CEO Hank Paulson was sworn in as Treasury Secretary just a month prior in July, 2006, and that rising gas prices were becoming an issue for the approaching mid-term elections. The fall in the energy complex not only led to relief at the pump, but a pretty drastic (but short-lived) selloff in commodities overall.

The Role of the Speculator

Speculators are convenient scapegoats, and they make especially good targets for corrupt and incompetent states when speculators profit while others suffer. Short sellers, CDS traders and commodities traders alike have recently received the vocal and regulatory wrath of the state. The infantile blatherings of the Greek prime minister come to mind:

“We will be taking actions to see how we can regulate this world market so speculation won’t be hitting otherwise healthy economies,” Papandreou told NPR’s Robert Siegel.

...

In a speech Monday at the Brookings Institution in Washington, Papandreou spoke of “malicious rumors, endlessly repeated and tactically amplified” that have driven up Greece’s cost of borrowing money.

Papandreou acknowledged, however, that much of the country’s economic troubles can be traced to Greece’s failure to balance its books, saying the country “fully take[s] responsibility” for its problems.

No it didn't. The ECB became the new market for Greek debt and bought considerable quantities from large European banks, many of which would have been insolvent had Greece defaulted. Greece was able to auction more debt with the implicit backstop, and the big banks got redeemed at par. Price fixing by the ECB papered over the problem for the time being, but prices cannot be suppressed forever. And, what the ECB has done, the Fed has done on steroids.

Through its so-called quantitative easing, the Federal Reserve is attempting to keep the Ponzi debt scheme alive and paper over the incredible wastefulness and fraud at all levels. And, not just the literal fraud related to phony mortgage securitizations that came about from the free money it handed out, but the fraudulent price signals it sent that caused what is probably the greatest misallocation of resources in the history of civilization.

A Nation of Zombies

The US is mired in record unemployment with rising consumer prices not dissimilar from the 1970's stagflation era, and will remain in such a state because the ruling class hands out money to buy votes, both to individuals and corporations. Government subsidies create these zombies that are necessarily inefficient and increasingly parasitic.

Two of the three big US auto makers required government bailouts to survive the 2008 panic. Even with favorable accounting rule changes, cash for clunkers, and other subsidies, they are still barely hanging on, notwithstanding the recent popular media spin (that $20.1 billion IPO is equal to the amount of new QE2 funny money that's been printed through November 16, as Robert Wenzel points out). Most of the airline industry has been in a perpetual zombie state for decades. The signals have been clear--what is needed is more productive (which is probably to say fewer) workers in these industries.

The price signals that the Fed attempted to suppress from the dot com bust only created more false signals that were magnified. After the Fed reversed its money printing binge in 2008, the signals became crystal clear. We did not need as many houses, they did not need to be as big, the commute was too wasteful in time and energy. There are entire zip codes that would not exist were it not for the Fed's free lunch. Unfortunately, the lunch was not free and some of these zip codes will become ghost towns.

There are also entire industries that would not have existed or been but a shadow of their size. Many related specifically to mortgages and housing have already gone through the painful adjustment. However, many have not.

Prices Matter

It's easy to look at the manager at the GM plant, thankful to have his job, and say, "See, the government made that happen. He gets his paycheck for helping to produce a tangible product that people use, and he turns around and spends that paycheck in the economy." However, it takes imagination to see the possibilities that have not happened. Let's consider him the marginal employee who is ambivalent about his job and who, under different circumstances, would have chosen a different career path.

Perhaps he had once dreamed of working in another industry. Perhaps he dreamed of owning his own business. However, when the state enacted laws favorable to unions a century ago, it sanctioned wage price fixing. Perhaps high promised wages enticed him to stay in his hometown as a teenager. When the state bailed out his employer, perhaps it enticed him not to retrain to learn to utilize his talents elsewhere.

The state cannot support all its pet zombies for perpetuity, so there will be a reckoning, and it is already underway. Instead of our manager making an easy decision in his late teens, or a difficult adjustment in his twenties while single, he now finds himself in his thirties with a family to support, with nearly two decades wasted developing skills that are not needed or enjoyed by him. Through price fixing, the state has similarly robbed its subjects of aggregated eons. Our manager is thankful, however, that the state takes from productive industries to support his employer, and rewards his rulers with his vote, not realizing the alternative life that could have been.

The fact is, prices matter because they send signals to people about what to do with their money. When prices are suppressed, people tend to make incorrect economic decisions that only magnify the underlying problems the price fixing was intended to "correct". Further, these suppression schemes are only temporary. Below is the same chart of the Goldman Sachs Commodities Index, but extended two years.

Clearly, the Fed's previous money printing binge was enough to quickly reverse the trend upward in commodities in early 2007, which persisted until the Fed changed course to outright tightening in early to mid 2008.

It is easy to look at the 2008 run-up in crude oil to $150, to look at the unprecedented open interest by commodity index funds and ETFs, and to conclude that the speculators were the cause. It is easy to look at bond spreads in captive EU states that cannot print their own currency and conclude similarly. To be sure, the speculators did exacerbate these price movements; however, the signals they were sending were important messages themselves about state profligacy.

It was the flood of new money created by the Fed out of thin air that heightened the demand for new investment products, including the very mortgage securities that triggered the panic. The expectation of money losing its purchasing power created an urgency that encouraged lax standards and outright fraud. The Fed's price fixing of the cost of money led not only to costly malinvestments that would later be revealed, but also led to the entire spectrum of the stages of production simultaneously bidding up the same resources. Throw in the recognition of commodities as an asset class to preserve purchasing power, and there could not have been anything other than a bubble.

The CFTC's Top Concern: Price Fixing

A Reuters article explains (brackets and bolding ours):

Position limits for futures and swaps mandated by the Dodd-Frank financial reform law are a top concern for commodity traders who say the plan could limit fund participation in markets.

Industry groups including CME Group Inc (CME.O) and Morgan Stanley (MS.N), and the Futures Industry Association have told the CFTC it risks harming commodity markets with overly restrictive speculative trading limits, and have urged the agency to move cautiously.

COALITION URGES TOUGH APPROACH

But a coalition including farmers, petroleum marketers and convenience store operators told the CFTC it must quickly implement position limits to bring stability and confidence to the market.

"It is not enough to deal just with manipulation, excessive speculation will require a stricter approach," the Commodity Markets Oversight Coalition said in a letter posted on the CFTC's web site on Wednesday.
r.reuters.com/vaw63q

The group said the CFTC should not wait to phase in the limits, and should consider setting more aggressive limits on positions held by exchange-traded funds and index funds.

The CFTC is unlikely to unveil its new position limits proposal in November, and would more likely wait until Dec. 1 or later to discuss the plan, [CFTC Commissioner] Sommers said.

Position limits are only the beginning. In the past few years, swaps and similar derivatives have quickly become the preferred method for price balancing by ETF and index fund managers, and are common to nearly every leveraged and inverse ETF. As we recently saw in the silver futures market, a simple margin increase was enough to temporarily halt a parabolic rally in the thinly traded commodity, and the effects were realized globally.

The Fed is less than one short week into its new, near-trillion dollar money printing scheme, which will expand its balance sheet by a net $600 billion. It's goal is to inflate away the world's problems--those of its kleptocrat patrons, anyway. If it fails over the next few months, it will simply try harder, as de facto debt monetization becomes institutionalized. Meanwhile, commodities will continue to be repriced in increasingly devalued currencies, with the flagship precious metals of gold and silver being recognized as festering sores on the interventionists' faces.

Gold Price Suppression

Nothing scares a central banker more than a gold rally, so one can surmise that the few stops that remain will be pulled. The easiest way is to stoke a broadly based risk market selloff, but that is contrary to the intention of QE2 itself. It also risks completely shutting down the US municipal bond market, already on the verge of imploding, as well as triggering another sovereign debt crisis in Europe. An already shell shocked public is increasingly suspicious of the prior bailouts, and is too much of an unknown risk to those who depend on the perception of state legitimacy (gold audit, anyone?).

No, the Fed can have its cake and eat it too if most of the risk markets keep rising or at least go sideways while the commodities complex takes a hit as a result of position limit changes. The CFTC has announced its intention to do just this as early as December 1, so short and intermediate term traders take head. After these stop-gap measures eventually fail and the commodities bull rears its head again, we will need to be on alert for stealth attacks via swaps regulation. Ron Paul should have no shortage of questions for Chairman Gensler if he is ever called before the US House Subcommittee for Domestic Monetary Policy. Inasmuch as the CFTC now regulates all currency derivatives, an appearance or three would be in order.

The war on personal wealth that the US state began nearly a century ago with the creation of the Federal Reserve and the Constitutionalization of income confiscation is in its final stages. Prices can no longer be effectively suppressed because of the advanced stage of the Ponzi, and other forms of information cannot be suppressed (yet) because of the internet. Though it's possible we will eventually transition to a new Ponzi (which is in the works), the case for optimism can be made that a better informed public with no prospects for a future bailout will rebuild a system in which prices are given the respect they deserve.

The Ultimate Insiders' Take on QE2 and Basel 3

This morning, Treasury released the minutes of the Treasury Borrowing Advisory Committee (TBAC). Why these are important, I've written previously:

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.

The most recent minutes do not disappoint and are filled with insight on what we can expect from QE2 and the new Basel 3 bank regulations. The highlights:

• QE2 is expected to be $130 billion per month, or $1,560 over the next year
• QE2 will last at least six months and up to two years
• The total amount of QE2 will be data dependent
• Treasury is encouraged to increase coupon issuance (especially in the 30 year maturity) to address "liquidity" shortfalls as a result of Fed purchases
• The Treasury yield curve is expected to flatten in the 5-10 year sector, with the yield on the 30 increasing with inflation concerns and US Dollar debasement
• Implications for the mortage market are that mortgage spreads relative to Treasurys may initially widen, but will ultimately narrow. However, as the 30 year yield is expected to climb, so should mortgage rates (as if the housing market needed another blow)
• A comparison of the scope of QE2 to "the entire combined expected net issuance of Treasuries, Agencies, Agency MBS and Investment Grade Corporates" leads us to speculate the Fed may end up purchasing these very instruments
• The Fed's QE2 "exit strategy" may involve simply selling its holdings in small, predictable increments (no mention of term deposits, IOER or other Fed tools)
• As a result of QE2, investors will be edged out of the 2-10 year range and into very short term (T-Bills) and long term (T-Bonds), and into riskier assets in general
• Basel 3 is being implemented at a record pace (beware of unintended consequences)
• Basel 3 will lead to increased lending costs, causing lending to move outside of the regulated banking system into the non-bank financial system
• Basel 3 will force banks to buy sovereigns ($400 in US Treasurys alone by 2015)
• The Fed is the 800 lb gorilla in the room, and all the other central banks are scrambling to adjust

The full minutes are here, but the relevant excerpts follow (boldings, underlines and brackets are ours):

With regard to the average length, several members of the Committee noted that if Treasury continued with its current issuance pattern, the average length would gradually increase from current levels. One member suggested that Treasury should issue significantly more 30-year bonds, despite some metrics that suggest that long-term issuance is expensive (i.e. the spread between 10- and 30-year yields). This member underscored that 30-year rates were near historic lows. Overall, the committee was comfortable with continuing to extend the average maturity of the debt.

The discussion about lengthening the average maturity of the debt led to a discussion about the size of the Treasury bill market. One member noted that bills were near historically low levels as a percent of the portfolio and that further shrinkage would be problematic for the bill market. Another member stated that negative bill rates ultimately benefit Treasury, because reduced bill issuance would most likely result in making longer-dated coupons and bank deposits more attractive to investors. Members agreed that Treasury should monitor the bill market going forward.

At this point, a member asked about the impact of the Fed's potential quantitative easing (QE2), expected to be announced at the November 2010 FOMC meeting. The question arose regarding whether the Fed and the Treasury were working at cross purposes, given that Treasury is extending the average maturity of the portfolio while the Fed is expected to purchase longer-dated securities. The member noted that from an economic perspective, the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.

It was pointed out by members of the Committee that the Fed and the Treasury are independent institutions, with two different mandates that might sometimes appear to be in conflict. Members agreed that Treasury should adhere to its mandate of assuring the lowest cost of borrowing over time, regardless of the Fed's monetary policy. A couple members noted that the Fed was essentially a "large investor" in Treasuries and that the Fed's behavior was probably transitory [right :)]. As a result, Treasury should not modify its regular and predictable issuance paradigm to accommodate a single large investor.

...

The Committee next turned to the second question in the charge concerning the outlook for non-bank financial institutions in the aftermath of the 2008 financial crisis and the more diminished role played by these entities in the allocation of credit.

The presenting member began with a theoretical discussion of similarities and differences between non-bank and traditional bank financial institutions, noting that both institutions engage in maturity transformation, liquidity transformation, and credit quality transformation. However, it was noted that traditional banks engaging in these activities are subject to regulatory oversight, have deposit insurance, and have access to a lender of last resort. This is not the case for the non-bank financial institutions.

The presenter then discussed the primary changes in "shadow-bank" liabilities versus traditional bank liabilities. The main changes in shadow bank liabilities include a large decline in commercial paper, asset-backed securitizations, and repurchase transactions (repos). On the traditional banking side, the presenter noted that bank liabilities are continuing to grow, particularly small time deposits. [note: the subtle shift from demand for zero maturity to slightly longer is a predecessor of M2 growth] The presenter highlighted that, although shadow banking liabilities have declined, they still exceed traditional bank liabilities.

...

The member concluded by discussing the overall implication of the diminished role of the shadow bank credit allocation on the US Treasury market. The member forecast higher Treasury security holdings as the likely outcome of these changes. This is due to a combination of factors that include high investor demand for cash-like investments, lower supply of alternative products, and regulatory changes like 2a-7 liquidity requirements and the Basel 3 liquidity coverage ratio.

The Committee next turned to the question in the charge regarding the impact of the Basel 3 on financial markets and the Treasury debt market. The presenting member began by noting that Basel 3 is going to impose stricter capital, liquidity, and leverage requirements on regulated financial institutions over the next decade. The benefits of doing so will be a significant reduction in systemic risk to the global banking system [only in your dreams, as risk is shifted to the very central banks themselves].

The presenter stated that Basel 3 is still a work in progress and many details have yet to be decided. That said, Basel 3 is significantly broader in scope and a more complex regulatory undertaking relative to prior Basel accords. It is also being implemented at a faster pace than previous Basel accords and these changes are occurring at a time when global economic activity is slow. Isolating the potential macro-economic and financial market impacts of Basel 3 is made more difficult by the fact that there are a number of other regulatory reforms being considered around the globe [that is an understatement].

The presenter then began discussing the changes in the Basel capital requirements. Capital requirements for banks are expected to rise due to the proposed increases in risk weights for certain asset classes and an overall increase in capital ratios. By some estimates, risk weighted assets are expected to increase by 60 percent. Calibration of the capital requirements going forward is critical to maintaining support for certain credit activities such as securitization and hedging. The presenter suggested that without proper capital calibration, borrowing rates will likely increase under Basel 3, and the inability for banks to hedge credit risk will ultimately reduce the bank's ability to extend credit. Capital calibration may impact such performance metrics like return on equity and the cost of equity for large banks, which in turn, may impact the supply of lendable funds and potentially move some lending activity outside of the regulated banking system into the non-bank financial system [this is huge: there's going to be a shift in consumer and small business lending to non-banks (and yes, your local loan shark will play his part)].

The presenter next focused the discussion on the Basel 3 liquidity ratios. Liquidity ratios are intended to guard against runs on banks' wholesale liabilities. This requirement is expected to be implemented by December 31, 2011. The liquidity coverage ratio is defined as the "stock of high quality assets divided by the projected net cash outflows over a 30 day horizon." High quality assets are defined as cash, sovereign, investment grade corporate and public sector debt, [this is the institutionalization of forced lending to big corporations and sovereign states] while cash outflows include retail deposits, unsecured wholesale funding, secured funding, conduits and contingent liabilities. As proposed in Basel 3, the liquidity requirement may prove to be problematic, particularly with regard to the treatment of deposits and unfunded liabilities. Banks would be required to carry a higher percentage of liquid assets, which would reduce lending capacity and banks' return on assets.

Overall, it was noted that these proposed changes in liquidity requirements could result in higher lending costs, reduced interbank liquidity, diminished ability of banks to hedge credit risk and a reduced ability to provide back-stop facilities for commercial paper. It could also lead to an expansion of the non-bank financial system.

The presenter then discussed the proposed leverage ratios contained in Basel 3. As currently proposed, Basel 3 creates a more conservative leverage standard than currently exists for most US banks, due to a stricter definition of Tier 1 capital in combination with a broader definition of total assets (including off balance sheet derivatives and contingent liabilities). The leverage ratios are expected to be implemented by 2015 and imply further deleveraging by US banks in order to comply with the proposed rule. This requirement would also impact the ability of banks to provide credit lines.

The presenter also noted that Basel 3 will have an impact on Treasury markets by its impact on economic growth and rules governing the ownership of securities and loans. There have been a number of studies on the potential macroeconomic impacts of Basel 3. These estimates indicated that Basel 3 will result in an increase in lending rates of between 20 to 100 basis points in the US, and real GDP growth impacts of -0.1 percent per year to -0.9 percent per year. In terms of Treasury securities, Basel 3 will probably result in banks holding more Treasury and agency securities in their portfolios and fewer loans. There are a range of estimates but one private forecast predicted that Basel 3 liquidity requirements would result in $400 billion of new Treasury security purchases by U.S. commercial banks by 2015.

The Committee finally addressed the fourth question in the charge regarding the implications of a second round of quantitative easing. The member provided a presentation that considered market expectations of QE2 and its impact over the medium- and long-term horizons.

[Back to QE...]

The presenting member stated that the market expects the Federal Reserve to purchase $100 billion per month, as well as $30 billion per month in MBS reinvestments. This will total $1,560 billion in Treasury purchases over the next year. The member stated, however, that market participants believe the Fed will leave the status of QE2 open ended, with purchases ultimately dependent on economic conditions [this is consistent with Brian Sack's remarks that we commented upon on October 4, 2010]. The presenter also noted that the program should last six months to two years.

The presenting member thought that over the medium term (one to two years), QE2 would force Treasury yields lower and would likely lead the curve to flatten in the five- to ten-year sector. Meanwhile, the risk premium in 30-year bonds would likely increase given concerns about inflation and the value of the U.S. dollar [watch for the 10-30 spread and especially the 5-30 spread to become completely unhinged].

The presenter stated that financial markets generally believe that QE2 will push swap spreads wider as the float of U.S. Treasury supply declines. It was also noted that there could be some tightness in the repo market. Credit spreads are also expected to tighten alongside other risk premiums. While mortgages will initially trade wider versus Treasuries, the presenter expected that mortgage spreads should narrow relative to both the Treasury and swap curves [but keep in mind 30 year Treasury yields are expected to climb, so mortgage rates will rise as well]. The presenter further noted that rate volatility will decline as market rates approach zero, with realized volatility in the long-end remaining higher as uncertainty and re-inflation fears increase.

According to the presenting member, liquidity issues could arise as the projected scope of QE2, along with MBS reinvestments, may exceed the entire combined expected net issuance of Treasuries, Agencies, Agency MBS, and Investment Grade Corporates [this could just be to establish a reference point, OR it could be a projection that the Fed will eventually extend QE2 to cover these other securities, including IG CORPORATE DEBT]. The member noted that potential illiquidity in the intermediate sector of the Treasury curve could push some investors into bills, 30-year Treasuries, and/or riskier assets [watch out, M2].

The member noted that the U.S. Treasury and Federal Reserve are two independent [:)], separate institutions with different mandates. As a result, it was noted that Treasury should not alter its issuance strategy [get ready for a complete 180, no sooner than the following sentence]. However, the presenting member suggested that Treasury could address potential illiquidity issues through additional issuance in sectors impacted by QE [as predicted, though there's still the issue of the pesky debt ceiling].

The presenting member then discussed the potential impact on financial markets of the Federal Reserve's exit strategy [presumably still years away] from QE2 [note: the only real exit strategy will come with the end of the Fed itself]. The member noted that there was the potential for an extreme market reaction associated with the Fed's exit from potential purchases. This risk, however, may be mitigated according to the presenter, if the Fed were to gradually and predictably sell the assets on its balance sheet [interestingly, there is no mention of the plethora of new Fed tools designed to soak up excess liquidity].

Finally, the presenting member also stated that the Fed's monetary policy actions had global ramifications. It was noted that the recent depreciation of the U.S. dollar has forced many central banks around the globe to re-calibrate their monetary policy stances [but China is the real currency manipulator].

Project Weimar: Why QE2 Could be More Inflationary Than You Think

"In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places."

-Dallas Federal Reserve Bank President, Richard W. Fisher, October 19, 2010

After yesterday's long overdue risk unwind, odds of a Fed QE2 announcement on Nov 3 have now become one decimal place closer to 100%. And, as various Fed folk continue to shoot their mouths off about the so-called liquidity trap under the false premise that one can print with impunity once short term rates approach zero, Keynesians and non-Keynesians alike might be surprised to learn that we're closer to a highly inflationly scenario than is commonly believed. That is, we could expect not only the pockets of asset price inflation that accompany each crank of the Fed printing press, but the economy-wide inflation for which Gentle Ben prostrates himself before his Keynesian shrine each night (though not necessarily the tame 2-3% doses he prefers).

The thinking goes: the Fed bought $1.75 trillion in assets. The banks took some of this money, levered it, and ramped the risk markets for a year. They left a trillion (or so) parked at the Fed to earn 0.25% interest, where it remains today. If the Fed prints another half (or whole) trillion over the next year to purchase Treasurys, we can expect more of the same. Banks don't want to lend, and what they don't use to bid up risk assets (such as junk stocks, Indian rice futures and now gold), they'll continue to deposit at the Fed.

This assumes, however, that the Fed's bank subsidies vis-à-vis its permanent open market operations are uniform in effect across asset classes, which is not the case. The Fed's $1.25 trillion in MBS purchases merely covered the banking system's collective lousy bets on the mortgage industry. The banks happily put their MBS securities to the Fed and for the most part left the digital zeros in their reserve accounts. The $200 billion in Agency debt purchases (Fannie and Freddie paper) allowed China, et al to swap out its Agency holdings for Treasurys, as Chris Martenson explained in August, 2009. Finally, it was the Fed's $300 billion in long term Treasury purchases that really goosed the risk markets, as we concurrently explained.

This should be no surprise, as Treasurys are highly liquid, "riskless" securities, and have been the Fed's instrument of choice in managing short term interest rates for years. If the Federal Funds rate strayed too far above from the target rate, the Fed would arrange a temporary (or sometimes permanent) purchase of Treasury bills or coupons on the open market from its primary dealers. The intent and result was that the PD's would put the newly minted money to work, where it would compete with other short term investment money for yield. With a greater supply of money available for short term lending, yields would fall accordingly. The opposite would apply when the Fed Funds rate is below the target rate, whereby the Fed would extract liquidity by selling Treasurys to raise short term rates.

From time to time, the amount of money printing or extraction required to achieve a target rate is deemed to be too much by the Fed, so it capitulates and the FOMC adjusts the target rate. This is why the actual Fed Funds rate usually leads the target rate, leading some to believe the Fed is impotent when it comes to interest rate policy. However, the Fed's modus operandi is that it leads the markets as much as possible with expectations, then matches or exceeds expectations until the markets demand too much, after which it backs off a bit. Make no mistake, the Fed exerts considerable influence over interest rate and monetary policy--more now than ever with its unprecedented collection of interventionist tools.

The below chart shows the progression of Bernanke's mad science experiments. Readers have likely been immunized against shock by the hockey stick monetary charts that have littered the blogosphere for nearly two years; however, what is likely a new presentation is the breakdown of bank reserves by bank type. The Fed's H.8 Release (Assets and Liabilities of Commercial Banks in the US) divides banks among the largest 25 domestic banks, all other (small) domestic banks, and foreign banks. The line item for Cash Assets is an excellent proxy for reserve deposits, as it:

Includes vault cash, cash items in process of collection, balances due from depository institutions, and balances due from Federal Reserve Banks

Such balances (Fed reserves) comprise most of the Cash Assets and the other items do not fluctuate enough or are not large enough to be of concern. Accordingly, the below story unfolds:

Click image to enlarge.

Notable is that Federal Reserve balances have been drawn down from the February 24, 2010 peak by $249 billion, of which $169 billion is non-borrowed (those extra reserves that banks can, and have, removed from Fed custody). While the small banks have kept their cash assets nearly constant since December, 2009, large banks have withdrawn $211 billion and foreign banks $96 billion from their respective peaks. These are material sums. Also notable is that QE Lite, now two months old, is not popping up in bank reserves. Importantly, though, we do see M2 ticking up again.

For anyone who still doubts the power of the Fed's open market Treasury ops, it's instructive to zoom in on the second and third quarters of 2008--a time when fears were escalating over the imminent Bear Stearns collapse.

Click image to enlarge.

Like a good shop-vac, Treasury open market operations work just as well in reverse--risk on/risk off. Judging by the spread between the 13 Week T-Bill rate and the Fed Funds target rate, it's clear that the markets were demanding more than a 75 bps drop at the March 18, 2008 FOMC meeting. Regardless, the order was given to reign in liquidity until the two converged, which they nearly had by the last such operation on May 21, $144 billion later. The dramatic slowing in money supply growth was noted by EPJ at the time. Whether Gentle Ben was blindly targeting an arbitrarily set metric or deliberately tightening while talking an easing game to engineer one of the century's greatest market meltdowns is unknown. Historical Fed duplicity tends to make one think the worst, though it's important not to ascribe too much prescience to these people--much less omniscience.

Okay, one final chart via Zero Hedge for the remaining three doubters:

What to Expect

At the conclusion of its November 3, 2010 meeting, the FOMC will likely announce a new round of de facto debt monetization (QE 2), though it may not be the nuclear announcement that has been hyped. As we said, the Fed prefers initially to get as much bang for its buck by talking while simultaneously doing as little as possible (relatively speaking, of course). The current QE2 hype phase appears to be drawing to a close.

Even if there is some initial disappointment on November 3, monthly Treasury purchases will likely be several times the current monthly amounts of ~$30 billion, and they will soon make their presence known. First asset prices, later credit and loans--as incredible as that may seem. Consider that the large banks have ceded to political pressure by dismantling their proprietary trading desks and need to generate income. Also consider that there is a strong tradition in the US and other Western welfare states of governments coercing banks to abdicate lending standards in order to buy votes. Add in some new half-baked government fix-all for the roboforger mortgage mess, and we find all sorts of skeins of potentiae (none ultimately beneficial, of course). As Robert Wenzel comments:

Will banks start loaning out their excess reserves? Will the Fed react to this by draining reserves or raising the rate on excess reserves? How high will the Fed have to raise rates, if they choose this route to counter things if money supply starts to explode.

So there you have it. In an economy that could operate perfectly fine with a stable money supply (That is, no printing of money ever). A machine has been created that can ratchet up the money supply at any time. The methods now available to control the money supply are so complex that economists are now calling for Bernanke to go nuclear, when, in fact, Bernanke has created such a structure that it has to be considered so shaky that it could turn into a financial Chernobyl.

This is not to dismiss the pervasive trend of debt deflation, as Dave Rosenberg will happily point out to you on any given day. We're merely pointing out the first pebbles of monetary inflation rolling down the mountain and how they can quickly turn into a rock slide. What we know is that the next round of large scale asset purchases will be concentrated in Treasurys and will likely dwarf the previous bout of $300 billion by 50% to over 300%. We also know that these operations are highly correlated with asset price fluctuations and that banks are unlikely to simply leave their money at the Fed. At what point this spills over into economy wide inflation is unknown, but we would keep an eye on (1) consumer credit YoY, the second derivative of which turned at the beginning of this year, (2) M2 money supply not seasonally adjusted YoY, which bottomed in April, and (3) long term Treasury yields, keeping in mind that the announcement of QE1 on March 18, 2009 was the high in Notes and bonds for months. One may watch employment as well, if only to imagine the horror on Bernanke's face as he realizes he resurrected stagflation.

Is it possible the Fed achieves asset price inflation and manages to keep the money supply in check enough to avoid rampant economy-wide inflation? For the time being, yes, though it's not the most likely scenario, in our opinion. In the long run, the answer is assuredly no. The Fed has three mandates, one of which is full employment. There is too much interventionist nonsense and resulting uncertainty for businesses to create jobs en masse, so employment statistics will not improve. The Fed is a one trick pony. It will attempt to print the economy out of depression until it eventually errs on the side of easing.

Estimates for Oct-Nov Treasury POMO

MBS prepayments continue amidst continued jaw-dropping plummeting mortgage rates. While it might be academic at this point to continue the exercise of predicting the next month's Treasury purchases (as Brian Sack was kind enough to disclose they would be $30+ billion for the next few months), we have nonetheless pulled out our slide rules and crunched the numbers.

Agency MBS Principal Payments $24,872,870,000

Agency Principal Payments 477,958,000

Agency Maturing 3,188,000,000

Est. Treas. POMO mid-Oct to mid-Nov $28,538,828,000

Last month we were about $1.5 billion shy of the actual $27 billion announced, so a similar margin of error would push this month's estimate above the expected $30 billion. It would appear as though the Fed's model not only incorporates the most recent published Pool Factors (as we do), but also anticipates next month's. We'll find out for sure next Wednesday at 2:00 pm.

Fed Portfolio Manager: Preparing for QE Ad Infinitum -- Don't Expect Any More Big Bang Announcements

Today, Brian Sack, manager of the Fed's System Open Market Account (the SOMA--or, the world's largest hedge fund), remarked on the Fed's resumption of Treasury purchases (so-called QE Lite) and the prospects for full-fledged QE 2.0. Two things to take away:

1) QE Lite purchases will increase slightly to $30 billion per month (up from $27 billion for mid-Sep to mid-Oct). (Don't be surprised for the last two weeks of October before the election to be especially front loaded with risk-market-juicing cash injections.) This is no surprise as mortgage rates continue to break records to the downside and refis continue unabated.

Chart courtesy of Consumer Metrics Institute

2) Reading between the lines, QE 2.0 is virtually guaranteed to be announced at the FOMC's Nov 3 meeting; however, there could be major changes in the FOMC's approach to establishing and communicating future QE policy. Sack proposes five questions for the Committee to consider inasmuch as it is de facto targeting the Fed's balance sheet size similarly to how it (used to) target the Fed Funds rate. From his speech:

Designing a Purchase Program

If the FOMC were to move forward with an expansion of the balance sheet, it would presumably want to take into consideration the perspective gained from the asset purchases conducted from late 2008 to early 2010. The FOMC would have to decide the extent to which a new purchase program would follow the approach from the earlier round of purchases.

An alternative approach would be to design a purchase program that shares more of the features of the FOMC’s adjustment of the federal funds rate in normal times. After all, adjustments to the balance sheet are in many respects a substitute for changes in the federal funds rate. Both instruments attempt to influence broader financial conditions in order to achieve a desired economic outcome. However, the way in which the FOMC implemented asset purchases differed in important ways from the manner in which it has historically adjusted the federal funds rate. With this contrast in mind, I raise a set of policy questions that could be considered in designing a purchase program.

First, should the balance sheet be adjusted in relatively continuous but smaller steps, or in infrequent but large increments? The earlier round of asset purchases involved the latter approach, which caused the market response to be concentrated in several days on which significant announcements were made. That might have been appropriate in circumstances when substantial and front-loaded policy surprises had benefits, but different approaches may be warranted in other circumstances. Indeed, it contrasts with the manner in which the FOMC has historically adjusted the federal funds rate, which has typically involved incremental changes to the policy instrument.

Second, how responsive should the balance sheet be to economic conditions? Historically, the FOMC has determined the federal funds target rate based on the Committee’s assessment of the outlook for economic growth and inflation. If changes in the balance sheet are now acting as a substitute for changes in the federal funds rate, then one might expect balance sheet decisions to also be governed to a large extent by the evolution of the FOMC’s economic forecasts. The earlier purchase program, in contrast, did not demonstrate much responsiveness to changes in economic or financial conditions. Indeed, the execution of the program largely involved confirming the expectations that were put in place by the two early announcements.

Third, how persistent should movements in the balance sheet be? An important feature of traditional monetary policy is that movements in the federal funds rate are not quickly reversed, which makes them more influential on broader financial conditions. A change that was expected to be transitory would instead move conditions very little. For similar reasons, one could argue that movements in the balance sheet should have some persistence in order to be more effective.

Fourth, to what extent should the FOMC communicate about the likely path of the balance sheet? The FOMC often communicates about the path of the federal funds rate or provides other forward-looking information that allows market participants to anticipate that path. This anticipation of policy actions is beneficial, as it brings forward their effects and thus helps to stabilize the economy. For the same reason, providing information about the likely course of the balance sheet could be desirable. In fact, such communication might be particularly important in the current circumstances, because financial market participants have no history from which to judge the FOMC’s approach and anticipate its actions.

Fifth, how much flexibility should the FOMC retain to change its policy approach? The original asset purchase programs specified the amount and distribution of purchases well in advance.9 However, the FOMC would be learning about the costs and benefits of its balance sheet changes as it implemented a new program. This might call for some flexibility to be incorporated into the program, providing some discretion to change course as market conditions evolve and as more is learned about the instrument.

Assuming the FOMC adopts some or all of Sack's suggestions, we can expect balance sheet targeting language to be a regular, rather than punctuating, feature of future FOMC announcements--i.e., the big bang announcements with x trillion multiples may be a thing of the past. With the markets already pricing in $0.5 to $1.0 trillion in the next announcement, there could be some disappointment on November 3.

Fed Alert: FRBNY Studies "Educational Intervention"

In a climate where the word "czar" can be casually bandied about without raising an eyebrow, the New York Fed isn't the least bit shy about studying "intervention" in each and every form.

And this relates to monetary policy how?:

Program Design, Incentives, and Response: Evidence from Educational Interventions

Forthcoming

JEL classification: H40, I21, I28

Rajashri Chakrabarti In an effort to reform K-12 education, policymakers have introduced school vouchers—scholarships that make students eligible to transfer from public to private schools—in some U.S. school districts. This article analyzes two such educational interventions in the United States: the Milwaukee and Florida voucher programs. Under the Milwaukee program, vouchers were imposed from the outset, so that all low-income public school students became eligible for vouchers to transfer to private schools. In contrast, schools in the Florida program were only threatened with vouchers, with students of a particular school becoming eligible for vouchers only if the school received two “F” grades in a period of four years. Unlike the Milwaukee schools, Florida schools therefore had an incentive to avoid vouchers. Using school-level data from Florida and Wisconsin, this study shows that the performance effects of the threatened public schools under the Florida program have exceeded those of corresponding schools in Milwaukee. The lessons of the study are broadly applicable to New York City's educational reform efforts.

HTML executive summary PDF full article22 pages / 302 kb Press release

Given that the new Bureau of Consumer Financial Protection is being sequestered (off balance sheet) under the Fed's umbrella, is it paranoid to wonder if we'll see similar shifts with respect to educational concerns? Or, is the New York Fed simply targeting the victims of its next PR campaign?

Geithner Outlines Basel's All New Boom-Bust Detonator

Your central planners have been toiling ceaselessly to reshape the global financial ponzi landscape for the benefit of all. Now that round one of the so-called Basel III talks has wound down, Geithner graced the House Financial Services Committee with a missive outlining how two half measures equal a whole, describing in broad terms how the ruling class will banish the pesky business cycle once and for all. We thought we'd extract a few choice quotes upon which to expand:

It is also essential that the Basel agreements are implemented by national authorities in a way that generates a `level playing field' in our increasingly integrated global financial system. We will engage our foreign counterparts to look for ways to ensure that that these agreements are implemented in a transparent and consistent way by supervisors in different countries.

We will also continue to explore innovative ways, such as the use of counter-cyclical buffers and contingent capital, to expand the capacity for the system to absorb unexpected losses without amplifying shocks to the system.

Note the use of scare quotes around "level playing field." One wonders which staffer had to strike "LOL" from Geithner's Kool-Ade-stained draft. And, while the term "innovative" out of the mouth of a regulator is enough to make the hairs on our neck stand on end, we'll move on and explore just what are those counter-cyclical buffers. Felix Salmon writes:

When credit in an economy is growing faster than the economy itself, a countercyclical capital buffer kicks in, which essentially says that banks need to have more capital in good times. That countercyclical buffer won’t be set by the BIS in Basel; it’ll be left up to national regulators. But you can probably expect the UK, US, and Switzerland to enforce it up to the maximum of 2.5%.

So when the economy’s booming, banks are going to need 9.5% common equity, 11% Tier 1 capital, and 13% Tier 2 capital.

To which, Robert Wenzel, at EPJ Central adds:

Got that? Central banks create the boom bust cycle by printing money, which enters the economy through the banking system. If the economy "heats up" a "countercyclical buffer" will kick in to slow bank lending, as part of Basel III. But this "countercyclical buffer" could be done without all this Basel III mumbo jumbo by central banks simply slowing money printing. Since central banks target either interest rates or money supply growth, if the countercyclical buffer kicks in, it simply means that central banks will have to be more aggressive adding reserves to maintain a particular interest rate level or money growth level. Bizarre.

As for protecting banks against a future crisis by these new capital levels, not a chance. Following the 1929 stock market crash margin requirements were boosted to 50% to eliminate stock market crashes, a lot of good that did.

As long as central banks pump money into the system, the economy will be vulnerable at the points where that money goes first and since banks are the ones who put that money into the system, they will continue to be vulnerable to slowdowns in money growth. 10%, 12% and 13% capital levels will never be enough to protect them (especially when some of the assets are held in the form of Freddie and Fannie paper, not to mention sovereign debt of the PIIGS).

Not to be accused of passing judgement rashly, we thought we'd consult the source--the BIS' own Countercyclical capital buffer proposal, where on page 21, we find the magical formulas that will save mankind from future financial Armageddon. Namely, the "aggregate private sector credit/GDP gap," which is subsequently transformed into the crisis-averting capital buffer:

RATIO_t=CREDIT_t / GDP_t Х 100%

where

GAP_t=RATIO_t – TREND_t.

where

TREND is a simple way of approximating something that can be seen as a sustainable average of ratio of credit-to-GDP based on the historical experience of the given economy. While a simple moving average or a linear time trend could be used to establish the trend, the Hodrick-Prescott filter is used in this proposal as it has the advantage that it tends to give higher weights to more recent observations. This is useful as such a feature is likely to be able to deal more effectively with structural breaks...

We could continue into the buffer transformation, but it's a bit nauseating. Despite the fancy Hodrick-Prescott filter--the functional equivalent of an exponential moving average--the immodest model builders are trend followers, never catching the highs or lows--just the juicy middle, seemingly oblivious that they are the lead foot on the pedals of the very monetary and credit trends that mystify them so.

Did the Fed Simply Pass the Printing Baton to the Bank of Japan?

Yesterday, rumors fueled an early equities rally on speculation that the FOMC would announce next Tuesday a new round of Treasury purchases--the long awaited QE 2.0--in no small part to the statement we quoted from Morgan Stanley in our discussion of the same subject. The theory being: this would be the Fed's last chance to accommodate during the historically perilous September/October time frame for the stock market, and also not wanting to be seen as influencing the November mid-term election (the next announcement would actually occur the day after the election on November 3). Regardless, MS has relegated its stock-goosing hypothesis to a low probability event. Yet overnight, the Bank of Japan, as agent for the Minister of Finance, took printing matters into its own hands. From Goldman Sack's Fiona Lake:

In the last phase of Japanese intervention running from early 2003 to March 16th 2004, the Japanese intervened on 129 of those days, accumulating Yen36.3trn-worth of reserves in the process. The most persistent phase of intervention was in late 2003, beginning of 2004 and the largest one day Yen selling January 9th 2004 of JPY1.6trn. Over that period, the Japanese initially defended the 116 area, before stepping away in late September, in the run-up to the Dubai G7 meeting and ‘smoothing’ the cross down to 105-106. This level was subsequently defended heavily. The BoJ/MoF will provide aggregate data on the size of today’s intervention and any subsequent intervention on the last business day on the month. Detailed daily intervention data typically becomes available on a quarterly basis.

On the assumption that the volatility around the DPJ election result yesterday was a key trigger for intervention today, it is quite possible that the Japanese authorities will intervene again in response to similar circumstances and it is indeed possible that we see more intervention in the next few days. Broadly speaking, the administration likely want to introduce more two-way risk in USD/JPY in order to stem further speculatively Yen appreciation vs the USD or on a TWI basis. Despite intervention today, we would not rule out notable new lows in $/JPY at this stage. Importantly, the political environment is unlikely to tolerate persistent Japanese intervention given the broader political pressures to allow Asian FX appreciation.

BoJ Governor Shirakawa commented that he hopes MoF action will stabilise FX rates and that the BoJ will continue to supply ample liquidity to the markets and pursue strong monetary easing. This suggests that the BoJ are not in a rush to mop up the liquidity provided by today’s intervention. As a reminder, in an emergency meeting on August 30th the BoJ announced it would start providing 6-month term funding of approximately JPY10trn.

If this is, in fact, only the beginning of a sustained intervention with no attempt at sterilization, the Bank of Japan may simply be picking up the global liquidity slack now that its own election is over while the Fed awaits the end of mid-terms to tag back into the printing ring. Though it's true the BoJ removed US Dollars in an amount equal to the Yen it sold at the prevailing exchange rate, there is nothing that constrains it from sheltering those Dollars. It could lend them to its banks (Nomura's also a primary dealer), purchase US Treasurys or use them to buy any other number of Dollar denominated assets. The BoJ has even been known to buy equities held on its member banks' books (its most recent stock buying program ended in April, 2010, which coincidentally top ticked the US equities rally).

Accordingly, it's instructive to review the prior BoJ intervention period from 2003 through March, 2004, which was also concurrent with extreme Federal Reserve accommodation.

Click for larger image.

While there are, of course, many other variables at play, the image is startling. (Incidentally, this too was a period when the BoJ purchased equities.) Given the apparent failure of the prior intervention (the Yen actually strengthened 10.8%), one wonders if the goal was as much to make Japanese exports cheaper as it was to salvage a principal market for its exports--that is to save the US economy by conspiring with the Fed to kick off the next bubble.

As RW at EPJ Central noted earlier, there were big currency movements underway even before the intervention, with the US Dollar sliding big against the Euro and actually reaching parity with the Swiss Franc. With Yen strength so prevalent as of late, it could simply be a last ditch attempt to preserve the carry trade. Regardless, we'll look with keen interest in the days and weeks ahead as this potential source of back-door QE develops.

Why the Federal Reserve MUST Print, Print, Print...

The law of unintended consequences continues to wreak havoc with the Fed's ad-hoc dart throwing exercises plans, as only yesterday, the New York Fed confirmed our expectations that it will have to ramp up its Treasury purchases by 50% over the next month to the tune of $27 billion (our estimate: $25.5 billion)--all, to keep up with the Jones' refis, defaults and loan mods. It's easy to lose sight of just how this latest round of so-called QE Lite came to be. And, as this is but a hint of future printing, upon which a hand-bound Fed will find itself with no choice but to embark, a brief recap is appropriate.

During and after the carnage of Fall, 2008, the Fed engaged in a multi-trillion dollar large scale asset purchase program, otherwise known as quantitative easing, or QE. It complemented the myriad temporary lending facilities it also had conjured, some as early as August, 2007. QE was essentially a series of permanent cash subsidies to those holding certain financial instruments--select primary dealers that transact directly with the Fed, in particular. But, anyone holding a similar class of security benefited from the price floor that the Fed established. This influx of cash had a side effect of funding a global risk rally that hit its stride in the second and third quarters of 2009 (which was also aided in no small part by 10 to 100 times levered bets from US Dollar borrowings at record low interest rates--also abetted by the Fed).

$300 billion in long term Treasury purchases and a near-zero interest rate policy kept yields suppressed across the curve. $1.25 trillion in mortgage backed securities and $200 billion in agency debt purchases single handedly propped up the financial side of the housing industry, and in turn, the housing industry itself, and in turn the global Ponzi scheme built upon housing and its related securitization. Other central banks joined the fray, and their actions sucked volatility and risk premium out of the entire global financial system, taking corporate risk onto their own balance sheets. The purchased instruments, in private hands, would ordinarily be hedged as interest rates fluctuated, but not so when bathed in the SOMA's warm amniotic Sack.

Thus, nearly every signal available to investors--from interest rates to liquidity to volatility--had been distorted by the Fed's actions to induce the Pax Reserva--that fleeting window in time when some semblance of normal emerged from financial Armageddon. Fleeting and semblance are the operative words, because when one scratched the surface of the statistical recovery, there seemed little beyond a junk-off-the-bottom risk rally (including stocks) aided by a fiscally imprudent (read Keynesian) administration. The Pax Reserva would not last.

Fourteen months and one flash crash later, amidst daily rumors of an imminent Eurozone breakup, the world couldn't get enough Dollars and govvies in the summer of 2010. May 6 was not only a day in which the Dow dropped 1,000 points, but one in which months of pent up volatility was unleashed in a matter of minutes. To be sure, dubious trading practices, such as high frequency trading, exacerbated the situation, but the unprecedented central bank intervention provided the framework.

With the Treasury on the hook for Fannie and Freddie paper, an up-trending mortgage default rate mattered naught, and what was sauce for the goose was sauce for the gander. With fundamentals out of the way and Bernanke willing to buy paper that would make Angelo Mozillo blush a shade less tan, anyone chasing incremental yield was happy to scoop up MBS paper guaranteed against default, yielding a few whole percentage points over Treasurys.

The result: 30 year mortgage rates tumbled 70 bps over the summer of 2010 to 4.35%, which lead to a second refinancing boom. While MBS securities are designed to payout in line with the terms of the underlying loans (15 to 30 years in the case of fixed rate loans), changes in interest rates to the downside will accelerate the MBS principal payments (prepayments) as the proceeds from refinanced loans are funneled to the holders of the MBS securities (a phenomenon known as negative convexity). In addition, MBS principal payments will increase as a result of loan modifications or defaults (which, as of March, 2010, Freddie has pledged to pay on any loan 120 days in arrears).

The Fed's share of these prepayments led to an accelerated decline in the asset side of its balance sheet--effectively giving a tightening bias to Fed monetary policy as it accepted principal payments on its MBS assets. In addition, the Agency (Fannie/Freddie) debt that the Fed bought has been maturing and rolling off its balance sheet at the rate of a few billion per month. To recycle this money into the economy, it began mid-August purchasing Treasury securities at auction from its primary dealers in amounts equaling the expected influx of payments and maturations. Of course, there's no guarantee as to where this money will be deployed, so while this is declared to be reserve-neutral, it is most certainly not effect-neutral.

So what's it going to be then, eh...deflation or inflation?

We've avoided this discussion in the past because rarely does inflation or deflation alone persist across an economy. Most times, there is a mix, with one more visible than the other. From the Fed's perspective, debt deflation is currently most critical, yet its advisors and peers also see hints of inflation, notably in the food sector. Overall, this is a marked reversal from the beginning of 2010, when the Fed was crowing at every opportunity about the tools it would need to fight future inflation. Indeed, as Congress was making up its collective rassoodocks whether or not to reappoint Bernanke in January, 2010-- a time when "green shoots" was still uttered by a few without a smirk--we were discounting the Fed's inflation warnings:

Since October, 2009, the Federal Reserve has increasingly hyped the inflation meme by publicly touting the more than $1 trillion in excess reserves (held by banks with the Fed) which, as the theory goes, could come flying out into the economy in an HFT-New York second, in one hyperinflationary swoop. If all the world’s a stage, then Bernanke will be winning an Oscar for this performance, because the futures and currency markets are pricing in a Fed rate hike in the second half of 2010 and a robust US economy. Rather, we have postulated that this tightening theatre is mere preparation for QE 2.0, which has been confirmed today (at least with respect to more Agency MBS purchases by the Fed). We suspect the Fed will wait until the US Dollar index rallies to at least 81 or 82 before announcing the next round of long term Treasury purchases. Make no mistake, however, those pesky excess reserve dollars will eventually get itchy to rejoin their friends in the economy (perhaps when they amount to $3 trillion sometime in 2011), and the Fed will need all the tools it can strap around its bloated waist to reign them in.

Expectations of a rate hike have been pushed out to Q3 2011 and, with serious talk of the next round of easing, it's time to start thinking about those excess reserves again and how they might find their way into the economy against the best wishes of the Fed.

The Fed is perceiving its greatest enemy--deflation--at work, as evidenced by Bernanke's post-Jackson Hole speeches. Recent data from the real time consumption-side GDP measurements of the Consumer Metrics Institute demonstrate that current consumer retrenchment is approaching the extreme levels seen in the last election cycle that preceded the panic of 2008.

Consumption is unlikely to rebound until the uncertainty of the election is over, and the Fed is acutely aware of this. Accordingly, we're fast approaching the window of time in which the Fed would attempt to reclaim the Pax Reserva with a second great reflation attempt. On that note, Morgan Stanley recently hypothesized that the Fed may open the door to QE 2.0 as early as the September 21 FOMC meeting so as not to be perceived as attempting to influence the upcoming election at its early November meeting. [Update: this hypothesis has since been withdrawn] If this is the case, it would be characteristic for hints to be dropped in Fed speeches over the next week.

The effects the next reflation will have on the markets and economy depend on its magnitude and timing, as well as concurrent fiscal initiatives, including the 2011 tax cut expirations. With all the variables and skeins of potentiality, we are indeed living in kaleidic times. What we can say is that if the Fed undershoots or simply maintains present policy, deflationary forces, especially with respect to interest rates, could certainly persist. This appears to be the case with the current Treasury buybacks--just enough buying pressure to keep yields low, while having little stimulative effect on the money supply (when measured year over year, non-seasonally adjusted).

If, on the other hand, the Fed overshoots, inflation expectations could immediately reverse. It's instructive to remember that on the original Treasury QE announcement of March 18, 2009, the 10 year yield dropped an eye watering 55 basis points that day to 2.47%. However, it dramatically reversed to the upside over the next three months to reach a high of 4.01% and, to this day, has not reclaimed the prior low. Notwithstanding the current intermediate down trend in yields, they are susceptible to an upwards reversal on a change in inflation expectations. The most likely candidate is the Fed's next reflation announcement, but any number of other events could be catalysts as well.

While it is assumed that future Fed accommodation will come from asset purchases, it is also possible it would lower the interest rate on excess reserves (IOER) it pays to banks to keep their money tied up at the Fed, currently 0.25%. While this route is much less likely, it is instructive to understand the dynamics of the IOER and how it relates to other rates because it will have implications for recognizing when the Fed has truly lost all appearances of control. We wrote about these relationships here in August:

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.

One of the worst case scenarios for the Fed would be to engage in a new large scale asset purchase scheme, only to see the Fed Funds rate creep (much less jump) above the IOER threshold of 0.25%. This came close to occurring in mid-June, 2009, but was averted by fears that the nascent equities rally had come to an end. If the Fed Funds rate were to trade up to say, 0.30% or 0.40%, the effect would be similar to that if the Fed had lowered the IOER--banks would start looking for places other than the Fed to put their money, and money multipliers would start taking over. The Fed could either allow the consequences of serious inflation to take hold, or it could raise the IOER. Neither would be attractive, as it would look either negligent or pusillanimous.

The bottom line? The "recovery" is ubiquitously recognized as a statistically-manipulated sham (at least, in a universe that excludes CNBC hosts). The Fed, when faced with signs of both deflation and inflation, will always resolve such dilemma in the direction that the printosine bases embedded in their phosphate-deoxyribose backbones direct. Ad hoc interventionist measures beget only more of the same, and thus, what seemed a binary central banking world a mere two years ago--to print, or not to print--is a unary one. The "decision" is only the magnitude, with the margin for error exceedingly small.

Update Sep 15 2010: Date of next FOMC meeting was corrected.

Estimates for Sep-Oct 2010 Fed Treasury Purchases

Due to material increases in MBS factors for the 4.5% and 5.0% coupons in the Fed's MBS portfolio (indicating not only increased refinancing but mortgage default payouts by the GSEs), along with an increase in agency debt maturing over the four week period, Treasury purchases are expected to jump nearly $7.5 billion from the $18 billion bought in the first four week purchase period. Next Monday, Sep 13 at 2:00 pm, Brian Sack tells us just how close we are.

Agency MBS Principal Payments* $21,066,000,000

Agency Principal Payments 494,657,000

Agency Maturing** 3,946,000,000

Est. Treas. POMO mid-Sep to mid-Oct $25,506,657,000

* Includes purchase of 120 day delinquent mortgages by Freddie Mac. See page 37.

** Per FOMC Minutes released Aug 31, 2010, Fed will replace maturing Agency debt with Treasury securities. This accounted for our shortfall in the Aug-Sep estimate wherein it was believed the Fed would replace maturing Agency debt with like securities. Apparently, the Fed cannot miss the opportunity to gift a commission to the PDs and float the Treasury market.

How Congress Literally Turned Back the Hands of Time to Ram Through the Federal Reserve Act

Prior to television, it was the duty of newspaper reporters to inform the public of the important facts surrounding the signing of a major bill--the names of those present, the color of the president's suit, who remarked which witty remarks, etc. The signing of the Federal Reserve Act by President Wilson on December 23, 1913, was no less an occasion for the NY Times to practice an introduction worthy of what would later regularly appear on page 6 of the New York Post. How appropriate that the headline, "[President] Affixes His Signature at 6:02 P.M., Using Four Gold Pens" would foreshadow Wilson's own remarks on gold which, themselves, would foreshadow a century-long love-hate (okay, mostly hate) relationship between the progressive central planners and the yellow metal:

With the second of the plain gold pens he wrote the first syllable of his last name, and finished his Signature with the other pen. "I'm using a series of pens," explained the President to the gathering. In response came the deep voice of Senator James Hamilton Lewis 0f Illinois: "the bill came forth in installments."

Everybody laughed at this, of course, and there was another laugh when the President, as he reached for the fourth pen, remarked: "I'm drawing on the gold reserve."

And with that precedent set, whereby future presidents would assume the authority of Gold Steward/Leaser in Chief--incrementally, then completely abdicating the gold standard--the [young] gray lady then treats us to a procedural blow by blow of how the Grinch was enabled to steal every single future Christmas Federal Reserve Act came to be. All we can do is reproduce the text and wonder what shenanigans went on behind closed doors and off the record.

After debate that began at 10 o'clock and lasted until 2:30 the Senate adopted the conference report by a vote of 43 to 25. All Democrats present. Three Republicans and the only Progressive in the Senate voted for the report.

...

The vote was taken at 2:30 when Mr. Owen ended [sic], and the engrossed bill was rushed to the House for the Speaker's signature. Before it returned the Senate had agreed to the House resolution providing a recess until noon of Jan. 12, and had gone into executive session.

The bill was received in secret session and the Vice President signed it before the doors were open. Adjournment was taken with the doors still closed and when they were thrown open it was found that only four Senators remained on the floor. Most of them had already caught trains for home. Speaker Clark placed his signature to the enrolled parchment copy of the currency bill at 13 minutes to 3 o'clock, in the presence of the House.

After its late session of last night the House had taken an adjournment until 2:30 o'clock this afternoon to await the acceptance of the conference report by the Senate. When it met the action of the Senate had not been "messaged" over to the House and a recess was taken until 3 o'clock. While the House was in recess the bill, in its final enrolled form, bearing the signature of Vice President Marshall, was received at 13 minutes to 3 o'clock. As the House had recessed until 3 o'clock orders were given to employes to turn the hands of the clock over the Speaker's desk forward twelve minutes, to make the time 3 o'clock, and the enrolled copy of the bill was then signed.

The article closes with some words by the remarkably self-assured Speaker Clark:

Clark Congratulates Coutry.

Speaker Clark, after signing the bill issued a statement as tollows:

"Most assuredly the country is to be congratulated on the fact that, at last, the Currency bill is upon the statute books; for in such matters of great pith and moment, it is the uncertainty that hurts--even where a bill might be the sum total of human wisdom on any particular subject. Now, all men of intelligence will know very soon what the Currency bill contains and what it means, and can conduct their affairs accordingly.

"My own judgment is that it will be satisfactory to the country in a high degree--at least I hope so. The fact that a large number of Republicans and Progressives voted for our bill is proof positive that the country is well pleased with the bill. [Notwithstanding the time-bending convolutions exercised to get it passed two days before Christmas.]

"So many of them so voted that it may not improperly be denominated non-partisan law. We certainly have ample cause for self-congratulation that in nine months we have passed a bill revising all the tariff schedules and a bill thoroughly revising and overhauling our currency system-presenting bills so fair and so wise that even political partisanship gave way to such an extent that many Republicans and Progressives voted with us.

"Our two bills are excellent samples of constructive legislation. The tariff bill is working well and now that the uncertainty as to the Currency bill is removed. I hope and believe that the country is entering upon a long period of prosperity.

"Everybody in any way responsible for these two bills is to be congratulated on the results."

Most striking is that, a century ago, it was not necessary for legislators to hide airs of omniscience and the pretense of being conduits of infinite wisdom. The participation of a few members across the aisle was enough to suggest that words scribbled on legislative parchment in the hallowed halls of the Rotunda state temple had been revealed by a divine creator. While such speech would be derided today, the content of the voluminous bills passing across the current president's desk suggests the public is, if anything, more deferential. Hopefully, historians a century from now will look back and see our present time as one in which the veil of fog was lifted and the naked emperors were seen for the dim-witted, banal thieves they are.

The full article is below.
NYT Federal Reserve Act 100414417