Debtor's Prison

Greetings fellow inmates:

Due to data-storage technical problems, we were unable to report last week on the state of the FedBS, but we will now resume our weekly updates.

Lately, we’ve noticed an apparent consensus in the mainstream media that Uncle Benny has begun the process of unwinding some of his liquidity facilities and the process of shrinking the balance sheet has begun. We find this optimism completely misplaced and delusional. In particular, it started after the announcement the Fed would modify some of its existing programs. The media focused on the fact that one of the programs, the Term Securities Lending Facility Options program, would be allowed to expire and two others were trimmed in size while completely ignoring the fact that several other programs were actually extended. Moreover, there was a premature anticipation that Uncle Benny might increase the size of his QE asset purchase programs that led to rampant speculation that monetary tightening had finally begun once he didn’t do so at the last FOMC meeting. The reality is that they stated very clearly that they remained open to the possibility of expanding the program should the economy deteriorate further. We expect that Uncle will in fact increase the size of QE, particularly the Treasury program as the enormous scheduled debt issuance will be met with less demand worldwide.

Today, St. Louis Fed president James Bullard made some bold claims about the Fed’s programs. When referring to the them, he said “we are going to have just the right policy to get the right inflation rate”. Wow, what gall. He even said “I do not buy into the stories about the Fed making a mistake one way or the other going forward”. Can you believe this guy? Not only have Uncle Benny and Co. made a plethora of mistakes from refusing to admit there was a credit problem long after it had started, to failing to rein in inflation last year to the bumbling of the Lehman fiasco; but they are now engaged in an unprecedented and dangerous QE experiment. To state that the Fed will not make a mistake “one way or the other” in what amounts to a huge gamble is not only arrogant and delusional, but it is utterly misleading. We believe that in all likelihood, QE will prove to be extremely destructive when all is said and done, potentially leading to a broad fiat currency crisis and the subsequent superinflation (versus commodities). The end result will likely be the institution of a single world currency which will be – for better or worse – the touted solution to this upcoming crisis. Now, on to this week’s happenings in the FedBS.

Each side of the balance sheet shrunk by a scant $9bln, remaining at close to $2tr. On the asset side, the decline was mostly due to a decrease in Term Auction Credit, the Commercial Paper Funding Facility and Central Bank liquidity swaps. On the liability side of the FedBS, the Treasury general account decreased by $34bln, which meant that reserve balances had to increase by a significant $25bln to make up the shortfall. Remember that reserve balances are the high-powered money and amount to a silent cash infusion to the banking system. It is in fact these reserves that could be lent out if banks so chose. It is also a common misconception that these reserves can be easily be removed at the Fed’s choosing. The fact of the matter is that now, as some liquidity facilities draw down, the asset side of the Fed balance sheet is increasingly composed (proportionally) by long term assets, which in turn are financed by reserve deposits on the liability side. These assets are not easy to dispose of, nor will be the reserve balances that support them.

As for the asset purchase programs, Uncle Benny bought $11bln of Treasuries, bringing the total so far to about $200bln of the target $300bln. MBS purchases were non-existent this week and last, following their usual pattern of fits and starts. The total MBS purchases are now at $460bln, way short of the $1.25tr target. Agency debt purchases totalled $1bln this week, bringing the holdings to $97bln, of the $200bln promised. All in all, we can still expect a further growth of $1tr more in the FedBS simply from the QE that has already been scheduled. For those people that believe we are now entering a tightening mode, we point out that the total amount of money left in the main liquidity facilities (Term Auction Credit, Commercial Paper Funding Facility, Discount Window and Currency Swaps) totals about $600bln. So even if all these facilities were to completely draw down to zero, which they decidedly wont, we could still expect the FedBS to grow by another $400bln, or 20%. Of course, this is the absolute best case scenario, which will not come to fruition. The FedBS will likely grow much more than that, especially if QE is ramped up, as we expect it will be.

Below is the chart of the cumulative totals for each program versus the yields on the 30-year bond. After a couple of weeks of strong performance, the long bond has stagnated these past two weeks at about a yield of 4.30%. Remember that we expect the hidden costs of QE to show up in higher yields, much as they did during the first three months of QE. A period of lower yields, as we saw for a couple of weeks, could definitely be interspersed in our expected long-term view. The fact of the matter is that given the fiscal and monetary deficits, the gargantuan debt overhang at all levels in the US and the prospects for the economy, lending the US government money for 30 years at an interest rate of 4.30% is absurd.

The dollar reversed its earlier strengthening these past couple of weeks, dropping to 104.71. The dollar, along with the long bond, will be hit hard by the deleterious effects of QE in the long term. As you know, we believe that a broad fiat currency crisis will be largely driven by problems with the dollar. It is no coincidence that the dollar hit its peak right before the announcement of QE.

Commodities, as measured by the Rogers Commodity Index, continued to slide the past couple of weeks. Similarly with the long bond and the dollar, we expect QE to result in higher commodity prices for everyone as the reserve currencies get devalued, not versus each other but versus real assets.

That’s it for now. Tune in next week for more of Uncle Benny’s adventures in Bizarre Mystery Science Theatre of Black Money Magik.

May your capital be safe and your investments prosperous,

MAAA