Is the Fed Monetizing Bad Debt?

There is a funny situation going on with the Fed this morning.

As you know the Fed conducts two types of open market operations, permanent and temporary, through their NY office. This is how they manage their monetary policy.

There is a third type of hybrid repo recently created called the Treasury Auction Facility (TAF). Its similar to the Temporary Open Market Operation except its opaque and the terms are lengthier, and the types of collateral they accept appear to be looser than the Treasuries and agencies which are customary. Its a kinder, gentler, more discreet Discount Window. They kicked the amount up to 100+ Billion this morning. We like to think of it as "free money (below the inflation rate) for the banks" in return for shakey collateral.

Here's what we find confusing. The Fed has not conducted a 'Permanent Open Market Operation" since May 2, 2007. That's right, almost a year ago. At least, that is, before this morning when they conducted a 10 billion dollar permanent operation.

NY Federal Reserve Permanent Open Market Operations

What surprised us was that this is not an ADD, which is a purchase on their part and an addition to the money supply, but a sale of Treasuries to the banks by the Fed out of their own account in return for 'cash' which is considered a DRAIN.

Huh? The big tickle has been the liquidity crunch, so the Fed does a DRAIN?

Here's our take. The Fed has been taking all sorts of collateral from the banks at the TAF window. The banks are going to have to mark this debt to market at some point. We don't know how the Fed is actually valuing it for their repo purchases, since it has no liquid market.

In turn, the banks have plenty of short term liquidity. but they need to recapitalize and use that to build their cash flows with a 'multipler effect' which is tough to do with short term monies. The multiplier of a permanent add is 9x based on a 10% reserve requirement.

So the Fed, having just lent the banks 'cash for whatever' turns around and sells US Treasuries to the banks in return for the amount of 10 Billion which the Fed has recently lent to them short term with God knows what for collateral. How was that collateral valued? Who takes the loss?

See the gimmick? The Fed is letting the banks borrow short from the TAF on questionable collateral and get some nice solid long term Treasuries that can be loaned to the Public at 9x the amount or 90 billion. Looks better on the books, gives them some breathing room, and is nice and quiet.

If that was too complex an explanation, we'll offer the one from our friend Sean in Zurich:

They [the Fed] said they were going to neutralize the new TAF/term RP stuff... so banks end up funding their dodgy mtges with Tim at NYFRB and holding bills to compensate.

And there you have it. Selectively placed helicopter money. Our only curiousity is what exactly the Banks will be showing on their books when they start honoring FASB 157 and start marking to market. Are we going to be going through this at the end of each fiscal quarter for the forseeable future with the Fed playing Mr. Market?

Statement Regarding Sale of Treasury Bills from System Open Market Account

March 7, 2008

On Friday, March 7, 2008, the Federal Reserve’s System Open Market Account will sell $10 billion of Treasury bill holdings for settlement on Monday, March 10. This action is being conducted by the Federal Reserve Open Market Trading Desk (the “Desk”) in conjunction with the series of term RP transactions announced earlier today in order to maintain a level of reserves consistent with trading at rates around the operating objective for the overnight federal funds rate.

The Desk will continue to evaluate the need for the use of other tools to add flexibility to its open market operations. These may include further Treasury bill sales, reverse repurchase agreements, Treasury bill redemptions and changes in the sizes of conventional RP transactions.

The Potemkin Economy Just Fell Over

Let there be no mistake, no further debate. With two months of back to back Jobs Report declines the discussion on the US economy must shift from "full recession or mild slowdown" to "how long a recession and how bad."

The internals of the numbers were actually worse than we expected, and worse than the headline number.

We often thought that this would be an interesting economic experiment, with the Fed chairmen, first Greenspan and then Bernanke, getting the chance to replay the onset of the Kondratieff Winter and an economic depression. This time they were allowed to pour the money on in significant amounts, in the absence of that barbaric Gold Standard and honest mainstream economic scrutiny, to try and turn the winter into spring.

Well now we know. It's not working. It raised up a Potemkin economy that looked pretty on the surface from 2003 to 2006, but in reality was as thin as ..... paper.

We're chuckling to ourselves this morning as stocks rally from their lows, ignoring the economic news presumably, perhaps using the increased largesse of the Fed and their Treasury Auction Facility (aka Selective Helicopter Money). But we like to think of it as a fresh coat of paint on the Potemkin facade, to make people doubt their own eyes, and ears, and reason. The first principle of the Big Lie is to never tell the truth, never admit a mistake, while you can shield the people from the consequences of your deceptions.

But the charade can only continue for so long. As von Mises observed:

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved... The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment."

February 2008 Non-Farm Payrolls Report

We are not going to try to forecast tomorrow's Non-Farm Payrolls Report. The work we have done so far with this report has made us believe that it is written in sand, and equally subject to change, and more adjusted in opaque ways than most numbers from official sources.

The consensus of economists is a net addition of 25,000 jobs, against a prior decline of 17,000 jobs in January. We fully expect January to be revised, and probably December as well. It will not surprise us to see this number come in revised to positive, with a potentially lowball number for February. Why? Because that is how the Bureau of Labor Statistics has been rolling their adjustments lately. They give us the 'bad news' but then show its unreliable, and probably not so bad.

We would like to show three graphs in anticipation of this report.

The first compares the seasonal adjustment with the actual numbers. As you can see February is a quite large downward adjustment, although not quite as large as the upward adjustment in January. There is obviously substantial room to play with adjustment in both months, especially when the adjustment method keeps changing and is 'proprietary.' The swings in the non-adjusted number are enormous this time of year, making the 25,000 net adds in the seasonally adjusted headline number almost a statistical rounding error. But Wall Street will react.

The second graph shows what we have been calling the Imaginary Jobs Component, more familiarly known as the BLS Birth-Death Model of small companies that are incognito. The net add in February should be about 100,000 jobs based just on prior history as we have shown here. We have heard that BLS will be issuing some major revisions in their methods, but cannot recall if its in this month or some coming month. This number is added PRE-adjustment, so its tossed in the wash in many months, and is not so big a deal as many have come to believe.

No matter how the number comes out tomorrow, highball or lowball, with a prior month twist, or a total restatement of everything back a couple of years (yes they do that too often we might add), we would like to emphasize that no matter what the stock market does in reaction to the headline numbers, there really is only one type of chart worth looking at for these types of volatile numbers: the moving average trend chart.

We have included the chart below to show how clear the the trend has been. The peak of Jobs Growth occurred in early 2006, and has been in a slow but steady decline since then. During the entire 'recovery' that the stock market was discounting we kept asking, "But where are the Jobs?" Well, they really were not there after the first few bubble years after 9/11 during what we like to call "The Great Reflation." Mask the unemployment as they might by dropping people from the counts as their unemployment runs out, the fact is that we entered a recession at the end of 2007 at the latest, and probably earlier than that if we could obtain a realistic Inflation number with which to deflate our bloated nominal GDP.

Don't be shocked if we do get a positive number tomorrow. Its well within probability given the revisions, and the history of Administrations messing with the numbers going back to LBJ at least. And don't be shocked if the Financial Talking Heads say "What Recession?!!".... or not. The number is capable of coming out any which way, and will be revised next month regardless. We're in the silliest of seasons here, as the proverbial piper comes to be paid, and the entire financial and political structure in the United States seems badly in need of adult supervision.

IRX index, Interest Rates, the Yield Curve and US Equities

Someone asked us to comment on the IRX index, and its relationship to the SP 500.

The IRX index is the discount rate of the 13 week Treasury bill. It is called the discount rate because it has no coupon, but matures to its full face value. But it does have an effective interest rate, and this is what the IRX index is.

So to understand the IRX we need a little understanding of Treasury Bills.

U.S. Treasury bills (T-bills) are among the safest short-term financial instruments denominated in dollars because these debt obligations are perceived to have virtually no default risk. Moreover, because T-bills mature in less than one year, with most maturing in a matter of months, they do not have a significant interest rate risk component, either. This is a major difference between T bills and T bonds and notes which are of longer durations.

There are four major influences on the price and yield (discount rate) of Treasury bills:

• Demand for risk-free fixed-income securities in general as opposed to other short term investment choices. For example, a "flight to safety" caused by concerns about default or liquidity risk in other financial markets may cause investors to shift to T-bills to avoid risk.
  
• Supply of T-bills by the U.S. government--for example, federal budget surpluses in 1998-2000 temporarily reduced the supply of some Treasury securities issues.
  
• Economic conditions may influence rates-- T-bill rates typically rise during periods of business expansion and fall during recessions.
  
• Monetary policy actions by the Federal Reserve--Fed actions that affect the Federal funds rate likely will influence interest rates for short-term instruments like T-bills.
  
• Inflation and inflation expectations also are factors in determining interest rates--for example, periods of relatively high (low) rates of inflation usually are associated with relatively high (low) interest rates on T-bills.

Here is a graph showing the 3 month discount rate going back to 1934. The primary value of this is to show what a truly dramatic event the inflation of the 1970's had been, and how remarkable and historic the steps taken by Fed Chairman Paul Volker had been to bring it back under control and prevent it from growing and evolving into something more dangerous.

Here is a graph showing the profound effect that the Fed Fund Target Rate, with changes anticipated by the Effective Funds Rate, has on the 13 week T Bill rate in the secondary markets. The 13 week T Bill discount rate is called by the Fed the 3 month Treasury Bill secondary market rate. There is an index that tracks this yield that is called the IRX. The short term rates move lower with recession and higher with business expansions. This is not only the result of Fed actions, but also the demands of business as stated in the four influences above.

If we include the Ten Year Treasury Note Yield to the Chart, we can see the long end of the yield reacting to the perceptions of inflation. But perhaps more importantly we can see Yield Curve Inversions on the chart. These are times when the long end of the curve, represented by the Ten Year note, has a yield less than the effective interest rate of the short end of the curve, as represented either by Effective Fed Funds or the 3 Month T Bill Discount Rate.













If we add the SP 500 to this chart, we can now see the interaction of a relatively broad stock market index with the short end and the long ends of a the yield curve. Of special interest is the clear presaging that a yield curve inversion provides for an economic recession and a stock market bear market. Note the timing of the inversion, the recession, and the approximate stock market market bottom.













We find the example above just a little 'short' because it does not reflect the real SP 500 adjusted for inflation, but merely the nominal number. Of course the interest rates shown are not real rates, but the nominal rates. With inflation, the real interest rate has probably gone negative. The problem we have in most of these instances is that the CPI in our opinion is no longer a valid measure of inflation, having been corrupted by the Clinton and Bush administrations. So we will deflate the SP 500 by gold.













The chart above helps to illustrate the sad truth that the economic recovery after the bursting of the tech bubble was just a mirage caused by what we call The Great Reflation. The clever boys at the Fed, thinking they had learned their lesson from the Great Depression, were determined to pile on the monetary stimulus early and heavily. Alas, although it triggered a housing bubble and a reflating of the stock bubble, it was coopted and misspent by a corrupt financial sector. There is also a strong case to be made that one cannot reflate their way out of a bust following a boom, by attempting to recreate the boom. The recovery must come from reform, hard work, and savings.

It becomes difficult if not impossible for most people to pick out relationships on charts like these, unless they have a mathematical background or many years studying complex graphs. And personally we like to use the math anyway, because we find the eye deceives where the numbers tell the truth.

Let's just say that we're in for a rough time of it in equities in the US, and we are in a recession now. Why couldn't the Fed have kept rates low? Why did they have to raise the Fed funds rate and trigger the yield curve inversion? Why not just keep things as they were. The answer is clearly contained in the first chart. There are too few instances wherein you can unleash the inflation genie from the bottle, and hope to get it back in again gracefully. Volker did a remarkable job AND was exceptionally fortunate. It may not be so easy the next time, and the alternative is, for bankers at least, hyperinflation and the abyss.

As a final note, we wanted to mention that some years ago a few clever economists found out that its not so much what the inflation rate is that triggers the inflationary spiral, but rather what people think it is. This is not some arcane Clintonian parsing of logic, but a clear connection between perception and behaviour. It is the behaviours that people take in anticipation of inflation that reinforce it like a feedback loop and make it particularly nasty. So if you can control their perception of inflation, the Fed will have a much greater degree of latitude in engineering the economy and money supply since inflation is a major pitfall. What might they do to manage that perception? They aren't being subtle about it, we'll say that much for now. (Hint: three major indicators of inflation are the CPI, broad money measures like M3, and Gold.)

To summarize, the economy is in a recession, and the SP 500 has more correcting to do by historical standards. Short term rates are moving lower ahead of the recession. The Fed will not be able to raise short term rates until the recession is behind us, which means that the US Dollar has further downside potential unless the G8 countries take some extraordinary actions to help the dollar, most likely by inflating their own currencies. The Fed has a tradeoff between the stock market and the economy on one hand, and the dollar and the Treasuries on the other.