Debtor's Prison

Greetings fellow inmates:

Yesterday, Uncle Benny released the minutes of the June 24-26 FOMC meeting. As the public has become increasingly aware of its greatly expanded balance sheet, the Fed discussed several of these concerns as well as some of the risks it poses. Before we give you the update of what actually happened in the FedBS this week, we will present to you a list of excerpts from the minutes that pertain to the balance sheet, with our comments in italics.

• Staff projections suggested that the size of the Federal Reserve’s balance sheet might peak late this year and decline gradually thereafter.

This is consistent with the announced schedule of asset purchases. Assuming gradual or no changes to the current use of existing liquidity facilities, the FedBS would be expected to peak at about $2.5-$3.0tr, a whopping amount. Of course, this is assuming that QE is not expanded as we expect it will. The gradual reduction they speak of seems to imply that the liquidity facilities currently in place are expected to remain until at least next year, supporting our notion that market expectations of balance sheet contraction are still very premature.

• The analysis also suggested that the market value of the Federal Reserve’s securities holdings could decline appreciably under some scenarios. However, while the Federal Reserve would retain the option of selling securities before they mature or are prepaid as a means of tightening policy when appropriate, it was not expected to have to do so.

This is a very interesting statement for a couple of reasons. For starters, it concedes that the market value of their securities might fall, which includes not only the toxic debt held as collateral, but also its long-term MBS and Treasury paper. Secondly, they state that they don't expect to have to sell these assets! This is what we have been saying for a while. These long-term assets cannot be easily disposed of, which means that the FedBS will remain greatly inflated for a very long time.

• Some participants thought that increases in purchases of Treasury securities might have little or no effect on long-term interest rates unless the increases were very sizable, given the large amount of current and projected supply of Treasury securities.

As you know, we expect Uncle Benny to increase his purchases of Treasuries and to have commited by the end of the year to purchase $1tr of them. We believe he will be compelled to do so by the waning demand from foreign creditors and the inability of domestic markets to absorb the expected issuance as well as a potential re-ignition of financial stress. This statement could be a veiled warning that if it were to come down to it, in a move to try to stem the upcoming surge in long-term yields, Uncle Benny could purchase very sizable amounts of them. As we have learned from their slew of "tools", nothing is out of the question.

• While most members did not see large scale purchases of Treasury securities as likely to be a source of inflation pressures given the weak economic outlook, public concern about monetization could have adverse implications for inflation expectations.

We disagree with the first part of this statement, though we respect that they at least called monetization by its name.

• Several participants pointed to the possibility of an upward shift in expected and actual inflation if the stimulative monetary policy measures and the attendant expansion of the Federal Reserve’s balance sheet were not unwound in a timely fashion as the economy recovers.

The important take-away from this in our view is that there is an admitted possibility that the FedBS is not unwound in a timely fashion. Up until now there has been absolutely no exit plan whatsover, only assertions that one would come about when the conditions warranted it. Let's face it, it is overwhelmingly likely that they will fail in shrinking the balance sheet in a manner and timing that prevents superinflation. At the very least, this admission is somewhat more frank than we've had in the past. Perhaps they are preparing the sheeple.

• Participants discussed the merits of including securities backed by adjustable-rate mortgages in MBS purchases.

Yet another open possibility for expansion of QE through purchase of even more toxic debt.

• Still, meeting participants judged that market conditions remained fragile, and that concerns about counterparty credit risk and access to liquidity, both of which had ebbed notably in recent months could increase again.

Counterparty credit risk and liquidity concerns could certainly increase again, and we expect they will. The fact of the matter is that several large problems loom in the horizon for debt markets, including but not limited to commercial real estate, consumer loans, commercial and industrial loans, and municipal securities. The attendant losses could be large enough to trigger yet another wave of counterparty fears and a liquidity freeze. This of course will only lead to Uncle Benny pumping more liquidity into the market.

• However, if financial stresses do not moderate as expected, the Board and the FOMC were prepared to extend the terms of some or all of the facilities as needed to promote financial stability and economic growth.

Take that you premature-balance-sheet-contraction-expecters! Remember a couple of weeks ago when Uncle Benny extended the duration of most of the liquidity facilities yet the media focused solely on the couple that they trimmed? Well, this is loud and clear. We are not out of the woods yet by a long-shot, and the possibility for further BS expansion is palpable.

• The inclusion of commercial mortgage-backed securities (CMBS) in the Term Asset-Backed Securities Loan Facility (TALF) program resulted initially in a narrowing of commercial mortgage credit default swap (CDS) spreads; however, spreads later widened as rating agencies expressed concern about the credit quality of the senior CMBS tranches.

As we said some time ago, it was always unlikely that TALF would solve the underlying problems in the CMBS market. Admittedly, prices for these securities rose more than we expected following the annoucement of their inclusion in TALF. Nevertheless, the credit quality remained rotten of course and continues to deteriorate. Yet another humongous stupidity by the rating agencies to have rated the senior tranches as high as they did. They still have a long way down.

• The dollar depreciated substantially during the intermeeting period against all other major currencies. This decline appeared to be driven by a renewed sense of optimism about global growth prospects, leading investors to shift away from safe-haven assets in the United States to riskier assets elsewhere.

It really pisses us off that people in power refuse to admit that the dollar's recent slide has had anything to do with QE. As we have reported in this series of weekly updates, the evidence is quite compelling that QE and the dollar depreciation have gone hand in hand. Of course, this does not prove causation, merely correlation. But it is no coincidence that the recent peak in the dollar index came immediately before the announcement of QE and the strong reversal immediately following. Moreover, we take issue with the notion that the dollar was previously strengthening mostly due to investors seeking safe-haven in the US. In reality, much of the strenghthening was due to people deleveraging their excessive dollar-denominated debts.

• A few participants were concerned that inflation expectations could continue to rise, especially in light of the Federal Reserve’s greatly expanded balance sheet and the associated large volume of reserves in the banking system, and that as a result inflation could temporarily rise above levels consistent with the Committee’s dual objectives of maximum employment and stable prices.

Again, another somewhat frank admission. In this case, they specifically mention the large volume of reserves as potential sources of unstable levels of inflation, which we have been trumpeting for a while now. Gee, Uncle Benny, is it getting harder and harder to hide the likely consequences of your actions? Ease them into it Uncle, that is your M.O. after all.

• Worsening credit quality, especially for consumer and commercial real estate loans, was seen as an important reason for reduced lending and tighter terms, and banks could face substantial losses in their loan portfolios in coming quarters.

Banks will face substantial losses in the coming quarters from the continued deterioration of credit quality across the board. This means continued government support and an expansion of central bank accomodative policies. TALF might increase. Direct purchases of other assets, or absorption of them as collateral could be implemented. The FedBS is afterall the crutch of the credit markets at the moment and will continue to be so for quite some time.

• In addition, some noted the difficulty in gauging the macroeconomic effects of the credit-easing policies that have been employed by the Federal Reserve and other central banks, given the limited experience with such tools.

Limited experience. Exactly. Not only are central bankers in reality flying blind, but the size of their combined undertakings is truly staggering. The implications will be gargantuan in the long-term and yet no credible plan has come from any of them for the eventual unwinding of their policies.

Now, we finally turn to this week's happenings in the FedBS.

This week, each side of the balance sheet grew by a substantial $34bln. In contrast with previous weeks, we saw barely any change in the main remaining liquidity facilities (Term Auction Credit, the CP facility and central bank liquidity swaps). As always, one point does not a trend make. We will say however, that we expect the shrinking of these facilities of the past few weeks to moderate and achieve an equilibrium. We have no idea what this equilibrium level is, but it certainly isn't zero as many commentators would have us believe. We shall see in the coming weeks if they have finally stabilized.

This week Uncle Benny bought $8.6bln of Treasury securities, bringing the total purchases to date to almost exactly $200bln of the $300bln target. He also purchased $1.7bln of Agency debt, bringing the total to $99.6bln, or about half of the target. As we predicted last week, MBS purchases were significant this week with a total of $26.6bln bringing the cumulative total to $489bln. The asset purchases accounted entirely for the growth in the FedBS. On the liability side, as usual, reserve balanced financed the purchases. They grew by $30bln, coming to a total of $781bln. As stated in the meeting minutes, the Fed expects that these will continue to increase as they are the only means they are employing to finance QE.

30-year yields rose significantly this week by 13bps to 4.43%. As usual, we remind you the long bond will suffer some of the worst long-term effects of QE. Uncle Benny will fail to reign in yields at the long end, and might in a desperate attempt make things worse by commiting to further monetizing the debt. It is very likely this will be necessary as issuance far exceeds demand in the mid-term future.

The broad dollar index rose compared to last week to 105.95 from 104.71, though it remains in the range in which it has traded for the past few weeks. The data does not allow us to say anything other than it seems to have stagnated recently. We do expect in the long-term for the USD to suffer an extreme devaluation, largely due to QE. The devaluation of the USD, and other reserve currencies, will be severe enough versus commodities that we believe superinflation is the biggest threat created by these unprecedented global experiments.

Commodities, as measured by the Rogers International Commodity Index picked up sharply this week, rising by 3.6% to 2765. In connection to the expected effects on long-term yields and the dollar, we expect commodities to rise sharply in the medium to long-term due to QE. Productive assets all over the world are being increasingly replaced by paper, which is being absorbed onto central bank balance sheets. Eventually, we will reach a point where the market realizes that all the blood has been squeezed out of the debt rock and investors will pile into real assets.

Tune in next week for more adventures in MBSTBMM,

MAAA