Excess Reserves

From Goldman: "Cutting the IOER rate down to zero could be harmful to market institutions. Chairman Bernanke made this argument himself in Q&A at the July 2010 Humphrey-Hawkins testimony: “The rationale for not going all the way to zero has been that we want the short-term money markets like the Federal funds market to continue to function in a reasonable way, because if rates go to zero, there will be no incentive for buying and selling Federal funds overnight money in the banking system. And if that market shuts down, people don’t operate in that market, it will be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.”

The reason for the ramp in risk as attributed by various buyside desks as to what recently has become the trademark of more hope, prayer and magic from Jefferies' (yes, Jefferies is driving the market for once, who wouldathunk it) David "SPOOS" Zervos, whose latest note that the Fed will follow the ECB and cut its overnight excess reserves rate to -0.25% has picked up some traction, and is causing a modest rise in risk markets. Here is the problem: the Fed will NOT do this, and certainly will not do this for months and months as not only would it destroy the US money market, general colalteral, unsecured and virtually every other overnight market instantaneously (and not even Ben is that dumb to trade a few trillion in private sector overnight funding for 10% in the S&P), but even as Zervos says this is nothing short of a thought experiment in what may happen: "Whether it happens or not is not the point. The issue is that we are not priced for it AT ALL." Correct David: they are unprepared because it will not happen. The Fed will do much more LSAP, and even that other flow-based lunacy, NGDP targeting, before it decides to blow up overnight markets (not to mention destroy the entire Primary Dealer risk analytics system all of which is based on positive flow from Reserves). Because if the Fed telegraphs it is ending the inflows from reserves experiment started 3 years ago, we better be having 4% GDP growth. Reality check: we have 1.1% Q2 annualized GDP. Finally, that whole ECB experiment with negative Deposit Rates led to... absolutely nothing... correction: it led to yet another plunge in Spanish and Italian yields: something the Fed is quite aware of.

The market's hopes and dreams for the next LSAP remain high. As gold inches higher, tail-risks priced out (expectations for extreme FX moves are considerably lower than sentiment would suggest), and US equity vol expectations (and put skews) are crushed; the equity market clearly remains 'at a premium' in its notional indices given what is sheer lunacy in earnings expectations going forward. The question every investor should be asking is not when QE or even if QE, but so-what-QE? As Credit Suisse notes, given the deterioration in US economic activity (and the extension of Operation Twist) the FOMC will probably wait until its September meeting (and remember the trigger for further pure QE is a long way off for now). The most critical question remains, will additional QE work? After all, few would argue that US interest rates are too high or that banks in the US need still more excess reserves. Two things stand out in their analysis of how QE is supposed to work (transmission mechanisms) and its results to date: QE1 was more effective than QE2, and it's easier to find QE's effect on Treasury yields than on real economic performance. Perhaps more concerning is that the potential negative effects of such unconventional monetary policy has received little attention (aside from at fringe blogs here and here).

Also: how the Fed's Biege Book is assembled, the $trillion+ sitting at the Fed as excess reserves, the LIBOR "scandal", Warren Buffet and much more...

While JPM may or may not have succeeded in burying its deeply humiliating CIO fiasco at the expense of two things: i) a loss of up to 25% in recurring net income and ii) Jamie Dimon proudly throwing numerous of his key traders under the regulatory bus as scapegoats because it took the firm until July 12 to realize that its entire CDS book was criminally mismarked, thus confirming a "weakness in internal controls" (a statement not only we, but Bloomberg's Jonathan Weil vomits all over), the truth is that one way or another, Jamie Dimon will find a way to reposition his prop trading book somewhere else, even if it means far smaller and less obtrusive profits for the next several years. Yet there is a way to virtually make sure that Jamie Dimon is never allowed to trade as a hedge fund ever again, and in the process risk insolvency and yet another taxpayer bailout. Ironically, it is JPMorgan itself that tells everyone precisely what it is.

We noted the significant drop in the ECB's Deposit Facility this morning and as the day wore on it became clear that few - if any - of the standard talking heads on media channels had a clue what this meant except the standard comprehension that it must be good for stocks as the money is finally being put to good use (though as we noted bond yields would say different). While it is true that a large chunk of money has shifted away from the deposit facility, the money has not gone anywhere else – it is still sitting at the ECB, just that it is now in the ECB current account where banks place money to fulfill their reserve requirements. The catch here is that both excess reserves and the deposit facility will earn nothing from now on - so why move it? Simple, as BofAML points out, placing the money in the current account has lower operational costs for banks – if a bank places money at the deposit facility, it will be returned automatically the day after; however, if placed in the current account, it will remain there until the bank manually requests to take the money out. So, it would seem, somewhere a young associate on the Treasury Function desk just lost his job as he no longer needs to press the 'send to ECB' button every night. The reality is that the information on bank lending activities that one can infer from these ECB data is minimal at best.

The debt-to-GDP ratio is gradually falling, yet it is still at a far higher level than the historical average, and it is still proportionately higher than industrial output. And at the same time, consumers are re-leveraging, and government debt is soaring. And industrial production is barely above where it it was a decade ago, and far below its pre-2000 trend line. We have barely started, and already this has been a slow and grinding deleveraging; rather than the quick and brutal liquidation like that seen in 1907 where the banking system was effectively forced into bailing itself out, the stimulationist policies of low rates, quantitative easing and fiscal stimulus have kept in business zombie companies and institutions carrying absurd debt loads. Like Japan who experienced a similar debt-driven bubble in the late ’80s and early ’90s, we in the West appear to have embarked on a low-growth, high-unemployment period of deleveraging; and like Japan, we appear to be simply transferring the bulk of the debt load from the private sector to the public, without making any real impact in the total debt level, or any serious reduction in the debt-to-GDP ratio.

In simple terms, Germany may be willing to prop up the EU, but only if its demands are met. The track record for the PIIGS in terms of meeting demands is abysmal. Moreover, implementing such measures takes months if not years. Given that Spain’s ten-year is back over 7% and Italy is now begging informally for a bailout, the EU doesn’t have that time.

In an excellent summary of the world's interconnected nature, reliance on everyone else to solve their problems, and Europe's epicentric catastrophe, Nouriel Roubini joined Bloomberg TV's Tom Keene for some serious truthiness and doomsaying. From the 'slowdown/recession becoming a depression' to 1930s CreditAnstalt comparisons and Germany's lack of trust that a few years of abstinence will regain peripheral Europe's virginity, the original Dr. Doom along with Ian 'G-Zero' Bremmer offer much food for thought as to the various scenarios as investors anxiously await an expected central bank response to the 19th failed summit and how "we will be lucky if we end up like Japan" as he concludes: "It’s getting worse, there’s already a sovereign debt crisis, a banking crisis, a balance of payment crisis, an economic crisis and all of those things together are getting worse."

Recently, there has been an intense debate in Europe on the TARGET2 system (Trans-European Automated Real-time Gross Settlement Express Transfer System 2), which is the joint gross clearing system of the eurozone the interpretation of this system and its balances has provoked divergent opinions. Some economists, most prominently Hans-Werner Sinn, have argued that TARGET2 amounts to a bailout system. Others have vehemently denied that. Philipp Bagus adresses the question of whether this 'mysterious' system, that we have been so vociferously discussing, simply amounts to an undercover bailout system for unsustainable living standards in the periphery? Concluding by comparing TARGET2, Eurobonds, and the ESM, he notes that all three 'devices' serve as a bailout system and form a tranfer union but governments prefer to hide the losses on taxpayers as long as possible and prefer the ECB to aliment deficits in the meantime.

Not like it should come as any surprise that the bank that first among peers "discovered" that flow, not stock matters, implying the Fed may literally never be able to stop monetizing, is expecting the FOMC to "ease monetary policy on June 20", but nonetheless here is the full just released Q&A from Goldman's Jan Hatzius, who just happens to be a Pound and Pence drinking buddy of former Goldmanite Bill Dudley, who just happens to run the New York Fed. Connects the dots. Implicit is that a big dollop of Large Scale Asset Purchases is imminent. That said, if the Fed does disappoint on June 20, and merely extends the maturity of bonds that it will sell as part of a Twist extension from 3 to 4 years, as the bond market appears to be implying (as first warned by Zero Hedge), then all bets are truly off. On the other hand, note where Goldman says: "However, it is also possible that the program would be specified as a "flow" of purchases of perhaps $50bn-$75bn per month." If that happens, gold is going to $2000, $3000, hell, $10,000 very soon, as it means the Fed will not stop printing ever again. Period.

"Private Debt Doesn't Matter" Because "Banks Can't Create Money Out of Thin Air"

As Many Have Predicted for Years

From early October of last year (Grand Plan and Global CB intervention) until the start of the LTRO program in Europe, Gold and Stocks (and Treasuries and the USD) all traded in sync with one another. Since the LTRO program, the equity market has generally been on its own in terms of belief. While growth hope, Europe's recovery, and the Bernanke Put (as well as a short-squeeze of epic proportions) were at play, it seems to us that the Fed's Twist program has been ignored by the money-printing crowd (since Twist was sterilized and did not expand the monetary base (excess reserves) - which gold reacts to; but did provide flow - helping stocks - as the Fed's DV01 increased; implicitly devaluing the currency even though Fed's efforts to dissuade have worked) while the ECB's LTRO provided a liquidity overhang that at-first-glance removed one short-term structural risk from US markets (the Europe contagion). Since we made clear that LTRO is in fact an encumbrance and not 'clean' debt monetization (which fits with gold not moving as much), equity markets in Europe have retraced all of those gains - leaving US still elevated. The last few days, gold and stocks have surged together as hope for LTRO3 (seemingly gone now) and Fed QE3/4 (not sterilized; with ES -7.75% from its highs?) has become imminent. However, Gold and stocks remain very far apart in the medium-term and Rick Bensignor sees trendline support and DeMark TD Setups providing an excellent risk-reward for a Short Stocks, Long Gold trade from here.

Deflation has effectively been abolished by central banking. But is it sustainable? The endless post-Keynesian outgrowth of debt suggests not. In fact, what is ultimately suggested is that the abolition of small-scale deflationary liquidations has just primed the system for a much, much larger liquidation later on. Central bankers have shirked the historical growth cycle consisting both of periods of growth and expansion, as well as periods of contraction and liquidation. They have certainly had a good run. Those warning of impending hyperinflation following 2008 were proven wrong; deflationary forces offset the inflationary impact of bailouts and monetary expansion, even as food prices hit records, and revolutions spread throughout emerging markets. And Japan — the prototypical unliquidated zombie economy — has been stuck in a depressive rut for most of the last twenty years. These interventions, it seems, have pernicious negative side-effects. Those twin delusions central bankers have sought to cater to — for creditors, that debt is wealth and should never be liquidated, and for debtors that debt is an easy or free lunch — have been smashed by the juggernaut of history many times before. While we cannot know exactly when, or exactly how — and in spite of the best efforts of central bankers — we think they will soon be smashed again.