Fed Eunuchs Reveal True Selves In Technicolor
How did they let this one out?
Many observers have expressed disbelief that the Fed is actually aggressively reducing the monetary base, in particular that part of the base which directly affects the trading accounts of 20 of the world’s largest banks, the Fed’s Primary Dealers. Wall Street Examiner Professional Edition subscribers have had the benefit of seeing the data on a day to day basis as charted in the daily Fed Report. The general public however, has not had the benefit of that insight. The vast majority of market pundits, economists, and quasi-journalists for the mainstream infomercial outlets like Marketwatch, the Wall Street Journal, Bloomberg, and especially CNBC, are totally clueless. To a man and woman, they all think that the Fed has aggressively been adding liquidity to the system.
The proof, they say, is in the pudding and the Fed has just served it up in multicolored, multi-layered glory. The Fed itself is confirming, in graphical form, the very facts that I have been reporting on and charting for our subscribers every day for the past half year and more. The Fed has aggressively collapsed the size of the System Open Market Account, beginning slowly last July, then moving aggressively beginning in December. The effect has been to withdraw billions of dollars of what is, in essence, margin buying power from the trading accounts of the Primary Dealers.
It is no coincidence that the stock market topped out around the time the Fed began to withdraw liquidity last summer, and it is no coincidence that the market nosedived when the Fed began its massive moves to shift reserves out of the hands of the primary dealers and into other, mostly smaller, banks when it created the Term Auction Facility.
The Fed aggressively cut the size of its permanent holdings of Treasuries, and also substantially cut its holdings of repurchase agreements, resulting in the collapse of the System Open Market Account (SOMA). It replaced only part of that with the Term Auction Facility. The Currency Swap facility with foreign central banks has no direct day to day impact on the US market. When the Fed turned out the lights at the SOMA office in July, that was the end of the bull market. When the Fed began moving the furniture out to the hinterlands, again the US stock market took the brunt of the hit.
The Fed published this report without fanfare within the past few days. The report, somewhat dryly titled “Domestic Open Market Operations During 2007“, contains lots of interesting facts and figures. It also includes some discussion of the difficulties the Fed’s trading desk faced, particularly in the second half of 2007, when the financial crisis crept out from under the covers and on to the front pages.
Yet, in spite of the inclusion of this chart in all its brilliant color, the report had virtually nothing to say about it. There was one paragraph which got to the point in a roundabout way suggesting that the writer had been taking lessons from Alan Greenspan.
In late-August, developments influencing reserve supply grew more uncertain, including the possibility of heavy use of the discount window under its altered terms. In response, the Desk adjusted the composition of its portfolio to include a somewhat higher level of RPs and lower level of outright holdings, by arranging two redemptions of bill holdings at weekly auctions. In December, further redemptions were made and adjustments to outstanding RPs made as needed, to accommodate the impact of TAF loans and swap drawings on reserve supplies. These adjustments were designed to maintain an overall level of reserves consistent with achieving the operating objective for the overnight federal funds rate while still meeting the objectives of the TAF and swap programs.
Here’s what they meant:
We thought in August that there would be a run on the discount window, so we began to cut the size of the permanent SOMA to allow more reserves to go out the Window. Oops nobody showed up. So we started the TAF, and cut the size of the SOMA even more. But the effective Fed Funds rate in the market kept dropping faster than we could lower the official rate. So we had to cut the size of the SOMA even faster so that the effective Fed Funds rate wouldn’t collapse too far below our targets and reveal us to be the powerless Eunuchs that we are.
We didn’t think about the fact that removing reserves from the Primary Dealer accounts would trigger a mass liquidation in stocks.
Next time we’ll know better.
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Lee,
Please forgive my ignorance on this subject ( I want to avoid a beating ala Kokapelli!) , but is it possible that the Fed has chosen this course of action because it was constrained by other events? Could it be that the Fed is more panicked by the detrioration of the dollar than they let on. And therefore, saw draining reserves to meet TAFy pulls and discount window demand preferable to outright monetizing of the loan collateral they were taking in? Yes stocks have sufferred , but the dollar descent has been halted.
All things considered not such a bad result so far?
Which then leads me to consider; will we see another dollar decline commence when the SOMA begins “normalizing”?
I try not to theorize on why the Fed is doing what it’s doing. It’s hard enough figuring out what they are doing, and how long they are likely to continue doing it.
For those things I rely on the charts. I have speculated that the reason behind it may be that they are leaning against the explosive growth in MZM, and that if so it is a huge error because broad measures of money are egregiously overstated, and because 100% of the growth surge in the last half of 2007 was entirely due to capital flight out of commercial paper and into institutional money funds, CDs and retail money funds.
When these flows out of CP stop, which they will soon, it may not be long before investors realize that the money market fund emperor has no clothes. There a many big funds holding SIV paper and we have yet to see any big writeoffs in the MMF area. The losses are there. They just aren’t telling us about it.
About the dollar, I try to stay away from intermarket analysis and possible cause and effect relationships, and stick to technical analysis of the Dollar Index chart. Causal relationships are always next to impossible to figure out, and definitely impossible to prove.
The conventional wisdom about any particular causal relationship, is often turned on its head. In the early years of the BoJ zero interest rate policy and aggressive monetary expansion, wasn’t the yen strong?
So, I just don’t know. At this point, the dollar chart has what could be an interesting long term base, but it still has to prove itself on the upside. I’m agnostic at this point.
Thank Lee for the response.
Like you, for me the jury is still out on the dollar basing idea.
I hope no one here actually believes that the Fed is reducing the monetary base on purpose. It’s true that Fed credit has been shrinking, but this is due mainly to the following factors:
•Demand for credit has waned as everyone, including the banks, is scrambling for liquidity, not more credit.
•Monetary policy has an enormous lag time, especially in a system overburdened with debt therefor the negative growth in Fed credit, and the sharp slow-down in its YOY. Balance sheet growth must be partly attributed to the lagged effect of the previously in force tight policy.
•The yield curve remains inverted at the very short end thus, in order to achieve the target FF rate, the Fed may actually occasionally still be forced to drain money on autopilot. Fed policy implementation revolves almost entirely around the FF rate target, excluding the new TAF for a moment. In other words, it will add or drain money entirely based on achieving the rate target.
So what this means ultimately, is that at the current target rate of the FF, not enough credit demand can be spurred to make the monetary base grow. Therefor it’s a slam dunk that the FF rate has further to fall and in all likelihood it will end this current journey at the big fat ZERO boundary. By the way, the main reason why most banks now prefer the TAF to Repos is that it’s cheaper. The Fed allows them to pay only the prospective FF rate as indicated by the futures markets on the TAF borrowings. Also, the range of collateral accepted for TAF borrowings is much wider, so they actually ‘park’ toxic paper that is officially still rated AAA there.
There is essentially no overlap between the TAF operations and the repo operations. What the Fed gave to the TAF, they took from the repos, which directly negatively impacted the trading accounts of the primary dealers. The Fed even told the association of reporters that covers the Fed on a conference call regarding the introduction of the TAF that it would be reducing the size of the SOMA to offset the TAF credit, and that is exactly what they did. The action of reducing the amount of credit directly available to the Primary Dealers through Open Market Operations was indeed intentional.
I suspect that the consequences were probably unintended, but we cannot be sure.
There are over 9000 banks in the US,all eligible to participate in the TAF auctions. 93 of them bid in the first TAF auction. Participation declined to 66 bidders in the last one. The stop out rate at the last auction on February 11 was 3.01%.
By contrast only the Fed’s 20 primary dealers can participate in the repo auctions. They are not banks. They are securities dealers, although most are affiliated with banks, either as a subsidiary or parent company. Only half of them are US banks. The rest are foreign. At the Feb. 11 operation the stop out rate on Treasury collateral was 2.85 and Agency collateral 3.08.
The Fed now has exactly the opposite problem than they it through January and has begun pumping in liquidity in response. This is among the latest developments I have been analyzing in the daily Fed Report in the Professional Edition. Russ Winter and I also discussed it in the 11 minute free preview to the Radio Free Wall Street podcast of February 15.