The “Market Neutral” Fed

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A whole lot of misinformation has been floating around about how the Fed is adding so much liquidity to the market, much of it slyly fostered by the Fed itself. But when you look closely at the Fed’s language and, more importantly, its actions over the past week, it just is NOT so. The Fed has apparently cut its asset base by $4.5 billion over the past 5 days, not including whatever amount is fed out through the Discount Window today for the rescue of Bear Stains. Over the past two weeks it looks like they have cut about $12 billion. (For those who want to verify, you can find the data on the NY Fed website for the SOMA and the FRB website for the TAF.)

I get into more of the nitty gritty details in the daily Fed and Treasury Report in the Wall Street Examiner Professional Edition, but for now I want to address the mechanics of what the Fed has done via this supposed $100 billion increase in liquidity with the introduction of 28 day term repos that the Fed ballyhooed last week. Actually the 28 day repos aren’t new. They were used by the Fed for years until replaced by the 14 day repo a couple of years ago.

So far the Fed has done two of these 28 day term repo operations totaling $30 billion, but looking at the overall impact on the amount of cash in the system, it’s zero. The Fed did $30 billion in redemptions and sales of T-bills from its System Open Market Account holdings completely canceling the impact of the $30 billion in new 28 day term repo cash lent to the Primary Dealers (PDs). The Fed conducts all its operations through these 20 PDs, which are actually affiliates of 20 of the largest banks and brokerages in the world. 10 of these are US based, and 10 are foreign. Among the more infamous names in this august group are Countryfried Securities, the aforementioned Bear Stains, and all the other names you know so well as well as a few you don’t, but that’s a story for another time. Today I just want to think out loud with you a bit and get your feedback on the impact of these recent offsetting operations with the 28 day repos versus the bill sales and redemptions.

When the Fed engages in Open Market Operations (OMO) it uses temporary operations (TOMO) and rarely, permanent operations (POMO).

In temporary operations the Fed loans money to the dealers for short terms, usually overnight, but up to 28 days, in the form of repurchase agreements. Repurchase agreements put cash into the PD accounts and expand the System Open Market Account (SOMA) portion of the Fed’s balance sheet. They rarely use reverse repurchase agreements to drain reserves, but we have seen them from time to time.

The Term Auction Facility (TAF) introduced in December, is not the issue here. It is not included in the SOMA, but it is part of the Fed’s monetary asset base and is reported as a separate line item. The TAF is not directly related to this discussion, but you should be aware that the Fed is canceling out the TAF money too. It has not added new money to the system via the TAF.

In permanent operations (POMO), the Fed buys or sells securities directly between the SOMA to the Primary dealers. When the Fed buys securities it used to be called a Coupon Pass, or Bill Pass, but the Fed no longer uses that terminology, now preferring the term “permanent purchase”. These have been few and far between this year. Permanent purchases put cash directly into dealer accounts, and increase the size of the Fed’s assets on its balance sheet.

Lately the Fed has been redeeming many of the T-bills they hold when they come to term. This does not directly impact PD accounts, but it does impact the Fed’s balance sheet, the monetary base, by reducing the assets the assets the Fed holds. The Treasury must pay off the bills. This momentarily takes cash out of the system, but the Treasury needs to replace that cash with another borrowing, this time from the market, rather than from the Fed. It forces the market to put up more cash for Treasury paper. The Fed has been responsible for some of the increase in Treasury borrowing due to these redemptions. When the PDs buy the Treasuries, they can then pledge them as collateral in return for cash in Fed repo operations. This is why on days when the Treasury has large new borrowings settling, usually Thursday, we usually see big increases in Fed repo operations on Wednesday and Thursday. The Fed has to enable the PDs to pay for the Treasury securities they have ordered.

The Fed can also sell Treasuries directly from the SOMA. In the 6 years I have been watching the Fed daily, this last week is the first time I can remember the Fed doing this. They did it in an amount, when combined with bill redemptions, that was equal to the amount of 28 day repos issued this week, $30 billion. The Fed issued temporary money in return for T-bills which were due to mature in the short run, in most cases a couple of months. This exchange initially made little sense to me because it is a wash. They took cash in from the PDs in return for Treasuries, which the PD’s now use as collateral to replace the cash the Fed took in.

Short term Treasury paper now has a negative carry. Repo rates are higher than the yields on shortest term Treasuries. It costs the dealers money to carry them. On the other hand, MBS and Agency paper still has a positive carry, as do longer term Treasuries. So what advantage is there to putting more short term Treasuries into dealer accounts? Unlike the MBS paper they hold, the dealers can sell that paper. They need not borrow from the Fed to carry it. So they get the cash back on their balance sheets. They also have the cash from the 28 day repos for which they have put up the Agency and MBS collateral which is burying them.

Does this amount to a big deal? I have to think about it some more, but it would seem to at least give them breathing room. It certainly doesn’t add reserves to the system as a whole when considering the offsetting effects of the Treasury sale and the equal amount of repos, but it would seem to have the effect of giving the PDs a little more cash on their balance sheets while keeping the impact on the system net neutral.

The dealers are the Fed’s wholesalers to the banking system. The wholesalers cut the stuff and add filler called margin just like drug dealers when they push it out to the system. The Fed has added exactly the same amount of repos as it subtracted via the bill sales, so it is absolutely net neutral system wise, but it changes the dealers asset mix to a higher proportion of cash versus securities, since they would immediately sell the Treasuries they just bought from the Fed rather than hold them at a negative carry, plus they also have the 28 day repo cash. So what it does is change their asset mix, but it doesn’t add a nickel to the monetary base.

The Fed is just playing the old street corner shell game in its attempt to manage expectations. It wants to keep its actions neutral as far as the Fed Funds target and the overall amount of liquidity in the system. They said as much in their various postings regarding the new programs, and confirmed it with me in a direct conversation I had with an official at the Fed. In my mind this is much ado about nothing. The Fed is pulling lots of levers while running in place in a desperate attempt to stop the hemorrhaging.

Frankly, I don’t know if there’s much more than it can do.

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Lee Adler

I’ve been publishing The Wall Street Examiner and its predecessor since October 2000. I also provide analysis and charts for David Stockman's Contra Corner which I developed for Mr. Stockman. I’ve had a wide variety of finance related jobs in the past 44 years, including a stint on Wall Street in both analytical and sales capacities. Prior to starting the Wall Street Examiner I worked as a commercial real estate appraiser in Florida for 15 years. I also worked in the residential mortgage and real estate businesses in parts of the 1970s and 80s. I have been charting stocks and markets and doing analytical work since I was a teenager. My perspective is not of the Ivory Tower. It is from having my boots on the ground and in the trenches of the industries that I analyze and write about today. 

  26 comments for “The “Market Neutral” Fed

  1. mendobruce
    March 14, 2008 at 12:24 pm

    “The Fed issued temporary money in return for T-bills which were due to mature in the short run, in most cases a couple of months. This exchange initially made little sense to me because it is a wash. They took cash in from the PDs in return for Treasuries, which the PD’s now use as collateral to replace the cash the Fed took in.”

    I think the Fed may have done this to have better control. If they had to wait a couple of weeks to redeem those treasuries they wouldn’t be able to move $ in and out of the market today. Just a thought.

  2. Shawn H
    March 14, 2008 at 12:48 pm

    March 14 (Bloomberg) — The Federal Reserve is taking on the credit risk from collateral supplied by Bear Stearns Cos., which approached the central bank for emergency funds, Fed staff officials said.

  3. March 14, 2008 at 2:13 pm

    If the primary dealers were making new loans and expanding business, the Fed could not be so neutral. They would be fighting the upward pressure in interest rates. So I think the maneuvers are just buying breathing room.

    However, I cannot understand how the MZM measure of money keeps expanding so rapidly. Margin calls on Carlyle and other hedge funds and corporate tightening should have been showing a multiplier decline effect on money by now assuming SIV collapse is finished.

    Can you clarify that aspect? I need some help in that area.

  4. March 14, 2008 at 2:34 pm

    Yes, I have addressed this in the Macroliquidity reports which I occasionally right. I’m overdue, but events are happening so fast and furious, the daily reporting has been overwhelming.

    In short, the MZM explosion is entirely due to the massive influx of available cash into institutional money funds. It’s all counted in MZM.

    This is the end of the cash panic bubble because a huge portion of the holdings is backed by worthless fictitious capital- short term debt that will never be repaid. The funds are able to hide it because instead of a run ON the funds there’s been a run INTO the funds.

    Once that reverses, look the hell out. It’s going to make what’s going on today with Bear Stains look like a Sunday School picnic. It will be like the bank runs of the 1930s, only worse.

  5. March 14, 2008 at 3:20 pm

    The gold bugs are certain this MMF explosion is monetising the ficticious capital since it does represent money until some dealer or bank or broker goes bankrupt.

    We do need some heads chopped off amongst the broker/dealers and some FC evaporating into money heaven to prove MMFs are no safe haven and MZM growth is not monetary inflation.

    This Bear Stain event could be a revelation to the MMF holders.

    But I think the MZM counters won’t capitulate until MZM actually stops growing; ie. the proof is in the facts, not our theory.

  6. March 14, 2008 at 5:33 pm

    I agree with your appraisal.

    However one technical point: isn’t the assumption that dealers will sell Treasuries to raise cash not necessarily true? The reason is that they can use the Treasuries directly as margin collateral to speculate — this is the normal state of affairs for leveraged trading.

    One might note that this modus operandi gets used big-time in futures trading, at 10:1. This would jibe with Russ’ crack-up-boom theory.

    Some evidence for this might be that Treasuries continue to rally, as are commodities. You would think both would crash if banks were selling large quantities of Treasuries to raise cash, which would then be used to plug holes in the balance sheet, as opposed to taking on new speculative positions.

  7. Julio
    March 14, 2008 at 6:11 pm

    Hi Lee, your answer in comment 4, just so I am clear, you imply that when these MMF blow up sooner rather than later, that gold/silver will explode higher?..I see your point about MZM being inflated artificially and about the eventual default of the short debt in the MMF, but if this happens, wouldn’t this in fact be deflationary? Great work..good to get some real analysis instead of so much misinformation, even from supposed professional analysts and other financial types..JO

  8. B.S.
    March 14, 2008 at 7:47 pm

    So #4, what do you think all of that will mean for the avg. wage earning Joe/Jane Sixpack in the street? Great Depression 2.0 or a Great Recession (ie. economic conditions similar to early 1990’s recession but lasting for 15-20 yr. instead of 5 yr. or so)?

    Thanks.

  9. March 14, 2008 at 8:08 pm

    I am just not sure what happens with gold and silver from the standpoint of what happens if there’s an all out debt collapse. I am first and foremost a technical analyst, so I will stick the the technicals for things of that nature. They should give us signals on a timely basis. I report on them daily in the Professional Edition Precious Metals report.

    In a nutshell the charts suggest to me that the long term uptrend is not in any danger. The present move however appears to be nearing its end, probably between current levels and a bit higher. I project actual price levels in the Precious Metals Reports and also give chart picks on individual stocks. These are short term in nature however, but hopefully that would assist those with a longer term perspective too, at least in terms of the timing of entries. Right now I am cautious.

  10. March 14, 2008 at 10:21 pm

    Aaron- “The reason is that they can use the Treasuries directly as margin collateral to speculate — this is the normal state of affairs for leveraged trading.”

    They get more leverage with cash. With their positions collapsing, both the short Treasuries and the long everything else, cash is what they most need right now. Their goal at the moment isn’t to use leverage to speculate. It is to raise cash in order to survive.

    This IS the endgame, I’m pretty sure. They must raise cash, and do it now, or tomorrow there will be no market at all.

  11. March 15, 2008 at 9:31 am

    The endgame will only be here when expulsion of everything, including oil, gold, silver and the favoured stock groups are trashed along with financials, at least relative to the Euro+Yen+Cdn$. Until then, raising cash is not the priority of everyone.

    This is why Sinclair warns about not owning gold on margin. The big margin call in the sky is coming, I think.

    Strangely, we have not seen any money contraction yet, by way of this credit crunch.

  12. March 15, 2008 at 9:51 am

    Money has contracted. It just hasn’t been recognized in the data yet because cash is still pouring in to institutional money market funds. But the other side of the balance sheet is collapsing. My guess is that the broader M’s are probably overstated by 1/3. We won’t see it in the numbers however until the cash flight dries up, which I think will happen within months. When that reverses, and the runs on the money market funds start, the emperor will be revealed in all his glory.

    I would give zero credence to the money supply data. It’s fiction.

  13. Robert
    March 15, 2008 at 11:20 am

    Lee, your money supply theory is off base in my opinion.

    You claim that MZM and M-3 are fictitious because they reflect a flight into cash equivalents backed by bogus capital.

    You have to ask how that cash got into M-3. Assets such as stocks and bonds have to be sold to be converted into cash. However, there must be a buyer of those assets. That means the impact on cash is zero. Money going in and money coming out.

    Therefore, M-3 skyrocketing represents true monetary inflation. You have to look at all sides of the money flows.

  14. Bowserhead
    March 15, 2008 at 12:04 pm

    >With their positions collapsing, both the short Treasuries and the long everything else, cash is what they most need right now. Their goal at the moment isn’t to use leverage to speculate. It is to raise cash in order to survive.

    This IS the endgame, I’m pretty sure. They must raise cash, and do it now, or tomorrow there will be no market at all.

  15. Bowserhead
    March 15, 2008 at 12:08 pm

    There are whispering around that the
    Fed is considering direct purchases
    of GSE paper. Anyone else hearing this?
    That would solve the “cash” problem,
    would it not?

  16. Robert
    March 15, 2008 at 12:21 pm

    There will be no cash shortage when cash can be printed in unlimited quantities by the Federal Reserve. When push comes to shove (and it will), the Fed has no choice but to print.

    I expect the Fed to lower rates by 75 basis points at each of the next 2 meetings to get Fed Funds down to 1.5% which is flat to the 2 yr. treasury.

  17. March 15, 2008 at 2:11 pm

    Robert, here is an interesting thread saying the Fed is not printing:
    http://boards.prudentbear.com/bbs_read.asp?mid=646808&fid=1&tid=646695&start=1&sr=1&sb=1

    Cutting rates is not always printing, although it has grown money supply in the past.

    Like you, I am uncertain about how M3 MZM is growing. But I side with the notion it is not inflationary and it is just banks taking on MBS paper onto their books and refinancing it by issuing repos to MMFs. The rats fleeing the MBS circus are jumping out of that frying pan and into the MMF fire. They don’t know the banks filled the MMFs with MBS repos, I think.

  18. March 15, 2008 at 6:58 pm

    Robert- The growth of MZM is inverserly correlated almost dollar for dollar with the collapse of the ABCP market. In my research I am always on the lookout for correlations, and this one stucks out like a sore thumb.

    I have no desire whatsoever to convince anyone that I’m right. I’ve been doing this for a long time. I’m satisfied with my conclusion, and I know that those who have subscribed to the Wall Street Examiner Professional Edition are probably satisfied as well, but certainly other thoughtful people who have taken a hard look at the relevant data may reach other conclusions. Reasonable people can differ.

    I do not reach conclusions without strong support in the data. However, I am well aware that sheet happens.

    I think that the proof of whether my theory is correct or not should show up within 6 months. So we’ll see.

    As far as “true monetary inflation,” if you mean by that that the Fed is inflating the money supply, the data doesn’t show that. In fact, quite the opposite.

  19. March 15, 2008 at 7:01 pm

    15- Bowser- There’s no need for the Fed to do this when the foreign central banks have been buying everything the GSEs could disgorge, effectively backstopping the GSEs and serving as their lender of last resort since October 2004. Since then they have accumulated $600 billion of GSE paper, now owning more than 55% of Fannie and Freddie’s outstanding debt.

    Those guys know where their bread is buttered.

  20. March 15, 2008 at 7:07 pm

    16- Robert-

    The question is, why hasn’t the Fed already started printing. They actually cut the monetary base by nearly $12 billion over the last two weeks, bringing it to within 1% of where it was at the end of July when the crisis broke. The overall growth rate of the monetary base going back to the beginning of 2006 is about 3.5% annually. Is that excessive money printing? Maybe yes, maybe no. But it’s nowhere near the astronomical rates of growth seen in the broader money measures.
    We have to ask why the Fed took such draconian steps to reduce the monetary base in January. Maybe it was that 14% growth rate in MZM, virtually all due to the explosion of institutional money fund assets.

  21. Reinko
    March 15, 2008 at 7:25 pm

    Can we pan a lot of stuff down by saying: After the years of building up leverages, now the decline of leveraging induces a run on liquidity (let it be Federal bonds or commodoties)?

    For the rest: Why should the FED or the Social Security funds hold Federal bonds anyway? Here in Holland we do not have strange stuff like that, there is only real money in the above mentioned places.

    At last: This hin und her shipping of Federal bonds looks like replacing almost maturing Federal bonds with new ones, only now not done via the markets but (in part) via the FED. Most commercial corporate bonds that were supposed to be placed this year was also for paying for maturing stuff…

    Don’t loose yourself in details, this year the US economy needs an estimated 4 trillion more debt in order to stay ‘profitable’. That is about 30% of the GDP so go for the ‘top down’ and not the ‘bottom up’ approach is my advice (although the bottom up details are often so funny, just so funny…)

  22. don
    March 15, 2008 at 9:10 pm

    20 Canadian ABCP Trusts File Bankruptcy

    The Québec Pension Plan (Caisse) and the Ontario Teachers’ Pension Plan are on the hook for some $33 billion in ABCP as are 40 other trustholders, mining companies, paper companies, etc all of which thought they were buying short term easily marketable notes.

    This story has been brewing since last summer (see Global Credit Crisis Canadian Style). However bailout plans have now blown up as deadline after deadline for coming up with a solution has been missed.

    With the Bank of Montreal Missing Margin Calls earlier this month, what had to happen did: ABCP players to seek bankruptcy protection.

    The committee working to untangle $33-billion of frozen commercial paper plans to ask an Ontario judge Monday to grant bankruptcy protection to the 20 trusts that issued the paper, as it works to restructure them.

    Investors ranging from major corporations to provincial and territorial governments and private individuals have been stuck holding the paper since last August, when the U.S. subprime mortgage crisis tossed financial markets into a tailspin, causing the market for Canadian third-party asset-backed commercial paper to come to a screeching halt.

    Three days after it nosedived, a group of major players, led by the Caisse de dépôt et placement du Québec, announced a plan to restructure the market. It involved converting the short-term paper into longer-term debt. To give the group time to hammer out the details and put the plan in place, the players agreed to a standstill period that essentially froze the market.

    The committee, which has missed self-imposed deadlines, failed to unveil its final plan to investors yesterday, even though an agreement that was helping to keep the market frozen was to expire at midnight. A committee spokesman said they remained confident that the market would not descend into chaos.

    The committee plans to file an application in Ontario Superior Court to put each of the 20 trusts under the protection of the Companies’ Creditors Arrangement Act, a law that’s normally used by companies that are trying to restructure under bankruptcy protection. CCAA prevents creditors from seizing assets and halts lawsuits against the company.

    As the restructuring drags on, it’s still not clear exactly how much money Canadian investors will recoup. While the committee had hoped that those who hold the long-term notes until they expire would receive most of their value back, it’s believed that investors who need to sell the paper quickly once the market’s unfrozen could lose one-third or more.
    Delays Cause More Pain

    I proposed last summer the plan dump its ABCP assets as soon as possible to get what they could. Instead the plan was frozen in a bureaucratic boondoggle in which they hoped to convert short term paper in to long term paper. Now, seven agonizing months later, the plan seeks a different solution: bankruptcy.

    On the Expect Everything To Be Worse Than Expected principle, if losses are held to 33% I will be amazed. However if by some magic they are, then the losses might have been as little as 15%, seven months ago.

    The Psychology Of Suspended Redemptions looms large simply because so many hedge funds and asset managers refusal to accept reality until margin calls or bankruptcy forces the issue.

  23. March 16, 2008 at 8:24 am

    This is a story I have reported on extensively. I broke it to subscribers to the Fed and Treasury report last July, before it hit the media, and I also told Mish about it. I have a close relationship with someone who is responsible for credit risk analysis at a large Canadian banking institution, and who was dealing with this issue directly as soon as it occurred. At the time, he informed me that for the first time ever, they did not get repaid on commercial paper they held as it was coming due. The amount was $500 million. Some weeks later they got half their money. As the story hit the media in Canada, while getting almost no US coverage except for Bloomberg, he told me that even in the Canadian media reports the scope of the problem went well beyond what the media was reporting.

    When the Montreal Accords were announced I went on record saying that I expected them to collapse. It didn’t happen on the timetable I expected, but it has finally happened. I also wrote that I thought that the paper was probably worthless, and that I thought this had the potential to bring down the Canadian financial system, and trigger a worldwide credit panic.

  24. Rod
    March 16, 2008 at 8:45 am

    Lee, can you point me to a good chart or writeup with the MZM/ABCP inverse correlation. Intuitively this is the case, just looking for more detail. Thanks

  25. March 16, 2008 at 8:49 am

    I’ve already posted a few on our new message board. I’d like to invite everyone who’s interested to join the discussion here:

    http://wallstreetexaminer.com/discuss/index.php?topic=4

    It begins with a repost of the article followed by several other posts. I will post additional charts.

    Feel free to register for the board, and open new topics! I think we can have a wonderful discussion there. Russ will also be trying it out.

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