Debtor's Prison

Greetings fellow inmates:

On Wednesday, Uncle Benny himself addressed Congress in his semiannual monetary policy report. In general, the testimony was quite self-congratulatory. He began by stating the usual tentative signs of economic recovery, or at least a slowdown in the pace of contraction. Notably, an improvement in short-term lending spreads was specifically tied to the Fed’s and other central banks’ efforts at providing short-term liquidity. This has led to an improvement in risk taking, with more private capital flowing into credit markets. He mentioned recent stabilization in household spending, though he notes that there is still a significant possibility that this will prove transient, posing one of the greatest downside risks to the outlook.

Naturally, what most interest us in this particular post are his comments on monetary policy. The mainstream media touted it as an exit strategy, but we are much less sanguine. Much of his statement was based on the old trite “trust us, when the time comes, we’ll be able to act not only on a timely basis, but also a smooth one.” He also assured Congress that he and his cohorts were devoting a considerable amount of time on issues relating to the exit strategy. In our opinion, a lot of this must have been contemplated from the very beginning, not on an on-the-fly basis only in response to market pressures. Of course, they could have well have, away from public view. Or, they might know that the endgame is a massive currency devaluation and superinflation. He notes that a lot of the policy measures will unwind automatically as they expire, a song we’ve heard a lot recently. Yes, these will expire, but even if the $600bln of extraordinary credit outstanding dwindles to zero, there is still close to $1tr left of QE purchases. Very interestingly, he cites his ability to pay reserves on deposits as the most important tool to tighten policy. By raising the amount of interest paid on reserves, he is confident this would set a floor at the desired short-term rate. While this might be true, it is yet another blatant example of his catering to his friends in the banking system. Remember, these reserves were digital creations, given to the banks for free and they are now earning interest on this imaginary money. Raising the interest paid on reserves is yet another gross violation of what are supposed to be their constituents’ rights. Finally, he does cursorily mention long-term asset sales as a possibility. One thing that he fails to mention is the precarious situation yields will be in, once a recovery does set in, supply is off the charts and foreign creditors back away from holding the paper. Sales onto this environment threaten significantly higher rates, and he knows it yet fails to warn on those dangers. Will be right here Uncle Benny, when it all blows up in your face (and everyone else’s).

Now on to this week’s happenings in the FedBS. Each side of the balance sheet was virtually unchanged, shrinking by a mere $1bln. This belies strong movements in different components however that balanced each other out. On the asset side, in contrast to last week, we saw another strong decline in the outstanding Currency Swaps and Term Auction Credit which fell by $22bln and $36bln, respectively. There are currently $90bln of swaps outstanding and $238bln of Term Auction Credit. As we said last week, it is still highly uncertain where these two facilities will find any short-term equilibrium, if at all. They might as well go down to zero, though we think this would take a lot longer than most seem to expect. These strong declines in these two components of the FedBS were balanced by the strong asset purchases. On the liability side, we had two counterbalancing forces. The Treasury general account grew by $46bln. There was a $16bln decline in the “other” category, and a decrease of $29bln in reserve balances.

Asset purchases were very strong this week. As usual, Treasury and Agency purchases were in line with their weekly average. Treasury purchases were $7.7bln, bringing the total to $208bln. Agency purchases were $2.6bln, for a total of $102bln. Uncle Benny also bought $1.4bln of TIPS this week. MBS purchases were quite substantial, at $48bln, for a total of $537: a buying spree week for sure, but plenty more to go.

Even though there was a brief lowering in yields following Uncle Benny’s testimony, long term yields are still 11bps higher than they were last week, coming in at 4.54%. In the long run, 30-year yields will rise dramatically as a direct result of QE, of that we are certain.

The dollar, as measured by the St. Louis Fed broad trade-weighted index, dropped by 1.1% relative to last week. It is still trading in its recent range and there is no evidence yet that it has broken to the downside. As usual, we remind you that we expect the dollar to be decimated by QE when everything is said and done.

Commodities, as measured by the Rogers International Commodity Index, continued their strong performance from last week, rising by 2.9%. QE has effectively engrossed the very base of the global monetary system with more debt and toxic financial instruments. It is a circular game of accounting tricks that now pervade an even deeper structural element of the financial/economic system.   As the gargantuan pile of paper supporting a dwindling resource base becomes even more unsustainable, the end result will be a rush into real assets, driving their prices into the stratosphere.

Tune in next week for more adventures in MSTBMM,

MAAA