Debtor's Prison

Greetings fellow inmates:

This was a relatively slow week in Fed World Live!  Uncle Benny did release his Beige Book, a document that expounds on the status of different aspects of the US economy, as reported by the 12 Fed Districts.  As we have come to expect from these releases recently, the Beige Book noted some signs of improvement in certain markets. However, it was less sanguine than others have been, perhaps due to the fact that it’s a “dryer” release.

Most districts reported sluggish retail activity. Consumer spending increased or became “less negative” in three of the districts, while the rest showed flat or declining sales. In general, consumers remained price conscious and focused on purchasing expensive necessities rather than big ticket items. Unfortunately for all of us, this will be an increasingly common and pervasive story over the next few years as the prices of basic necessities, which are heavily dependent on natural resources, will soar once Uncle Benny’s zany adventures in Black Money Magick catch up to the currency markets.  Travel and tourism also continued to decline in the majority of Districts. In nonfinancial services, the reports were mixed. Business support, architecture, legal services, transportation continued to weaken, while clean technology, healthcare and defense-driven aerospace markets showed strong signs of improvement. We are especially pleased to hear that clean technology is picking up; perhaps people are growing increasingly weary of the never-ending oil volatility, which will not abate in the foreseeable future. Manufacturing remained very weak, though reports were slightly more positive than the previous Beige Book.  Selected signs of improvement were mostly in the nondurables industries, which again ties back to the cash-strapped consumer focusing on procuring the necessities.  Commercial Real Estate was the most negative of the results, with all 12 Districts describing it as either “weak” or “slow”. Talk about an understatement! Sales volumes remained low or even non-existent in certain all Districts.  Expectations are for further market deterioration through at least 2009 and possibly (likely) through late 2010.

As for the actual FedBS this week, there was very little activity. The size of each side of the FedBS remained essentially flat, declining by a paltry $600mm, at $2.06tr. On the asset side, the only real meaningful activity outside of the asset purchase programs was a substantial reduction of $16bln in the amount of commercial paper held by Uncle Benny which is now down to $94bln. Currency swaps dropped mildly, by $2bln, to $88bln. We remind our readers that the main outstanding facilities on the asset side are the Term Auction Credit, Commercial Paper Funding Facility, Currency Swaps and “other loans”, which includes primary and secondary credit, the AIG loan and TALF. On the liability side, this week we saw a substantial decrease in the Treasury General Account of $13bln. As a result, Reserve Balances increased by $12.4bln.

As for the QE asset purchase programs, it was a rather average week. Treasury purchases amounted to $8.5bln, bringing the total to $215bln out of a target $300. It’s beginning to get interesting as we get closer and closer to the target. Our expectation is that Uncle Benny will have to ramp up QE and before the end of the year is done he will have committed to purchasing at least $1tr of Treasuries. Agency purchases were stable as always, at $2bln, bringing the total to $104bln. MBS purchases were small compared to last week, though at a still significant $7bln. This brings the total to $544bln, way short of the $1.25tr target.

30-year US Treasury yields dropped by 9bps this week to 4.43%, following three straight weeks of rises. Current yields are still about 90bps higher than they were at the onset of QE. As we have said many times before, this is still a ludicrously low yield given the enormous interest rate risk currently posed by the long bond. The US has been in the process of swapping enormous amounts of private for government debt. This has in turn been recycled into the ballooning monetary base. This experiment will not end well and long term yields will be significantly higher as a result.

The USD, as measured by the St. Louis Fed’s Broad Trade Weighted Index, dropped by 1% to 103.77. This has effectively broken the lower end of the trading range of the past eight weeks. It is now at its lowest level since QE began, or 8% below its March 11^th peak. While our expectation for a USD decimation and broad fiat currency crisis in the next 2-3 years might seem a long way away, it is important to note these early developments that have convincingly tied the fate of the greenback to QE. It’s still very early in the game and the market is nowhere close to realizing the sheer magnitude of the danger posed by such gargantuan and pervasive QE programs in the reserve currencies.

Commodity prices, as measured by the Rogers International Commodity index, dropped this week by 1.3%. After showing a very strong increase of 34% during the first three months of QE, they seem to have lost some steam and appear to be trading in a range. In spite of some corrections, they remain 28% above their levels before QE was announced. Natural resources are inherently scarce. The enormous inverted pyramid of financial securities and leverage that continues to be built on top of finite productive assets will come crumbling down, thus leading to intense pressure on prices of real assets.

Tune in next week for more adventures in MBSTBMM,

MAAA