Revisiting The "Nuclear Option": Will The Fed Buy European Bonds?
Nearly two years ago, we first breached the topic of the Fed's nuclear option: the possibility (or is that likelihood) of the Fed stepping out of the continental US and proceeding to monetize European bonds. Back then we noted: "One thing learned over the past year is that everything is a distraction for something else, and that something else, quite usually without failure, ends up being the Marriner Eccles building on Constitution Avenue in D.C. What we refer to is disclosure from a paper written by none other than the Maestro Jr, in 2004, titled "Conducting Monetary Policy at Very Low Short-Term Interest Rates" (oddly appropriate). In this paper, Bernanke discusses not only the possibility of purchasing corporate assets (bonds and stocks), but emphasizes that one other security class which the Fed may be inclined to acquire under conditions such as those today, and has an explicit authority to do so, are foreign government bonds." The specific text referenced was the following: "In simple terms, if the liquidity or risk characteristics of securities differ, so that investors do not treat all securities as perfect substitutes, then changes in relative demands by a large purchaser have the potential to alter relative security prices. The same logic might lead the central bank to consider purchasing assets other than government securities, such as corporate bonds or stocks or foreign government bonds. (The Federal Reserve is currently authorized to purchase some foreign government bonds...)" So the question then becomes: with the ECB stubbornly refusing (for now) to proceed with outright monetization, and with its balance sheet already surpassing all time records as noted earlier (see below), coupled with tomorrow's LTRO which as discussed over the weekend will be a "Risk On" attempted failure, even if providing a brief relief rally in the interim, not to mention the complete lack of any long-term viability plan out of the Eurozone (EFSF failure due to lack of demand; IMF bailout plan failure due to the UK's veto and the circular joint and several funding by Italy and Spain of an Italian and Spanish bailout), will it be, once again, the Fed which at the end of the day will have to, by covert pathways or otherwise, be forced to step in and monetize European bonds: the so called Nuclear Option? Providing the latest thoughts on the topic is SocGen's Aneta Markowska...
Nuclear options - Can the Fed buy European bonds? This was a question that came up in Friday’s testimony by NY Fed’s Dudley to a congressional panel. Dudley confirmed that the Fed has the legal authority to buy foreign sovereign debt if the collateral is considered good and with appropriate haircuts. Though he wouldn’t rule anything out, Dudley noted that this has never been done and the bar is extraordinarily high. Theoretically speaking, this could actually be seen as a good option that solves a number of economic challenges: the US would see a weaker dollar, helping to rebalance its economy, while Europe would see its funding costs go down. Yet, we believe that the Fed would be facing tremendous political resistance in the US to such a decision. To date, the Fed’s crisis fighting operations have not led to any losses; buying foreign assets would expose US taxpayers not just to credit risk but also to currency risk. The Fed would probably think long and hard before taking such a step, particularly during a politically charged election year.
Yes, the Fed will think long and hard, but since as Kyle Bass observed, an ECB response would likely come only after a Eurozone default, and thus would be too late, an outcome which Draghi has telegraphed well in advance, we doubt that political considerations will hold the Fed back from doing whatever it needs to rescue the banking system, which currently has as its focal point day to day developments in Europe. It is also our contention that preserving the "Fiat way of life" is a sufficiently high bar for Mr Dudley. And yes, it is logical why such a move by the Fed is precisely what the Fed would desire, as it would lead to the same collapse in the USD that resulted back on March 18, 2009 when the Fed announced the expanded QE1. Finally, the primary reason why the ECB will likely not get involved is that its balance sheet is already at burgeoning records, and is well bigger than that of the Fed, making the final decision all too easy.