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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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  1. Crimson Ghost


    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?

  2. Lee Adler


    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.

  3. OOUA

    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 ??

  4. Lee Adler

    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.

    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.

  5. jim

    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

  6. BradH

    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.

  7. Lee Adler

    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.

  8. Lee Adler

    Please note that we are looking at recent history. We are not looking forward here, we are looking backward. In examining and understanding the past, we can establish context for the present and, hopefully, understanding for the future.

    The Fed can and will change course whenever it wants to. The Fed will not remain unfriendly to the markets indefinitely. Change may be under way even now, not because the Fed necessarily wants to or doesn’t want to goose stock prices, but because it may need to do some things which will have that effect in order to “meet policy objectives”, i.e. to try to keep the Fed Funds rate at the target.

    As long as the Fed focuses on the price of money rather than quantity, it will be at the mercy of the money markets in terms of how much liquidity it must provide or, as in the recent case, remove, in order to maintain that artificially determined price.

  9. Russ Winter

    “The truth is that liquidity, the only significant weapon remaining in the central bank’s arsenal as decision making moves to the markets, will not necessarily go where you want it to go when you need it to go there.”
    –Martin Meyer writes in The Fed

  10. Rocancourt

    Fed reduced their Soma in 2007 by $39 billion which was the first reduction since 1989.

    I think the plan is to induce market crisis so that they have the cover to lower interest rates to try to rescue the housing mess.

  11. wawawa

    So, does it mean that the FED is not really providing liquidity (contrary to media view) or the provided liquidity by FED is not absorbed (welcomed) by the banks? which one is it?

  12. Lee Adler

    Both. The market is contracting as a result of debt deflation and fear and reluctance to lend. The Fed cuts its base in response. But the way in which they cut it adversely affected the financial markets directly.

    I want to emphasize that it would not be wise to automatically assume that the Fed will continue with this pattern. There are seasonal historical patterns which strongly suggest, and even require, the Fed to aggressively add reserves going into tax season. We need to stay focused on today, rather than the past 6 months. That’s over and done with.

  13. Kokopelli

    The fed is privately owned and is not interested in a losing position. People seem to think they are part of the government and they aren’t.

    I would suggest that the fed is lowering the money supply simply because there really isn’t that much in the way of good quality equity to back any loans they might want to make to the banks and isn’t in the business of giving money away as money is power.

    How the money supply really gets ramped up is thru the federal government deficit spending and thru the fractional reserve banking system. IF there are fewer loans being made to the public due to credit concerns and lowering equity values, then the only other source is the federal government who last year actually spent less than previous years.

    That is one of the reasons for the increased deficit projections in 2008 and going forward as the government needs to inflate the monetary system to counter balance the deflationary effect of personal and soon corporate insolvency.

    I think that they will do to little to late.

  14. Lee Adler

    The statement that

    “The fed is privately owned and is not interested in a losing position. People seem to think they are part of the government and they aren’t,”

    is utter bullcrap.

    The Board of Governors is most certainly a government Agency, with governors appointed by the President and confirmed by the Senate. The Fed gets its operating authority and mandate from Congressional legislation which can be changed at any time.

    Any member of the Federal Reserve System must by law own a fixed share of stock in its district bank with a dividend as set by Federal law, and all operating surpluses are returned to the US Treasury.

    You want to post lunatic garbage on this site, fine, I’ll allow it once. That’s it.

  15. Kokopelli

    Ok Lee,

    Sorry to offend your sensibilities.

    They are appointed and run under rules set forth by Congress but they are not a department of the government, only an entity, do not have a seat on the Cabinet and are run more like a GSE. They do have private aspects, as per their own statement and no one in Congress, except possibility Ron Paul, has the knowledge base to even know what they are doing, much less do effective oversight and he isn’t a fan.

    From the federal reserve itself
    “The Federal Reserve System is not “owned” by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects……
    As the nation’s central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as “independent within the government………
    After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.”
    Until I went to their page and read this last statement I never realized that what they did was a zero sum game. So we borrow from ourselves and then give back the interest earned after expenses?
    Do you know if this actually happens?
    Thanks Lee for making me check out my own beliefs. You could be a little less harsh about it. We aren’t all as knowledgeable as you or as smart.
    But still if the quality of the asset wanting to be used as collateral for loans is below par and sinking, that could why the fed is not able to fund the banks and why the actual money supply is shrinking couldn’t it? They can’t lend on paper that is of inadequate/questionable quality.

  16. GSM


    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”?

  17. Lee Adler

    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.

  18. DaCheif

    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. 🙂

  19. Lee Adler

    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.

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