Weekly FedBS QE update 06.25.09
Thursday, June 25, 2009 at 08:09PM Greetings fellow inmates:
For starters we’d like to take a brief moment to apologize for this week’s scant posting; other items inside the penitentiary took up the time of your DP staff. We’ll return to regular frequency next week!
This week was an eventful one for Uncle Benny and Co over at FedWorld Live! Yesterday, the FOMC released its latest statement. As usual for the past couple of months, they cited a slowing in the pace of economic contraction, though household spending remains constrained by ongoing job losses, lower housing wealth and tight credit. Uncle Benny prognosticated that economic activity will remain weak for a time, though remains hopeful that fiscal and monetary stimulus will contribute to eventual economic recovery. The Committee left the interest rate unchanged and mentioned that conditions are such to warrant an exceptionally low rate for an extended period. Interestingly, Uncle Benny mentions higher commodity prices though he still expects inflation to remain subdued for some time. At this point we wonder what are the relative strengths, if any, of his time forecasts. For example, is an extended period longer than some time? If so, then does that mean that the fed funds rate will remain low even after inflation is no longer subdued? This might be just a pointless exercise on our part, but remember that if anything, Uncle Benny is very careful with his word choice, and he knows every word is scrutinized closely by the market. The release also confirmed the quantitative easing (QE) amounts and target dates for each asset purchase program, though they will continue to evaluate its timing and overall amounts in light of the evolving economic conditions. Remember that we have prognosticated that Uncle Benny will have committed to buying as much as $1tr of Treasuries by the end of the year.
The release ends with the usual empty fluff, “The Federal Reserve is monitoring the size and composition of its balance sheet (FedBS) and will make adjustments to its credit and liquidity programs as warranted.” As usual, what really bothers us about statements like this is the utter lack of a delineated plan for doing so. It is also extremely deceptive to make it seem as though adjusting the balance sheet is a simple matter of doing so, completely within the control of the Fed, free of constraints and severe repercussions. The QE program has now placed $1.75tr of long term assets on the balance sheet, more than double the total size of the FedBS before the crisis. Shrinking it below this will require sales of these assets, will result in much higher yields, rates, for everyone. This will squash any incipient recovery. We believe that the pressure will be continued to be exerted towards promoting growth, and Uncle Benny will be hand-tied to his FedBS. This is but one of the examples of potential problems that we see ahead and it frustrates us that Uncle Benny and Co. have not once mentioned this problem. Instead they always try to delude us by telling us they’ll be able to simply adjust the size of the FedBS whenever they feel like it. Even if they were able to, Uncle Benny expects us to believe he will be able to have the precision of a laser surgeon when he has shown to be more like a butcher working in the dark.
Uncle Benny also released a statement today about changes in some of the details of the liquidity facilities, or the alphabet soup. The Fed extended the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Primary Dealer Credit Facility (PDCF) and the Term Securities Lending Facility (TSLF). The expiration of the Term Asset-Backed Securities Loan Facility (TALF) remained unchanged at 12.31.09. Currency swap lines were also extended to February 1. The Money Market Investor Funding Facility (MMIFF) was suspended, meaning it will be allowed to expire in October. Though leaving the door open for further extensions if necessary, Uncle Benny sounds hopeful that financial conditions will improve enough to warrant the suspension of some of these programs. We do expect that some of these programs will get wound down, in large part due to the liquidity provided to banks elsewhere, including the FedBS. Currently, about $600bln remain in total for these liquidity facilities. Even if they wind down completely, that will still leave at least $2tr of long-term securities on the balance sheet that can’t be shaken off that easily.
Otherwise, each side of the FedBS shrunk this week quite significantly by close to $60bln. This was mostly due to a decrease in Term Auction Credit, which declined by $54bln. Currency swap lines also dropped by $29bln. The liability side of the FedBS showed some interesting activity this week. The Treasury General Account, which is in the liability side of the FedBS though not counted in the monetary base, grew by an enormous $76bln to $119. This meant that to compensate, reserve balances shrunk by a hefty $125bln. This quirky “anomaly” was somewhat modified at the end of the week, as yesterday alone, the Treasury account shrunk by $40bln and reserve balances grew $50bln. Cheeky Benny.
The asset purchase programs continued their pace from last week. Uncle Benny purchased $15bln of Treasuries, this time mostly in the 5-10 year sector. Agency debt purchases totaled $4bln, coming to a total of $92, short of the $200bln target. MBS purchases came to $12bln to a total of $467, still way short of the $1.25tr mark.
The long bond performed really well this week, continuing last week’s performance. Yields dropped by a substantial 27 bps to 4.33%. Remember that we ultimately expect QE to result in much higher long-term yields as investors shun US assets due to the unsustainability of sovereign debt issuance. The first few months of QE also tentatively showed the market punished the long bond for Uncle Benny’s excursions. Some commentators have sounded optimistic about the claimed reticence by the Fed to increase QE and have cited strengthening Treasuries as an indication. We believe there was a premature and concocted belief that the Fed would ramp up QE, so the market has reacted when they haven’t. While we do believe they will ramp it up, we also think it’s still early in the QE game. These past two of weeks of lower yields do not make a trend, significant as the moves have been. That being said however, we might experience a period of lower yields, especially if the economy takes another turn for worse as we expect. Also, if a scenario develops where primary dealers expect the Fed to increase QE purchases, there might be a run-up in price (lower yields) as they buy them up in order to sell them to Uncle Benny later. Ultimately what we are trying to say is that the path from QE to much higher long-term yields will not be a smooth one. There will be periods of widening and tightening, but the end result will be the same. Is this recent tightening the first significant retracement to the trend for higher yields since the onset of QE? We don’t know yet, more data is needed.
The USD put in another strong performance this week, rising by 1%. All the same statements we made above about lower yields can be said about a strong dollar. We believe QE will be in large part to blame for the eventual USD event horizon, a period of time when confidence in its worth as a reserve currency was waned terminally, potentially resulting in a broad fiat currency crisis. The path to it will not be a smooth one, and there will be brief periods of strong USD peppered in there. The USD remains 8% below its high, reached right before QE was announced.
Commodities, as measured by the Rogers International Commodity Index, declined for the second week in a row. The index dropped almost 3% to 2919. This marks the second week in a row of lower yields, higher USD and lower commodities. We dare not speculate on what has caused these counter-intuitive moves for the past two weeks nor how long this pattern will continue. What we will say, again, is that QE will in the long-term result in higher yields, a lower USD and higher commodities, much as it has for the past few months.
Tune in next week for more adventures in BMSTBMM
May your capital be safe and your investments prosperous,
MAAA
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Reader Comments (4)
In order to "sop" up the money that has been injected into the system, the Fed will have to sell these assets. The problem is that much of the Fed BS is depreciating in value. If the Fed could even find buyers for some of the junk on thier books, they can't soak up the excess money in the system once velocity picks up. What even theoretical way other than high taxes and running a surplus can the government use to "sop up" excess money?
All true but there is one more way. Borrowing. I believe that most of us are dubious about the viability of that option but it is a theoretical short term solution. In the long term however you are correct only running a surplus and/or higher taxes can sop up the money which has been spewed out.
attitude_check, you make a very valid point that we have also discussed in these updates before. Those asset sales are what concern me since they will drive up yields on everything. That is of course if they actually decide to shrink the balance sheet through those means. The way I see it, yields will go up in the long term no matter what; asset sales would only compound the problem.
Discipulus, you´re right to bring up the borrowing alternative. That is one that we have barely discussed here. I am definitely against the concept of the Fed issuing its own debt, both philosophically and practically. Of course, the problem with excessive debt will not be solved by having another quasi-federal institution issuing even more debt. There is a lot of uncertainty about how option would be carried out and the immediate effects it would have on the dollar. This short-term solution would only exacerbate the long term problems. I dont see the US returning to surplus in the foreseable future and I expect the problems of QE (dollar crisis, higher yields) to manifest fully before then.
Indeed I find it highly likely that the inflation resulting from quant easing is the most likely means by which the US will return to surplus. For a long time the dollar has essentially been worth more than the value of the US GDP. This relationship needs to reverse. The most obvious way for this to happen is for the dollar to be worth much less. Clearly this is less than ideal for those that hold dollars but hopefully after this the world will be a bit more leary of buying massive amounts of US securities.