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.
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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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