Notes From Underground:The Fed-All Theory and No Practice

CNBC: Market Insiders on Earnings

Friday’s unemployment number caused a sense of panic amongst the FED and the democrats. The conventional wisdom moved the nonfarm payroll up to a 50,000 gain, but as we all know now it was a loss of 85,000. The FED has to hold until the unemployment numbers begin to decline and that is making the markets very nervous–although the equity markets enjoy it as the carry traders take control. The equity markets wanted and needed to see a stronger jobs number so that the fundamentals can give some support to this current rally  The stock market rally is heavily oriented to cheap money and little else, so it is in dire need of corrobating data to give the bulls sustenance.

Following the poor jobs numbers was the release of consumer debt. While the market was looking for a decrease of 6 billion, the data revealed a decline of 17.5 billion and that is during the holiday season. It means either the consumer is totally strapped and nervous or on the brighter side is becoming a smarter utilizer of money–the results are open to debate.

Further bad employment news came out of Europe as the EU number increased to 10%—the highest in 17 years. The pundits are looking for the Union-wide rate to top out at 10.7%, which will put more stress on the peripheral countries. We wonder how the Greeks are going to cut their debt 3% this year with rising unemployment and falling tax revenues. We also received news over the weekend the Portugal was threatened with a credit downgrade, the cracks in the economic performance of the peripherals keep on widening and the fault lines run through Berlin.

Friday we reported that the Japanese finance minister, Naoto Kan, made a statement about his desire to see a weaker YEN because of the deflation setting in. Prime Minister Hatoyama was not happy with Mr.Naoto’s openess so the fianace minsiter backed off his forthrightness–sort of.

“Currencies undoubtedly should be determined by markets,”Kan said. He then added, “But I also believe that generally speaking,it’s the finance minister’s job to act against currency moves when needed.”

The prime minister appeared to be concerned about what other G7 memebrs would think and he didn’t want to ruffle the U.S. We say no worry Mr.Naoto, as the YEN is far from weak, and the U.S. has more concerns on its plate. Let the carry traders determine the YEN’s relative value and that is being market oriented. Besides,the Japanese are holding better cards, as they are a huge buyer of U.S. treasuries and Geithner and company are in no position to unsettle their lenders.We say to the Japanese, CARRY ON and let the market do your work.

In the weekend Financial Times, there was an interesting piece written by Michael Mackenzie. He in no uncertain terms calls the FED out on the mortgage backed security (MBS) program they have initiated under the quantitative easing program. Mackenzie sees no way out of the mess the FED has created and the impact will be much more negative on the motgage market then they have theorized. The FED balance sheet is laden with more than a trillion dollars of these instruments and the buying program will end March 31. Some analysts think that 10-year trasuries will sell off as this program ends, as more debt is brought to market and the major buyer has left the scene. The FED will be in a box as they will have to lighten their balance sheet at a time the market smells blood. Now some will argue that the FED doesn’t have to sell, which is true, but others will do it for them. The Treasury is bringing a great deal more to market and without the FED taking up the MBSs, there is going to be a great deal of competition for the investment DOLLARS. Something will have to give and we just may see our first failed auction. The FED is going to learn the lesson of Long Term Capital Management, in that your models may tell you the theoretical value of something but it is a different story when you need a price in real time.

We learned as floor traders long ago, we don’t want the first thousand of a 100,000 order. In fact, it may start racing you to establish real value. If you think that trading desks made good money front running the FED on their MBS buying program, wait until they have to sell. The FED is going to learn the hard way when they discover the pain of liquidating a bad position of which the market is totally cognizant. Is it any wonder why Bill Gross is out there talking negatively about U.S.- and U.K.-long-term debt markets as he know that the QE programs have to be unwound? He is putting upward pressure on rates just by his chatter and his firm is the largest non-sovereign participant. The FED reverse-repo program and its ability to pay interest on reserves has so far been so small as to not really register on its effect on short-term rates. As the FED begins to panic, and the politicians become more uneasy as the 2010 election season gets underway, it will not be good for the DOLLAR. That will lead to even greater uncertainty in the DEBT markets, creating the ultimate negative feedback loop. We don’t think we are there yet, but each piece of mediocre data brings us closer. The GOLD will outperform as the uncertainty builds.

If we ran the FED, we would raise short term rates to 2% immediately for that would act to anchor the DOLLAR, lead to a selloff in the GOLD and other commodity markets, and give the FED and Treasury some breathing room. Equities would get hit but would probably stabilize at higher rates than some think–if the S&Ps cannot see off 2% rates, then it really has no legs anyway and like the scene in Dirty Harry, we gots to know. Anyway, the rise in short-term rates would lead to a bear flattener and cause those short the long end of the curve now to rush to close their positions and would create buyers for the long end out of necessity. The losses on the curve play would be great, but they would be bourne by private speculators and not the taxpayer. Unfortunately, we do not run the FED, but if not us maybe Paul Volcker. This highly politicized FED does not have the backbone for this strategy and besides, their models have not told them this would be correct. So we will live with a weak DOLLAR story and continuing steepening in the curve as the smell of blood in the debt markets is beginning to fill the air. Oh, if only the FED accepted a little PRAXIS.

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3 Responses to “Notes From Underground:The Fed-All Theory and No Practice”

  1. ray mckenzie Says:

    one of your best blogs today Yra.

  2. FreD Ehrman Says:

    “Something will have to give and we just may see our first failed auction. ”
    Do you think we can ever have a failed auction? Isn’t the Fed monetizing the debt and aren’t they the “buyer of last resort”? And if their balance sheet no longer will support more debt, won’t the jig be up and the house of cards (bubble if you will) collapse very quickly?

    • Yra Says:

      True on all accounts. But we did see a failed auction in the U.K. in March 2009. Now, of course the U.S. is the world’s reserve currency with the power of the printing press. So theoretically we can’t have a “failure,” but the markets will push the Fed to find out what their response would be.

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