Notes From Underground: FED decides tomorrow and the envelope please …

Another FED meeting and another day when the parsers of FED SPEAK get to dissect the nuances that the media uses to fill the void of that vapid wasteland. The current rally in the EQUITY markets will give the FED Board of Governors the needed cover to maintain the extended period language and appear that it is above politics.

The most interesting part of the FOMC statement will be how the vote went. Will HOENIG be the only voice of dissent or will other voices find the strength to oppose Bernanke? FED Governors seem to talk tough from a distance but once they enter the inner sanctum of FEDLAND their voices lose their volume. We also give little chance to a new QE program as the FED will not want to expend all its ammo when so much uncertainty lurks over the markets. We at NOTES were entertaining the concept of another massive QE program and an idea entered our minds: How will the FED purchase of MBSs and longer dated TREASURIES disrupt Geithner’s plans for dealing with the CHINESE?

IF the FED were to purchase another trillion of debt instruments, wouldn’t that allow the Chinese to sell off their U.S. holdings at a great profit, as the Chinese moved to diversify away from the U.S. and its fear of currency debasement and/or some type of CONGRESSIONAL intervention to push currency intervention? The U.S. Treasury has been comfortable in assessing the Chinese exit strategy as impossible because a massive sake of U.S. assets would hurt the Chinese as their portfolio would get crushed. As we entertain another QE, it seems that the FED would be the largest buyer and would act to absorb a huge disgorgement of U.S. paper.

We stress this is merely HYPOTHETICAL but it is worth contemplating. If the U.S. Treasury were to lose the leverage of large Chinese losses, we wonder how the U.S. would retaliate to Chinese intransigence on currency and trade issues. The only action available to the Schumer clique would be tax surcharges on imports but maybe others have some other views. It just seems curiouser and curiouser as the political season is in full swing and the language of populist protectionism is the low hanging fruit.

A FED keeping its options open seems to be the best path to take. If Hoenig were to gather more support in the voting, we would get a selloff in the EQUITY and BOND markets but we would advise that a hard break would be a buying opportunity. Interest rates are still and will be low and the quest for higher returns heading into the final quarter will spur the animal instincts of the multitude of underperforming hedge funds.

Europe saw a widening of the interest rate spreads between high quality sovereign debt and the peripherals today. The spread on 10-year notes between Germany/Ireland increased 15 basis points while Portuguese versus BUNDS widened 22 basis points, just ahead of Tuesday’s Irish auction. The picture is not pretty as we are approaching very high levels on the spread differentials. Greece is presently yielding 900 basis points over German debt.

Why is this important? The high cost of borrowing for the PIIGS is the indicator of the NEGATIVE FEEDBACK LOOP that all the peripherals are facing. The more their borrowing costs increase, the more austere their budgets need to be. Yes, we agree that many of these countries have been blatant in their disregard for financial rectitude but as the late Congressman Dan Rostenkowski learned, it is very difficult to rescind government largesse once it has been bestowed. The PIIGS may have all the best intentions to correct their profligate past but the pain will be very real.

As the NOOSE of the NEGATIVE FEEDBACK LOOP tightens, will the political elites have the fortitude to stay the course? If the PIIGS lose their will to enact austerity, will the GERMANS and the IMF find enough money to ease the initial pain? Presently, the markets have turned its attention from this painful process and have even become sanguine as Sovereign Wealth Funds have been quietly acquiring some of these high yielding sovereign instruments. Sometimes it is easy to be a hero with OTHER PEOPLE’S MONEY,especially when its oil wells keep pumping away. For now we will be informed observers and look for ways to nibble around the edges without being squished by elephants.

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5 Responses to “Notes From Underground: FED decides tomorrow and the envelope please …”

  1. Danny Says:

    It would appear to me that Schumer and the others in Congress and Treasury who are challenging China on currency manipulation are positioning in such a way as to decrease the caliber of the Fed’s fire power if their is a need for QE the II. After all, per the constant of barrage of attack from the US, why wouldn’t the Chinese take the opportunity to decrease their USD holdings in the event QE II takes place? That would only be the smart thing to do, right? Billions of dollars of Federal Reserve fire power on the bid side will surely be used by the Chinese to put billions of dollars of holdings on the sell side. I suppose this assumes that the Chinese will know when the Fed is performing QE transactions.

    But a few questions need to be asked…What is the point of QE II if it is not incremental fire power but rather an offsetting force to Chinese liquidation? It seems to me that if QE II is met with Chinese selling, it will have a very limited impact on the real economy. Quite frankly, other than scaring everyone in the market to the sidelines, for the fear of getting crushed between the Fed and the Chinese, QE II might not have much of an impact in the financial markets assuming a dollar for dollar buy vs. sell side pressures.

    Perhaps more importantly, are there any potential benefits of shifting US debt holdings away from foreign countries back to the domestic institutions/population in terms of growth, etc? Think Japan and national savings with JGB’s.

  2. yra harris Says:

    Danny –the FED is not meaning to offset Chinese sales it is just an convenient move on the part of the Chinese to extricate themselves from an untenable position—but thank you for a very good post.

  3. Ron Says:

    After studying and traveling extensively to China, its highly doubtful the Chinese would be cowed to do anything by a worry they would lose money on their dollar positions. They wouldn’t really care if it meant giving up on their development strategy. They have been through the terror of the cultural revolution, losing some pieces of paper is not going to upset them much.

    Now is the best solution for the U.S. is to let the chips fall where they may and slap dumping duties on china? Not really, because the problem is not China so much as the trend of wage deflation in the West since the fall of communism. The goods will still be produced in China no matter the duties for reasons stated below. So, there really is no solution save for a major decline in living standards for the majority of people in the U.S. and Europe.

    The Chinese government is like a giant corporation that has only one goal: to build production and technological capability in China controlled 51% by local Chinese ownership (effectively the government). China is in many ways still smarting from its historical weakness and is now trying to copy Japan’s industrialization path of the 1800’s by not allowing any foreign ownership etc.

    The fact that everything is state owned does not lead to inefficiencies in the sense of communism because the Chinese confucianism work ethic and concept of honor makes everyone work very hard.

    Additionally, the rise in Chinese real estate prices is because in China, most everyone saves 90% of their salaries and tries to own as many apartments (50% down, 5 year mortgages by the way) as possible for their children. Their sons and grandsons can not find a decent wife without being given a decent apartment!

    So the challenge of America is to sell goods to a country that saves 90% of salaries and the only purchasers are state influence businesses that are told to support local chinese technology?

    And U.S. labor is supposed to compete with the chinese work ethic?

    Good luck!

    The strength of the U.S. is the innovation of our culture, but with 10x the engineers being graduated in China, even this will eventually be surpassed.

  4. yra Says:

    two very good posts—as we speculate .the situation is getting tougher and more interesting but if the Chinese were to sell off a great of assets the prisoners dilemma will begin to be resolved .THE FED today made the situation tougher and the currency market reacted appropriately–didn’t the FEd do today what Japan did last week–only by stealth

  5. Danny Says:

    I wasn’t trying to argue that the Fed will perform QE to offset Chinese sales. I was attempting to argue that QE may turn out to be a very impotent policy action, in terms of its impacts, if the Chinese counter by liquidating their holdings simultaneously. Which then leads me to wonder, if QE II has an unreasonable probability of sounding like a battle ship gun with the knock down power of a red ryder bb gun…why would the Fed risk it? Making such a move would further pin the the Fed in a corner. Not unlike the stimulus money…BIG BANG, itty bitty bullet…followed by the creation of a new party intent upon shrinking the role of the Federal Government in our lives and a total lack of political capital to do any further stimulus actions. The calculus just seems quite risky.

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