Debtor's Prison

Greetings fellow inmates:

Two days ago, Uncle Benny released his FOMC statement, whose content came as little surprise to the market.  Naturally, the Fed Funds rate was left unchanged at 0 – 0.25%, and will remain so for the foreseeable future, or in Fed speak, an “extended period”. Uncle Benny also gave a cursory shout-out to the QE asset purchase programs. MBS and agency purchases will continue as expected, with the $1.25tr and $200bln, respectively, to be completed by the end of the year. One comment that did stand out was that Treasury purchases would be gradually slowed down and would be completed by the end of October in order to allow a smooth transition into a market where they would not be purchasing anymore.  As you might remember, we have for some time prognosticated that Uncle Benny would be compelled to increase the size of his QE program, especially for the Treasury purchases, and we have even given an estimate of $1tr by the end of the year. Naturally, we will have to eat our words if this does not come to fruition. However, there is still plenty to go in 2009, and even if the target $300bln gets purchased by October, there is still the very real possibility that the program gets increased. This is all predicated on the fact that foreign creditors will buy less and less long-term US debt due to the clear unsustainability of the issuance and the deteriorating credit quality of the US as a sovereign. Moreover, there have been a few Treasury auctions where the bid-to-cover ratios have been anaemic. Under these circumstances, it seems strange for Uncle Benny to expect the market to be able to absorb the expected issuance.  Perhaps if another bout of economic and financial anxiety hits sometime in the near future, investors will once again flock to Treasuries. Our readers will be well advised to this possibility, as it is not only feasible but, in our opinion, also likely. Nevertheless, we do believe that the distribution profile of US sovereign debt will hit a point of no-return and the house of cards will come down on itself. More debt monetization will surely happen before then, in a desperate attempt to stave off the inevitable.  Irregardless, it will certainly be very interesting to see what happens in October when, and if, Uncle Benny actually completes his Treasury purchase program

In the past two weeks, each side of the FedBS have shrunk by $20bln. This has been mostly due, as usual recently, to a reduction in the outstanding amounts in the Commercial Paper Facility and the Central Bank Forex Swaps. The Swap facility dropped by $11.5bln, bringing the total outstanding to $76bln. As for the Commercial Paper Facility, the drop was a sharp $34.3bln, bringing the total outstanding to $60bln. Clearly, both of these facilities have been in run-down mode for a couple of months now. As we have said before, it is impossible to know what their near-term equilibrium will be. It might as well be zero, meaning they ramp down completely.  There is still about $475bln outstanding in the main credit facilities – Term Auction Credit, Loans, CP and Swaps. Again, even if these wind down completely, and we think they won’t, that still means the FedBS will grow given the $860bln or so left in the QE programs. That means we are still looking at a 25% increase in the size of the FedBS, even from these grossly elevated levels. Not to mention that as the temporary facilities wind down and QE increases, the FedBS is increasingly composed of long-term assets. These pose great interest-rate risk and could cause major losses.  Of course, as Uncle Benny himself has said, they are not obligated to sell. But then we are looking at years of a bloated FedBS and the crippling after effects this will have on the global financial system.

As for the asset purchase programs these past two weeks, we’ve have few developments. Agency debt purchases have proceeded at their usual pace, totalling $5bln these past two weeks, bringing the total to $109bln of the slated $200bln. Contrary to the “slowing the pace” mantra, these past two weeks have seen significant Treasury purchases of $25bln, bringing the total on the FedBS to $652bln. This means that since the onset of QE, Uncle Benny has purchased $240bln of them. Oooh, Uncle Benny, only $60bln left to go. Show us your poker face! Finally, MBS purchases have been non-existent for the past two weeks, even showing a slight decline in outstanding (sales) of $1.7bln. You better pick it up Uncle, you have a hefty $700bln left to go before the end of the year.

30-year Treasury Bonds have continued to trade within the range they’ve traded in the past month. Yields are currently at 4.45%. We continue to await the disaster that surely awaits the long bond once the marketplace fully absorbs the complete idiocy of this “grand” QE experiment. Uncle Sam is the most debt-addicted entity perhaps in the history of the world. Yet, people still have no problem in lending it money at such a low interest rate for 30 years! This debt isn’t even collaterized; it is truly full faith. More debt gets piled on top of non-performing debt in an ill-fated ruse to squeeze blood out of a rock. The long-end will fell the brunt first, and worst.

The USD continues to slide, having decidedly broken out of its range as we stated two weeks ago. The argument that the dollar has declined as people have moved out of safe-haven is wearing rather thin these days. Concerns over the sustainability of this recovery and the magnitude of the rally in several markets have begun to surface. As we have said from day one of QE, the dollar slide has definitely much to do with QE. This is something that the media NEVER states, but instead tries to spin the USD downturn with green shoot fantasies. The fact of the matter is the USD rose so much during the peak of the crisis not because people were seeking safe-haven, but because they had to meet margin calls on all their USD-denominated debt. Going that route, then we would have to ascribe at least some of the downturn in the past few months to an easing in these pressures, especially given rising equity and debt prices. Of course, there are multiple reasons for the USD downturn, but our point is that QE is definitely amongst the foremost ones, just look at the chart. This will be even more pronounced in the future, once this ill-begotten experiment goes awry and brings down the USD with it.

Commodities, as measured by the Rogers International Commodity Index have really shot upward these past two weeks. The index rose a mighty 8% since we last reported two weeks ago. There is still an enormous amount of over-capacity in the world, so we would not expect this commodity run up based purely on fundamentals. There has been a lot of chatter recently of people becoming more concerned about inflation and once again turning to commodities as a protection. This is, of course, natural. Remember that QE is the monetization of productive elements of the economy and this will lead to an eventual rush into physical assets as paper becomes increasingly toxic. In the end, along with the decimation of the USD, QE will serve to push commodity prices into the stratosphere, robbing all of us prisoners of our last remnants of purchasing power.

Tune in next week for more of Uncle Benny’s adventures in MBSTBMM,

MAAA