When Max Planck opined that “Science Advances One Funeral At A Time” it is believed that he meant that when proponents of long-held theories die, science is allowed to advance. In terms of trading I have applied this to mean that long-held losing trades have died a death due to lack of liquidity to support a flawed analysis. The BOND MARKET is going to provide the opportunity to put the wit of Planck to work as we try to examine the ways in which the FED will deal with the vast amount of reserves with which it has flooded the financial system. As traders and investors, the FED‘s decisions will impact the entire spectrum of the GLOBAL MACRO WORLD. Therefore, it is time to embark on thinking about ways the FED can remove reserves in the least disruptive and to anticipate what plans the central bank may have.
PREMISE: The Fed has injected more than $3.5 TRILLION into the financial system through QE1, QE2 and QE3. Inflationists have argued that the massive liquidity injections would result in a rapid rise in inflation as the money worked its way through the system. Up to this point–using government statistics–inflation has been well contained. But if one measures the rise in financial assets and other investable assets the low inflation argument is much tougher to defend. My contention is that if the economy is strengthening enough for the FED to end QE3, then the area of concern must be: HOW WILL THE FED REIN IN THE MASSIVE AMOUNT OF RESERVES IT HAS CREATED? If the FED allows the reserves to remain in the system and the economy heats up, how will the FED slow the velocity of the reserves? Presently, the bulk of the reserves have very low velocity as banks have not had the demand for loans as the economy is still seen to be in balance sheet repair.
If the FED were to sell some of the large-scale asset purchases on its balance sheet, there is a high probability that BOND YIELDS would RISE dramatically. A rise in BOND YIELDS would mean that the FED would sustain large losses on its holdings. In addition to the FED‘s losses, higher BOND yields would wreak havoc with the U.S. BUDGET DEFICIT and thus government spending programs. Historically low, Fed-induced interest rates would no longer be the salve for lowering the government’s borrowing costs, leading to massive cuts in discretionary spending programs. But most important will be the POTENTIAL EFFECTS OF THE INFLATIONARY IMPACT OF MONETARY INDUCED INFLATION.
When the FED began QE1 and QE2, there was a great deal of discussion of sterilization of the FED‘s unconventional actions. That leaves us at the last point best summed up by KM and is a poke at Tim Geithner: HOW WILL THE FED FOAM THE RUNWAY FOR PROTECTING AGAINST INFLATION AND ULTIMATELY ITS OWN REPUTATION? If it fails to solve the riddle of the impact of a $3.5 TRILLION balance sheet in an accelerating economy,its control over the economy will be history and FED INDEPENDENCE WILL BE AN OXYMORON.
The first stop on “foaming the runway” is a look at the importance of MACROPRUDENTIAL REGULATION. If the FED is afraid of selling its MBS AND TREASURY HOLDINGS because of the sudden increase in interest rates, then it is going to have to look at slowing the VELOCITY of bank reserves and that will require scaling back the leveraging capabilities of the mega banks. It seems that the FED will quietly support efforts for higher capital regulations and much stricter leverage ratios. By lowering the capacity of the TOO BIG TO FAILS the FED may be able to prevent an orgy of leveraging that could lead to a large increase in all prices.
Even the Basel Committee on Bank Supervision (BCBS) is looking at tightening up lending regs for large global banks. The efforts by Senators Warren, McCain, Vetters and Brown to curtail bank speculation will be supportive of the FED‘s desire to bring balance to the bank market. The role of the PRIMARY BROKER market and even the utilizing off-balance sheet maneuvers to leverage its capital will also slow monetary velocity. Remember, this is all theoretical and is meant to open discussion to the path of potential trades and investments based on FED intentions. Pall bearers are welcome.
Quick hitter: Tomorrow the Reserve Bank of New Zealand announces its rate decision at 4:00 p.m. CST. It is expected that the RBNZ will hold rates at 2.5% and I agree with the consensus. The KIWI currency has weakened but has strengthened against the Aussie. If the RBNZ were to lower the rate it would probably cite the strength of the Kiwi versus the Aussie dollar, but a low probability.
Quick Hitter #2: There was an interesting article in today’s Financial Times by Hans-Werner Sinn, a prominent German economics professor and researcher. The headline of the piece is a misnomer: “It Is Wrong to Portray Germany As the Euro Winner.”
The gist of the piece is to argue against mutualizing the debt of the euro zone through the creation of EUROBONDS
. A Eurobond means a unitary federal state and Sinn argues that an early Eurobond before the needed structural reforms have been enacted would be the beginning of a newly inflated credit bubble. George Soros and others have argued for the immediate creation of a Eurobond as way to end “fragmentation.” Many pundits believe the path to the resolution of Europe’s lingering problems is easy. The pushback by prominent German legislators and financial experts calls that into doubt.
Tags: Australian dollar, Euro, Eurobonds, Fed, MBS, New Zealand dollar, QE1, QE2, QE3, U.S. Treasuries