Fed Eunuchs Reveal True Selves In Technicolor

February 11, 2008

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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This entry was posted on February 11, 2008 at 4:33 pm and is filed under Money and The Fed. You can follow any responses to this entry through the RSS 2.0 feed.

25 Responses to Fed Eunuchs Reveal True Selves In Technicolor

Mehul on February 11, 2008 at 5:22 pm

Lee,

Where can I find this report/website for the Fed’s chart?
Lee Adler on February 11, 2008 at 5:32 pm

You can download it here:

http://www.ny.frb.org/markets/omo/omo2007.pdf
Aaron Krowne on February 11, 2008 at 5:53 pm

LOVE the translation!
Crimson Ghost on February 11, 2008 at 5:59 pm

Lee

You do superb work tracking the Fed but the implication that short-term Fed operations are the primary factor influencing stocks seems overdone.

The implication is that if the Fed starts pumping aggressively we will be back in full bull mode regardless of all the problems extent today.

Or am I missing something?
Lee Adler on February 11, 2008 at 6:11 pm

CG-

Would ’twere that simple, no?

I believe that you inferred an idea that it was not my intent to imply.

I produce quite a volume of serious research and analysis each and every day in our Professional Edition service that attempts to provide some clarity. The Fed’s actions in the market are a very important factor. But so are the actions of the Treasury, the FCBs, the behavior of commercial paper investors, the behavior of the GSEs, currency carry trades, and so on.

At the heart of my work is the idea that stock prices are driven by two primary interrelated factors, liquidity, and cycles, which I believe have a psycho-monetary component.

I’m just pointing out there that when the Fed starts experimenting, its actions often have unintended consequences.

Of course we knew that from Greenspan’s tenure and his long running experiment with excessive monetary flatulence.

I invite all serious investors and traders with an interest in these subjects to try the Wall Street Examiner Professional Edition risk free for 30 days. You will find facts reported there that you won’t find anywhere else, along with uniquely straightforward and timely analysis that will definitely help keep you on top of the market.
OOUA on February 11, 2008 at 6:14 pm

Lee, do you have a net add or drawdown of FOMC activities for all of 2007, I know there is a lot of other things that might not actually show, but for all of 2007, as a result of REPO and maturing REPO’s activity … what was the total net … an add or a drawdown ??
Lee Adler on February 11, 2008 at 6:23 pm

Actually, it’s right there on the chart. Right now they are down about $10 billion y/y including everything. The SOMA is down somewhere around $70 billion.

You can also check out the Fed’s H41 archive. http://www.federalreserve.gov/releases/h41/

The Fed doesn’t make it easy though. This is one of the few data series that it does not accumulate in linear historical data tables. I have been tabulating it daily since 2001 and reporting it daily since 2002.

The Fed only reports weekly. I fill in the blanks based on each day’s OMO.
jim on February 11, 2008 at 6:26 pm

Lee…great work…very helpful…however, maybe, the time has come to explain the birds & bees to all the Fed kiddies…after 1945, recently nuked…Germany & Japan…. our just former bitter enemies quickly became our new bosom-buddy friends…….whereas, Mother Russia…the one who truly beat the German & scared the wits out of the Japanese…quickly stopped being our bosom friend & quickly became our bitter-indispensible enemy, like Ossama but bigger….(ALL militarized TOTALITARIAN SPARTAN STATES)…the end result was that not only had we “colonized” the two most up & coming(threatening) industrial powers of the late 19th & early 20th century…we became equisitely position on Tom Freidman’s flat earth map(the Great Chess Game)….if not for the Marshall Plan, Cold War, Korean War and Vietnam….there would be no German or Japanese Korean, Tawainese economy….in addition we sent them every “consumer bid” (Toyota’s to BMW”s)…as we did, we proceeded to HOLLOW out all domestic production(this has been going on for nearly 70 yrs)…..we did remember to keep the nukes & the aircraft carriers….all that is left of the US economy is Loockheed Martin…out of 300 million people…only 14 million make anything…the rest push financial or legislative paper..and then most of the 14 mill are defense or Stasi related(machines make product, not humans)…THIS,….Atlas Shrugs, is what is holding up the dee Vorld…all the rest, economic, financial is nothing more than a staged opera…NOT GOOD…You are what you eat….all the boyzes gettin’ a little nervous as the fictions & forgeries get publically perceived….no more “tech shit” or Real state flippin’ to distract ‘em(Indians slowly leavin’ the reservations…no scam, no deal)…that’s what Patriot Acts, Blackwater & local SWAT teams, Tasers, Guantanomos’ are all about…the history of man is nothin’ more than who will control the “trade routes”….the control of material production & distrubtion…the rest is pure “SPIN”….British Gold was always more lethal than British Lead….it is not financial or economic…it is political…and politics( the haves(monopolizers-priviledge-subsidy) & the have nots(subsidizers of monolpoly//priviledge)…is always just another WAR…fought for “eternal peace(piece)….Alchemy has always been about makin’ somethin’ out of nothin’…in order to do so…you must turn somethin’ into nothin’….Amen
BradH on February 11, 2008 at 7:33 pm

This chart could be showing a picture which is:-

1. Causal;
2. Coincidental; or
3. Consequential.

By my recollection (which may be incorrect), the discount window changes arose after the August 07 market tizzy.

It may well be that the Fed’s actions didn’t help (and could have exacerbated) the situation, but that’s a very different proposition to them pushing the ladder over.
Lee Adler on February 11, 2008 at 8:32 pm

The Fed conducts Open Market Operations directly with the 20 Primary Dealers. When the Fed shrinks the SOMA they are pulling cash out of the Primary Dealer trading accounts. That’s a tremendous loss of purchasing power given the leverage.

To me, that’s causal, but I think the action was probably unintentional with regard to the stock market. I think that the Fed’s intent was to keep the Funds rate from collapsing, which is what they more or less said in their statement, to wit, they adjusted the level of reserves to meet “policy objectives”. The “Policy Objective” is the rate target.

The corollary was that the Primary dealers were forced to liquidate some of their securities positions. Oh well. In terms of your semantic choices, I guess that would make it consequential rather than causal.

Not that it matters. The result is what matters, and the fact that as soon as I began to see what was happening I predicted the “consequences,” repeatedly warning our subscribers that if the Fed did not reverse course, it would put major bearish pressure on stock prices.

Who knows, maybe Ben wanted to put the Boyz over his knee and administer a bit of a moral hazard spanking.

Bonds only held up as well as they did because the massive worldwide financial panic sent investors pouring into Treasuries with whatever they had managed to liquidate.