After reading through the vast amount of news on the Brussels “emergency” meeting, I am not sure I truly understand what the final outcome of the European resolutions for financial stability entail. There are bond swaps on Greek debt, which will mean a soft default, and then there is an increase in the size of the EFSF funding and a move to allow the buying of secondary sovereign bonds. Again, it is not so easily to understand at this juncture as so much contradictory information is being provided that the final agreement doesn’t appear at this time.
It is known that only Greek bonds will be swapped for longer durations but the unknown is what will the other PERIPHERALS ask for if the Greek rates were to drop to levels that make Ireland and Portugal envious. Sarkozy and Merkel seemed to be in agreement on many issues but it doesn’t appear as if there is a EUROBOND yet, which means there is no real movement on consolidation of fiscal policy. President Sarkozy made it seem as if an agreement exists for a European Monetary Fund, which would provide liquidity in emergency situations, similar to the IMF.
The question remains as to where the funds to support an EMF will come from and what country will ultimate backstop the need for the collateral for any future bailout operations. Rates on the troubled peripherals are still very high so it will take time to see how the market will absorb the details. The fact that it was only the GREEK DEBT singled out for some type of restructuring leaves me to wonder what price will be exacted from Ireland when it wants to lower it rates and lengthen its duration. The Eurocrats will demand that Ireland raise its LOW CORPORATE TAX RATE AS A PRIMARY CONDITION FOR DEBT CONSOLIDATION.
There will be funds forthcoming but the demands for a quid pro quo will be exacted. Still, the markets accepted the European plan as a huge increase in liquidity and credit reprieve. As anticipated, the BUNDS were sold off as the other European sovereigns rallied. More importantly, global equities staged a coordinated rally as the world breathed a sigh of relief that another European crisis had been averted. GOLD was sold as the EURO rallied and investors moved from safety to a more risk-oriented profile. Ultimately, the European plan leaves many questions. To paraphrase Churchill: “I cannot forecast to you the action of Brussels (Russia). It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is European (Russian) national interest.”
Yesterday, Brian Sack, the chief dealer of SOMA (SYSTEM OPEN MARKET ACCOUNT) gave a speech discussing the FED‘s investment portfolio. SOMA does all the buying and selling for the FED as it implements its QE strategy. Sack is the FED‘s key man and he now controls the largest DEBT PORTFOLIO in the world. Mr. Sack revealed that the FED‘s portfolio had now extended its duration to more than 4.5 years well beyond its traditional duration of 2-3 years.
“Together, the larger amount and longer tenor of our securities holdings result in a considerable amount of duration risk in the SOMA portfolio, meaning that the market value of the portfolio is sensitive to movements in interest rates.”
This is a significant revelation for it means that the FED is going to have to engage in FINANCIAL REPRESSION as to insure itself against low losses do to interest rate rises. The FED holds more than a TRILLION DOLLARS of 10-year instruments–MBS and TREASURIES. Thus, it is in the FED‘s self-interest to possibly cap long rates similar to the 1940s. Also, imagine the outcome for the FED balance sheet if the U.S. DEBT was downgraded by the rating agencies.
The FED‘s exit from QE2 is going to be a far messier affair than the economic models would indicate. When the FED‘s main BOND trader and portfolio manager issues a warning, it is important to pay close attention. If he is concerned, then we all need to be concerned. Those who say the FED is making money on the QE programs are marking to market and not anticipating duration risk. Time to look closely at the technicals on U.S. NOTES AND BONDS.