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The Fed's New Plan to Drain the Pond
From The Daily Capitalist
The word is out that the Fed will rely on money market funds to help sop up the "excess" liquidity created by the Fed's record shattering explosion of credit.
The Fed has been discussing it's "exit strategy" ever since they pumped huge amounts of credit into the markets since mid-2008. The dilemma, in Ben Bernanke's mind, is that if they tighten credit in an attempt to reduce the volume of "excess" reserves they may quash the recovery. On the other hand, if they don't reduce the credit created they face the specter of inflation, perhaps very high inflation.
The plan is that the Fed will allow money market funds to purchase Treasury debt directly from the Fed, much as do primary dealers. According to the report:
The Federal Reserve is in talks with money-market mutual funds on agreements to help drain as much as $1 trillion from the financial system as policy makers prepare for the first interest-rate increase since June 2006, according to a person familiar with the discussions.
The central bank is looking to the money-market mutual fund industry which manages $3.2 trillion in assets because the 18 so-called primary dealers that trade directly with the Fed have a capacity limited to about $100 billion, estimates Joseph Abate, a money-market strategist at Barclays Capital in New York.
Money-market funds may welcome the opportunity to trade with the Fed after the financial crisis reduced the supply of safe assets in which they can invest. ...
This has several ramifications. First, as U.S. savings continue to increase, more money has been flowing into the money market which has resulted in a jump in the amount of Treasuries bought by the domestic market.
Second, this new policy will further increase domestic purchases of Treasuries because in a competitive market, money market funds can buy Treasuries cheaper at the Fed window and offer better yields to investors. Domestic buying will also help offset any threat of foreign dumping of Treasuries.
We just saw where China took the opportunity to dump 4.3% of their U.S. holdings in December, 2009 which put Japan into the number 1 spot of foreigners holding Treasuries. The strong Treasuries market gave China an opportunity to lighten up. There are rumors floating around that they are really not dumping Treasuries, but there is still the danger that as the U.S. deficit grows, foreign buyers will become averse to Treasuries. With the PIIGS in trouble money has been flowing into Treasuries and the dollar rallied against the Euro. On the other hand, the threat of Fed tightening scares buyers because that would drive down the price of Treasury paper. It's a complicated game.
What increased domestic demand for Treasuries will do for us is serve as a cushion against well founded foreign doubts about our fiscal resolve and it will take pressure off of the dollar. For the time being. Thus we can expect relatively low interest rates as demand for Treasuries will stay strong.
When will the Fed tighten? They think they will soon, but they won't. In the latest FOMC report the Fed raised it's estimate of 2010 GDP growth from 3.0% to 3.2%. This enabled the inflation hawks (Hoenig) to muster enough brass to say that the Fed needed to tighten credit sooner rather than later. But what if GDP growth stalls? I am looking for flat real growth this year which is based on an anticipated decline in economic activity in the second half of 2010.
In such a scenario the Fed has few alternatives. Additional fiscal stimulus spending is probably infeasible because of political pressure. They wish to increase the interest rates on reserve accounts at the Fed to entice banks to leave their reserves there, but as I have been pointing out, banks don't view their reserves as excess as long as they fear the impact of bad CRE debt to their balance sheets and Tier 1 capital ratios.
The Fed is
also considering reverse repurchase agreements with mortgage lenders Fannie Mae and Freddie Mac, said the person familiar with the discussions. Freddie Mac spokeswoman Sharon McHale declined to comment. Fannie Mae spokesman Brian Faith also declined to comment.
“To further increase its capacity to drain reserves through reverse repos,” Bernanke said, the Fed is “in the process of expanding the set of counterparties with which it can transact” beyond primary dealers of government securities. ...
As we all know, the Fed holds about $1.25 trillion in GSE paper. They need to unwind these holding in order to drain credit from the pond. But will Fannie and Freddie do that? They are lending like crazy right now and selling paper as fast as they can to follow Congress's mandate to save the housing market. Reverse repos would thwart this effort and probably cause mortgage rates to rise. If the Fed thinks foreign sovereign wealth funds will step in to take up the Fed's position, they are mistaken.
Look for a continued strong dollar, increased demand for Treasuries from domestic buyers, continued low interest rates, and wait for the double dip.
What a tangled web the Fed weaves.
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To be fair, the Fed can unwind everything, including all of the emergency lending, paper asset-buying, all without debasing our currency and causing runaway inflation or downward spiral of deflation. This is the equivalent of "threading the needle" just right. It's possible, but unlikely at the moment.
I, for one, am not worried about inflation. I believe there is enough economic slack (unemployment, idling factories, etc.) that could handle demand for more products/assets. This is a different situation from the W.I.N. days of the late 60s and early 70s. The Philips Curve still works because of the simple notion that unemployed people want a job offer first, regardless of the pay. With unemployment so high, wage increases will be nearly flat for the next few years until enough unemployment is absorbed back into the market. At that point, then we can worry about inflation.
No one took me up on my last offer, but anybody who does not want their paper U.S. currency just let me know.
+100. I tend to agree. I think inflation is NOT an issue when unemployment near 10%. and for anyone who is complaining about M0, they need to look where M3 is going and velocity of money. When time will come FED can and will be able to deal with inflation. Will they be able to deal with deflation? We don't know but lost decade in Japan tells us, no matter how much M0 get printed, deflation can be sticky...
I you look at Zimbabwe, inflation can be sticky too.
It's easy for a central banker/government to destroy their currency if they want to. Japan could have issued a quadrillion yen note, with no debt attached to it, and then issued a law that the note was able cancel all debt in yen and pay taxes with and used at a bank to deposit into an account, and then send one of those notes to each citizen. Then the currency would have collapsed in hyper inflation. It is easy if you can a) print the law and b) print the notes.
I think the US intend to print to buy its own debt, and simultaneously try to squeeze the dollar upwards. But on the other hand that would kill the banks they just saved, but on the other hand they can then bail them out again.
Cyan,
Don't bet the farm on that concept. Inflation/deflation isn't about slack in the economy: it's about supply of and demand for money. You can have lots of slack in an economy and still have inflation. Remember stagflation? Or how about Zimbabwe?
What always seems inexplicably stupid about this is the way that ALL stocks - even precious metals, which should ostensibly be soaring - fall when The Fed speaks like this.
But one should never ever underestimate the degree to which major market participants are YIELD-FOCUSED. They want only one thing: regular returns in paper dollars. They are not interested in protecting the purchasing power of their investors' funds. They couldn't care less about the ongoing simultaneous falls in paper money. They believe in paper currencies because the HAVE TO in order to pay off their unitholders, fundholders, depositors, policy-holders, retirees and associated rentiers. For these reasons, their time horizon - in contrast to what is usually assumed about holders of longer-term bonds - extends about TEN MINUTES.
That's why gold will have trouble, even though this will all ultimately end in tears and currency destruction. At least in the U.S... Elsewhere it may be a different story, fortunately.
Here's the deal. The Fed illegally purchased Fred and Fan junk and admit to it. It is ILLEGAL FOR THE FED to buy these items as they are not explicitly guaranteed by the US Gov.
So, either the US Gov must explicitly guarantee this Fred/Fan junk paper and THUS the National Debt would immediately climb up and add around $1T (i forget the exact $).
Or the US Gov does not guarantee this junk and the Fed gets fried for illegally buying this Fred/Fan junk.
Worse still, who would buy this crap paper and obviously for maybe 40% of face. Thus Heli Ben's next trip in front of CONgress would mean he would have to admit to losing money on this junk paper, something he keeps saying the Fed has never lost any money on their purchases.
Heli Ben is stuck between a rock and the US Gov is in a hard place. Right now it is either Fed fraud or US Gov accounting fraud that is worse than pretend and extend.
Me? i bailed out of all this mess. Look, they tried TWICE this week to 'kill' gold between the IMF announcement of 191.3 tons ('they' love numerology so call it 1913 and am sure that year sounds familiar) and now the Fed just killed many traders with a kamikaze raise in rate and gold in once again climbing back after the brief attack trying to knock it down.
Got physical possession of gold? The Fed and IMF are 'telegraphing' what you should be buying. Are you listening?
**********************
NATIONAL STRIKE
APRIL 15 to APRIL 18TH
TELL EVERYONE YOU KNOW
www.taxfree15.com
**********************
Treasuries are "assets"?
wow. I am gonna get my Social Security back after all.
Its not a "double dip" but a "slipper slope" - into deflationary oblivion - as rents collapse and assets return to pre-1980 levels.
"Poof" - all that "Money" created by the extra-curricular banking system is gone. And too many assets - owned by too many people, pension funds, governments, etc - are now vaporized because of it. We're talking about QUADRILLIONS of dollars - already spent - that never really existed in the first place.
Assets will decline by 80%. At least in real terms.
The retirement funds of the "West" are fundamentally unprepared for this adjustment.
Somebody get Leo on the horn. He's not gonna like this.
this is a good take on the "interest on reserves" strategy
http://www.greenfaucet.com/economy/fed-chooses-to-exit-through-eye-of-ne...
Can someone explain how:
"Bernanke has emphasized that the Fed will use multiple new tools to prevent the excess reserves from fueling inflation, including the payment of interest on reserves at the Fed and the sale of Fed assets.
"
...is even considered a good idea? (Honest question, I am confused). Doesn't that give banks a no risk reward to keep money out of circulation and defeat everything the Stimulus is trying to do. If so, doesn't anyone in the WH or PPT understand that?
You hit on the fact he can't unwind so I question if he will even attempt it. He can't drain the liquidity it's not possible. Is the market going to pay him what he paid for that toxic waste. And should he dump it on the market and I''m sure Mr. Market will just point and laugh. Now imagine how bad he would look if he took a bath on the MBS purchases, I just don't see his ego allowing it.
I hear a lot of...cant's, not possible's, don't see's. Where do you come up with these conclusions, what's your reasoning? Inquiring minds...
It's not about Ben's ego. It's about whatever his puppet masters explicitly instruct. His ego has nothing to do with anything.
I could be wrong.
Okay explain to me how they will get ride of their MBS portfolio and not take a bath? With the Fed at roughly 80% of the market what will happen when they are a massive buying and start selling? I may not be the master of stocks and trading but when you have the main buyer turn into a seller I don't think it's good for the asset price. But hey I could be wrong tell me how dropping an unwanted asset into a crowded market will yield a return of at least what was put into it. If you can lets go into business selling bad assets for a profit, we'll make a fortune! Spinning straw into gold!
Look at their portfolio and tell me how it can be unwound. The only way I could see it is one of the big banking establishments or a collection of them to fall on their sword for Old Uncle Ben, and buy it up. Do you think that's likely?
I completely agree. Arguably, the Fed's rationale in buying up all the MBSs was to "take one for the team," since clearly with all that paper bearing interest at historically low rates, let alone the certainty of a a quantum of defaults within (10% bad?), the value of these assets has nowhere to go but down, meaning there is already an unrealized loss here. Then add in all the rest of the crap they have acquired or have accepted as collateral under non-recourse arrangements and you have further unrealized losses. I think a terrific brain exercise for someone way smarter than me would be to make some assumptions along those lines about the Fed's balance sheet and ask the question: is the Federal Reserve solvent?
While liquidity is unlimited when you own a printer, insolvency is something that cannot be cured for an entity like the Federal Reserve, except by extraordinary means.
Is solvency relevant at the end of the line, where the bucks stop? Maybe the answer is that they do not, and Dick Cheney is right. Ponzis don't work except at the end of the line.
I'm reminded of Weimar, after bonds issued north of 800% and the currency finally collapsed. The solution was to back the new currency with RE.
If it's back by oil today...I guess one could take a wild stab and say that someone is forward looking to where the $ will no longer be backed by convertibility to oil/gold.
Opens up a can of worms as food for thought.
But in regards to falling on the sword...seems like a very plausible option.
For those who feel the end is very near...not hardly. War has yet to become even a serious consideration.
Shameful...your logic is..logical. Expect the unexpected!
Jdrose