Notes From Underground: Good Trading Advances One Funeral At A Time (Thanks, Max Planck)

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.

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11 Responses to “Notes From Underground: Good Trading Advances One Funeral At A Time (Thanks, Max Planck)”

  1. kevinwaspi Says:

    Good piece as usual. Let’s not forget another tool the Fed could bring to bear (in addition to capital requirements) namely, reserve requirements. This seldom used tool could be dusted off to quell velocity and done so with much less “process” than regulated capital requirements.

  2. marcus Says:

    All of which leads to the question who is more powerful, the TBTF banks or the Fed? Given the response to LTCM, Lehman, Y2K etc. it is hard to believe that the Fed would slow velocity by any means while the banks are doing their best to increase it. The independence of the Fed is an illusion and Bernanke/Yellen is no Volcker. Besides we all know that devotees of Keynes, who dominate the economic conversation these days, believe in the “government spending during slow times part” and not really the “reigning in spending during good times” part.

  3. Mark T Says:

    Since the Fed prints the money that satisfies its liabilities, what does it matter if it sustains losses on its balance sheet? If it had to satisfy liabilities in gold, it would matter, but it just has to push a button to create money.

    I think the Fed has the tools to manage the unwind, between reserve requirements and the pool of securities it owns. As well, once it stops buying $1T a year of debt, the excess reserves will go to work replacing that demand. I do think rates will go up, but that is due, frankly. I agree they have to manage that so it happens gradually to not break the economy. I agree that is the main question. I don’t agree however thst passing new laws is needed or even useful in solving that dilemma.

  4. usikpa Says:

    Which leaves one issue outside of the discussion, which, by the way is not under the Fed’s control. What will happen to USD inflation, once China starts to retaliate to Japan’s monetary policy (say, via liberalising its FX regime)?

  5. Dustin L. Says:

    usikpa- You raise a very interesting point. This is why I love this blog, a collaboration of thought provoking ideas. Thanks.

  6. john rolando tolken Says:

    Regarding the 1st paragraph under Premise, in addition to bank reserves, a huge (and I mean ginormous) amount of the new QE money is currently retained in the capital markets.

    In the 2nd paragraph under Premise, in addition, rising yields will signal investors that the Fed is phasing in tightening, and current bond holders will begin to exit the bond market to protect their principle and gains, before the markets equalize at a lower level. Despite going to cash, velocity will remain low, as will price inflation on goods. This is because this investment cash will not go to purchase products, but will rather wait until capital markets calm down before redeployment back to the capital markets. This process will likely repeat itself.

    Although tons of money has been printed as part of QE, it has entered and continues to enter the capital markets (including energy) by privileged financial firms and folks close to the QE spigot. QE moneys have not really entered the finished goods market yet (except to reflect higher energy prices associated with extraction, transport, and processing of raw materials that get pushed up to the consumer), because the consumer (and the consumer market) is many steps removed from the QE spigot. Unemployment is high, and their portfolios (if they have one) are still recovering from losses. Plus the consumer is facing higher taxes in conjunction with higher energy costs. In essence, the source of goods price inflation, the consumer, is cash poor.

    Because of this, goods price inflation will not ramp up as quickly as hyper-inflationists would expect 3.5 trillion new dollars to cause…but sure as night follows day, goods price inflation will surface and it will be ugly when the ball gets rolling. The goods price inflation of the 70’s was a result of the monetary inflation of the 60’s. Goods price inflation seriously lags monetary inflation, but I believe we are close to the end of the lag period.

    When the capital markets and the Fed responses to the drops really start to oscillate, that’s when SOME of the QE dollars currently captured in the capital markets will start to be allocated to the non-capital part of the system, and when goods price inflation will begin chasing the equilibrium of the 3.5 trillion of new QE dollars in this land-locked world of ours.

    Of course, I could be wrong, but only time will tell.

  7. arthur Says:

    Learning by doing… “Inflation set to make a comeback in five years,” Luca Paolini is chief strategist at Pictet Wealth Management

  8. Chicken Says:


    By changing the “rules”?

  9. Bob Says:

    Hey Yra you asked me to keep you posted on the UK EU referendum so here is a quick article on what the man who ran UK politics through Labour with Tony Blair as PM is doing:

    They seem to think that there will be a referendum.

    I guess the tactic is to have a referendum sooner 2016? rather than later when they think they can win and have consent of the people, rather than let it drag on and risk leaving. There is no way the UK can leave this is the culmination of hundreds of years of work to unite Europe.

  10. yra harris Says:

    Bob–thanks.This will be a long drawn out affair—difficult as so many moving parts.German election,French problems,and so much more

  11. Mario Says:
    Great article from a few months back, has QE really helped much or have these several thoughts come true.Everyone who enjoys the NOTES, send in your favorite articles to shed some light on what came true and has worked out for youas time has played on. Contact me at

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