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On the Fed’s "Shock and Awe"

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When some deemed the Fed’s move today to expand its balance sheet by as much as a trillion dollars plus as “shock and awe”, I recalled that when that term was first used, at the beginning of the US invasion of Iraq. The notion was a display of superior force would lead to quick capitulation.

We know how well that theory worked. And I suspect the unintended Iraq-Fed analogy is apt.

Let me focus on the Treasury part of the equation, but with a recap first. The Fed announced today that it would buy up to $750 billion in Agency MBS this year (in addition to an earlier commitment of $500 billion) and up its purchases of Agency bonds from $100 billion to as much as $200 billion. It also said it would purchase up to $300 billion of longer dated Treasuries over the next six months.

As readers no doubt know, stocks took off, bonds rallied big, as did gold (note the last two are contradictory). And the general tone was that investors were surprised. Caught off guard might be the better turn of phrase. The Fed had indicated very clearly in December that it had moved to a policy of quantitative easing, sort of (as Tim Duy noted, the Fed seems to consider a commitment to continuing to expand the Fed’s balance sheet as QE. They have not taken that move, either then or now). Analysts were impatient at the Fed’s failure to announce how it intended to use the Fed’s balance sheet to improve credit market functioning, and didn’t get as much in the way of news in January or February.

But let’s consider further what is operative here.

The Fed said it was concerned that inflation was at sub optimally low rates, implying that these measures were being implemented primarily to combat deflation. But the numbers above tell what the real story is. The Fed first and foremost is trying to prop up asset prices, particularly housing, out of a view that their current level is the result of irrational pessimism. The Fed had indicated in earlier statements that it was going to target interest spreads over Treasuries of various types of credit products, and that is still by far the greatest use of firepower. However, the addition of Treasuries is a new, albeit expected, wrinkle. Let’s face it, if the long bond continues on its march to 4%, the Fed can do all it wants to contain mortgage spreads, but it become increasingly difficult to keep mortgage rates from rising.

But let’s look at that up to $300 billion over six months for Treasury purchases. Sounds formidable, until you consider how much the Treasury calendar is increasing this year.

I’ll admit I did not do extensive digging, but I found an interesting memo, “Report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee of the Securities Industry and Financial Markets Association” from early February. It isn’t too long, and it is worth reading. The SIFMA polled members on how to change the Treasury auction calendar to accommodate the increased supply coming over the next two years.

Read it closely. The memo does not say so in so many words, but the changes that SIFMA members could come up with (as in they were willing to recommend) do not appear sufficient to take up the additional supply.

And consider this cheery observation:

The net supply of Treasurys in 2009 and 2010 combined seems likely to total more than $3 trillion and could climb as high as $4 trillion. The Congressional Budget Office (CBO) estimates the 2009 Federal budget deficit to be $1.2 trillion. The consensus of private sector analysts is similar to that figure. Yet, neither the CBO estimate nor the private consensus reflect fully the funding needs associated with the Obama Administration’s fiscal stimulus plans, the implementation of TARP (or another TARP-like program), or the rumored creation of a bad/aggregator bank to help deal with the underperforming assets weighing down financial institutions. Some of the funding of these government programs will spill over into 2010, a year in which the “core” budget position also will be weak according to mainstream expectations for economic performance.

Actual and potential funding needs for financial sector stabilization programs already announced are considerable. Guarantees made on select assets of systemically critical financial institutions could require Treasury to raise hundreds of billions of dollars in the event that these assets continue to deteriorate. Similarly, guarantees made by the FDIC on select bank-issued debt could catapult government borrowing needs further should the issuing bank(s) default on its FDIC-insured paper. Any additional guarantees on future losses to assets held by financial institutions would further increase net borrowing needs by Treasury. The size of any such borrowing would hinge on the type and size of assets backstopped.

The expansion in quasi-government paper contributes to the risk of market saturation. Banks have issued nearly $150 billion in FDIC-backed paper since the programs introduction. Spreads on this paper have been narrowing over time with the latest deal, paper offered by Citi, pricing just 30 basis points over Libor. Real money investors have purchased the bulk of this paper in an attempt to pick up yield over Treasurys while not taking on additional credit risk. In some respects, this paper has replaced GSE debt as the instrument of choice for real money investors looking for modestly higher yielding, quasi-government debt.

So take $1.5-$2 trillion in incremental Treasury supply per year, which SIMFA is telegraphing it expects will prove low. That’s $125-$167 billion a month. SIFMA warns there has already been some crowding out due to FIDC backed bonds.

And now we get to the other half of the equation: thanks to falling trade deficits (which require foreign central banks to park FX reserves somewhere, generally a large chunk in Treasuries), foreign purchases of Treasuries have fallen sharply. Per Brad Setser:

I wanted to highlight one trend that I glossed over on Monday, namely that foreign demand for long-term Treasuries has disappeared over the last few months….The rolling 3m sum bounces around a bit, but foreign demand for long-term Treasuries in November, December and January was as subdued as it has been for a long-time. Among other things, that fall in foreign demand for long-term Treasuries after October suggests — at least to me — that the big Treasury rally late last year (and subsequent sell-off this year) doesn’t seem to have been driven by external flows. Foreigners weren’t big buyers of long-term Treasuries back when ten year Treasury yields fell to around 2%.

FYI, by long-term, Setser means 10 year and over. And his charts show demand for Agencies and corporate bonds is pretty much non-existent too.

His charts show a big spike for T-bills in the crisis months, but Setser notes:

However, that surge in demand for bills now seems to be fading.

The fall off in total TIC flows in January reflected private bill sales. The official sector is still buying — $100 billion in bill purchases over the last 3 months of data only seems small relative to the post Lehman peak. But with global reserve growth slowing (even China doesn’t currently seem to be adding to its reserves), central banks won’t be as large a source of demand for Treasuries going forward as they have been in the past…..

Why does this matter?

Foreign demand for Treasuries hasn’t kept up with Treasury issuance, but it undeniably has been strong. Over the last 12 months, net foreign purchases of Treasuries financed much of the US current account deficit….

The trade and current account deficit has fallen substantially as a result of the fall in oil prices, so the US needs less external financing now than in the past. But it still needs some.

The “quality” of the financial flows into the US consequently bears watching. A modest revival in foreign demand for longer-dated US assets would be a positive sign. To date, the sale of US assets abroad and a scramble for liquid dollar assets has provided the US with more than enough financing to sustain its deficit. Those flows though may not continue.

And if — as seems likely — foreign demand for Treasuries fades long before the US fiscal deficit, the US Treasury will need to sell an awful lot of Treasuries to American investors. For the past several years I have argued that it was almost impossible to overstate the impact of central bank demand on the Treasury market.

So $125-$167 billion of new supply a month (and SIFMA warned it could be more) and a big question mark about foreign demand means $50 billion of Fed Treasury purchases a month may not be enough to keep rates from rising. The fact that 10 and 30 year Treasury yields in Asia are higher than their lows yesterday in New York suggest some skepticism. By contrast, after the December FOMC meeting, when it announced it was doing its not exactly quantitative easing thing, bond yields fell sharply and continued to march forcefully downward over the next four days.

In addition, some of the Fed’s pet programs may not be getting the traction they want. The TALF (the $1 trillion facility targeted at fostering new lending to credit cards, auto and student loans, appears to be getting a lukewarm reception. A hedge fund correspondent had dinner with a colleague at a large hedge fund and reported that the said that the returns theoretically available weren’t high enough to make it viable, and there was no enthusiasm for the program among his peers.

And even if the Fed does win the yield battle, it may not prevail in the war. From the New York Times:

Jan Hatzius, chief economist at Goldman Sachs, said the Fed had adopted a “kitchen sink” strategy of throwing everything it had to jolt the economy out of its downward spiral.

But while Mr. Hatzius applauded the decision, he cautioned that the central bank could not solve the economy’s problems by expanding cheap money.

“Even if the Fed could make interest rates negative, that wouldn’t necessarily help,” Mr. Hatzius said. “We’re in a deep recession mainly because the private sector, for a variety of reasons, has decided to save a lot more. You can have a zero interest rate, but if you just offer more money on top of the money that is already available, it doesn’t do that much.”

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51 comments

  1. Anonymous

    Great analysis Yves.

    I think everyone is still digesting the implications of this, and it goes along with the 1 trillion public-private partnership you’ve been blogging about.

    The last quote you had seems to convey the Zeitgeist pretty well. There’s the idea that a massive program of new lending is pretty pointless. People are waiting for some sort of new structures or industry to emerge that might justify this kind of lending. The cynics might say they are waiting for the next bubble. The usual tack of just pumping more money into the system and expecting the system to know what to do with it, doesn’t seem to be working.

  2. Anonymous

    I find the shortfalls you pointed out in meeting goals in treasury auctions especially troubling. At this time, I doubt Bernake will let the auctions fail like the Germans do. More likely, he will print whatever is necessary to keep the treasury happy. It will be interesting to see what he does when the environment becomes highly inflationary.

  3. ndk

    I too was taken aback by the Fed’s willingness to purchase Treasuries outright, expanding from an earlier qualitative easing focus. They had made statements doubting the efficacy of QE, and I’m surprised to see them pitch in the towel and just try it so swiftly.

    I really don’t believe in the powers of QE. We’ve witnessed ample demonstration of its failure time and time again — just like Keynesian stimulus — but have apparently fallen back on it for lack of good alternatives. That’s a bad sign.

    Economically, as Hatzius points out, it’s functionally little different from stuffing banks to the gills with excess reserves in an attempt to get them to lend. Banks were unwilling to lend those reserves then for lack of appealing risk/return prospects. But he doesn’t mention that this worsens that situation. How willing will they be to lend as the Fed continues to forcibly compress the interest they can receive, which can only harm NII?

    As such, this action will force the Fed and Government to further involve themselves as private actors find their asset purchase/lending profit motive eroded by a price insensitive buyer.

    I don’t think this action is purely futile, though. I can still imagine effects: it converts a fixed Federal obligation to a floating Federal obligation, and it could destabilize the financial system further.

    The involvement of the government reduces the market-determined signals delivered by pricing data. The reference debt has been perturbed and its mass reduced, while the state is now exposed more to the vagaries of fluctuating interest rates.

    And, if they take a MTM hit on long-dated bonds (which they’re wisely avoiding) or a credit hit on MBS and other qualitative easing action, they could formally need recapitalization by the Treasury. Having witnessed the AIG public vitriol, how do you think that would go over?

    This is an act of desperation, not an act of inflation, that will only decrease private credit creation. I still believe dollars and shorts are the place to be until something snaps, as I have for months now. This isn’t a snap just yet, but if they keep pushing…

    p.s. As a Mellonite, I find this all really depressing.

  4. Anonymous

    umm. you are forgetting other govt programs… maybe $1.25 trillion is not enough, but $4 trillion is?

  5. doc holiday

    The connection to Setser’s TIC Flows connects to one of my favorite old links — Revisiting the M3 Contraction which keeps me thinking that The LHC is about to be turned on soon, and this time it might do even more “stuff”.

    There is a reason the yield on the current 3 Month is falling and it goes back to basics (from August 21, 2008 M3 chit-chat): The recent plunge in M3 makes it likely that credit lines have been fully tapped and/or banks have simply turned off the spigot. Liquidity shrinks by the day. Banks Scrambling To Refinance Long-Term Debt are going to have a very tough go of it. Weekly unemployment claims are soaring. Consumers out of a job are going to have a tough time paying bills. Those looking for a bottom in these conditions are simply barking up the wrong tree.

    Also see this type of stuff: $$$

    If the Fed is fundamentally asked to foot the bill for the deficit, global investors will have no confidence in the U.S. because then the emperor will truly have no clothes as the Fed merely prints more USD bills than it’s worth. The basic result is spiraling inflation and a severe decline in the USD, if not crash. To tiptoe a little down this dark path, we see that M3 (full measure of inflation) has spiked to over 15 percent YOY growth, all in the last four months. The difference between rates on 10-year notes and comparable TIPS (Treasury Inflation Protection Securities), which reflects the outlook among traders for consumer prices, touched 1.15 percentage points yesterday, the widest since October 21 and showing no signs of abating. In the long term, you’re going to see Treasury yields rise as we deal with the mother of all supply challenges. Add to it the fact that gold has risen 12 percent over the past two months just speaks to the “tip of the iceberg” on this line of thought. If the Fed buys, you will see double digit interest rates in the U.S. by 2011 as a worst case scenario.

    … What was the topic? Am I close?

  6. Yves Smith

    Anon of 3:14 AM,

    No, I am not forgetting the other programs. The TALF is a trillion, and Tyler DurdenTyler Durden says that the uptake will be vastly lower, under $200 billion, perhaps only $80 billion. So that $4 trillion is not $4 trillion.

    And if the shy of $3 trillion were adequate. why is the Fed throwing more money at the problem?

  7. ndk

    And if the shy of $3 trillion were adequate. why is the Fed throwing more money at the problem?

    It’s an interesting question, Yves, but I think it’s a much more interesting question if you omit the first sentence.

  8. Anonymous

    I wonder if there is something additional going on here:

    In questioning Liddy yesterday, Rep. Alan Grayson zeroed in on an item in AIG’s 10K which said that if the yield curve expands by a mere 100 basis points, AIG would be on the hook for $500 Billion (that’s not a typo) given their current derivatives portfolio.

    I wonder if the Fed is hell bent on preventing that, other consequences be damned.

    They keep adding floors to the house of cards.

  9. alex black

    If I’m understanding Bernanke’s intent here, it’s to lower interest rates a bit to consumers, so all of those people who are right on the edge of deciding to buy, say, that new GM car, will say, “Well, I just couldn’t do it at 5% interest, but hey, at 4%, where do I sign?”

    All ten of them.

  10. Simon

    This macro economics thing is brilliant! It’s really really important and yet you don’t need to do any hard maths, you can do it all in your head! A bit like theoretical physics which is also fun.

    So Mr B. wants asset prices to stop falling. So he makes money really cheap and then promises to print it. Basically he’s saying… You don’t want your money to become worthless? Then you better buy something solid with it pretty quick.

    Well that worked! The dollar dropped gold popped. We are back on the old familiar course are we not? A dropping US dollar means greater global liquidity and rising asset prices at least for the next few days or weeks perhaps. That means bank stocks rise and their capitalization improves enormously as the doggy doo in their sieves and spives starts to look better.

    It’s all good no?

    Wait on there an minuet… If you have a 200k mortgage and you are able to save only 5k a year its still going to take you 40 years to pay it off and if you are 35 or more that is pretty grim is it not?

    I know about the 5k thing. For quite a while I though I was doing well saving even that much. Come to think of it I still think it’s not that bad going.

    But back to the macro economics thing. GDP= 14 T give or take. Aggregate debt to GDP is 3.5 times giving total debt TD = 49 T. Banks are leveraged about 10 times so actual deposits are about 4.9 T. So there is say 44T of Credit that has been taking a serious hit in the form of losses and write downs. What would be interesting to know is how fast that amount is decreasing. Then we would be able to compare the stimulus the Treasury and the Fed are providing with the bush fire they are battling.

    Is .3 or.6 or.9 T in quantitative easing a fire hose or a garden hose in comparison? Or was the intention of the proposed easing a head fake for Mr Market?

    Three percent of 44T is 1.3T. Don’t ask me why three percent, it just a guess, but that would be quite a high loss for a bank wouldn’t it? That kind of makes .3 or .6 or .9 Trillion seem a decent amount in comparison.

    Sorry to bore you while I think it through.

  11. aw70

    Minor nitpick: “shock and awe” actually worked fantastically, as far as the actual invasion of Iraq was concerned. A total, crushing victory within days over a not *that* small opposing army, which theoretically also had the advantage of fighting a defensive battle in their home country. This spectacular outcome was not entirely a foregone conclusion.

    The screw-up was not “shock and awe” in and by itself. Rather, invading a country without a clue as to what they should do with the damn thing once they had it in their hands was the real problem.

    Of course, that does not mean that the analogy is not apt. The discussed fed strategy might (probably will) also yield some visible short-term gains, and then die a miserable death. Unfortunately. It’s not like we could do with some real, working countermeasures against the crisis by now…

  12. eh

    When some deemed the Fed’s move today to expand its balance sheet…

    What a ludicrous phrase/euphemism – ‘expand a balance sheet’. I guess the Fed just happens to have $300b under its mattress, and it will now put this money on its balance sheet — whatever that is/means — and use it to buy treasury debt. I can understand the decision, as the stock market is obviously pretty risky right now.

    Question: Why does this money have to be created as debt?

    Thomas Edison:

    “If the Nation can issue a dollar bond it can issue a dollar bill. The element that makes the bond good makes the bill good also. The difference between the bond and the bill is that the bond lets the money broker collect twice the amount of the bond and an additional 20%. Whereas the currency, the honest sort provided by the Constitution pays nobody but those who contribute in some useful way. It is absurd to say our Country can issue bonds and cannot issue currency. Both are promises to pay, but one fattens the usurer and the other helps the People.”

  13. fresno dan

    Yves; wonderful, wonderful stuff – just terrifc analysis and commentary.

    The US can make money until it can’t. “The Fed first and foremost is trying to prop up asset prices, particularly housing, out of a view that their current level is the result of irrational pessimism.”
    The policy of no pain, no losses, for no one, will result in much, much greater pain for us all.

  14. Richard Kline

    An interesting stiching together of pieces into a whole, Yves. I had read Setser’s piece separaterly, and to me it is one of the most significant data points of 09 to date. We’ve seen those _plunging_ export numbers out of Germany-Japan-China, and so as night follows day we now see their Treasury purchase rate bleed out because (duh) they didn’t earn the promissories to swap for them. There is no foreign-government market for our public debt with the step down of trade . . . and that foreign-government market was all that was keeping our debt-for-goodies game going. This is the dead ostrich in the coal mine on the end of finance as we have known it, to bend a metaphor.

    —Which makes an attempt at quantitative easing, strong programme or weak programme, pure madness. Contexts where quantizing could have a positive effect on economic output are conceivable, but our present context in the US is NOT one such. Too many dead banks rotting in the credit pool have sucked all the capital-oxygen out of the liquidity. And even those banks conparatively healthy have no incentive to lend in an environment of forcibly negative interest rates. The idea that they might is something that would only occur in the reality-challenged cortex of an academically trained economist; no one who manages money for a living thinks that way. Then too, why would any of these banks go out and take risks lending when Daddy Fedbucks is only too happy to roll them over in the clover-window for nothing, indeed to pay for their time if they bother to show up?

    Your hypothesis that “Madman” Bernanke is trying to prop up asset prices seems a good one. I wish, though, that we had more direct confirmation of this as opposed to a chain of defensible, and indeed good, inferences. The notion is beyond nuts, and will only fail spectacularly, but doesn’t seem quite certain. It is, to me, hard to accept that Bernanke, Geithner, and Summers actually believe that asset prices are ‘suppressed.’ Yes, collective insanity can happen, but that’s what such a ‘determination’ amounts to. I know, I know, incompetence is the answer if Occam’s Razor cuts baloney here, but still. As a partial alternative, I might propose that our government financial brain(dead) trust doesn’t so much have a goal as they have a determination to try to force a return to ‘normal activity’ of the recent past by any means necessary; I mean, it worked _then_, right? Until a perturbation in the system, hey? So the idea is to get the system breathing again, kinda like artificial respiration. To me, they just expect the patient to sit up and get back to normal if they keep pounding on the chest and breathing down the conduit of all these corpses on gurneys in the Treasury’s ER. These guys are _that_ stupid, and also that close to the problem. They just can’t bring themselves to accept that all those Moneybags are dead, _dead_, DEAD.

    So they’ll kill our currency too trying to prove the Reaper wrong. *sigh*

  15. pigeon

    Actually this step taken by the FED was, if I get it right, also proposed by Professor Hamilton. The logic was as follows:
    1. It is bad for the FED to inject liquidity into the system via MBS or other ABS because if those fall in value the FED would loose its power to mop up this liquidity once the deflationary spiral ends.
    2. It is therefor better to buy long term treasuries. As long as prices keep falling, this would do no harm to the markets but provide a direct inflationary stimulus.
    3. Buying treasuries also solves the problem of rising government debt as long as inflation is low or negative.
    4. When things turn better, the inflationary impact of that massive liquidity injection can be mopped up easily and be converted into real government debt by selling the treasuries to the market. That would be much better than havin an insolvent FED due to broken assets like agnecy bonds.
    So I presume the FED will step up its purchases of treasuries as needed, be it 3 trillion or more. The only reason it anounced only 300 bn so far is to send a signal of prudence.

  16. s

    Yves

    Sester talks a lot about the opacity of flows coming out of london. I continue to wonder about those swap lines. The fed and gov have a long track record of doing defarious things in the national interest – hitchens would agree. That said the indirect bids is a worrying opacity in the auctions themselves. Your broader point is well taken. I sugest people buying a house begin to normalize rates to see what their investment will be worth on exit.

  17. Dan Duncan

    Bernanke is like a poker gambler in an old western…only he has Acme Poker Chip Supplier at his disposal.

    And it goes like this:

    BB enters a game and the deck of cards is not kind to him.

    In order to stem the tide and assert control over the table, he makes a big bet.

    He is raised.

    BB, not one to be pushed around goes “all in”.

    The opponent laughs, and raises him again even though BB is out of chips.

    BB, a resourceful student of gambling, recalls the Mavericks of the good ole’ days…so removes his gold Rolex and gets his car keys (to a fine European 800 Series) and throws them in the pot.

    He’s raised again!

    But BB has a joker card: He calls the friendly folks at Acme Poker Chip Suppliers. On demand, they bring in a large chest of shiny new Acme Poker chips branded with an impressive looking eagle.

    With great ceremony and big smile, BB dumps them on the table with a triumphant, “I’m all in some more!”

    The opponent, with WTF incredulity, calls out to the casino boss/sheriff in protest.

    BB lifts the fold of his jacket to reveal a shiny sheriff star, and says, “That would be me.”

    And the opponent realizes he must eventually fold…or pull a gun.

    A Dime Store Drama courtesy of Acme Poker Chip Suppliers.

  18. ruetheday

    “The Fed first and foremost is trying to prop up asset prices”

    Correct, and they are doing this in an attempt to jumpstart the securitization business, which they think will return us to Nirvana.

    What the Fed does not realize is that the problem is not the asset side of the balance sheet being too low, it’s the liability side being too high. Individuals and firms are now focused on paying down debt, not making new capital investment.

  19. Anonymous

    Don’t know if this has been posted before, but Bernanke telegraphed all of his moves in this 2002 speech:

    http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm#f

    What is particularly interesting about the speech, other than it has served as a blueprint for everything he has subsequently done in this crisis, is that every single “unlikely” event he discusses has come to pass, as if a whole flock of Nassim Taleb’s Black Swans descended on Bernanke’s desk.

    I especially like Footnote 15.

    Bernanke seems intent on two things: destroying the dollar, and trying to make sure there is no natural price discovery in any asset market.

    I think he will succeed.

  20. john bougearel

    The bond rallied on the FOMC announcement to buy treasuries was noteworthy because it caught market participants offsides, on the wrong side of the trade. This is the second time this has happened. The first time this happened was on Dec 1 when Bernanke announced a “statement of intent” to buy treasuries. He retracted that statement fully by the Jan 28 meeting.

    Ben wanted to stay with credit-easing policies, but the worsening economy since the Jan 28 meeting forced him to join other central banks into QE in hopes that this will stoke up the moribund housing market this spring season. His timing was quite good. Not only was this spring season, but it is also option expiration today! Greenspan surprised mkt participants in Oct 1998 with a 25 bps intermeeting rate cut on an option expiration date. Stocks rallied 5% in 5 minutes.

    On Dec 1, the range of the 30 year bond was 4 points, and by Dec 18 had advanced 14.5 points from the Dec 1 low. Fast forward to yd’s announcement and the 30 year rallied 9.5 points off its low of yesterday. The post announcement drift, along with actual purchases of 10 year notes by the Fed beginning next week, will likely keep a bid in the treasuries for the next few weeks and possibly much longer, regardless of the inflationary impact (QE Japan style over the past 15-20 years never did cause any inflation, so we can’t exactly assume inflation will rush in where angels fear to tread in the US today)

    On March 17, the day before yd’s FOMC announcement to buy treasuries, Goldman’s senior economist Edward McKelvey made the following observation: “While we see several reasons why Treasury purchases make even more sense now than they did then, the FOMC appears disinclined to take this step yet.” While McKelvey’s expectations that the Fed would be “disinclined” towards printing money to buy treasuries did not pan out, the 30 yr bond fell 3 points following McKelvey’s note that day. Some of Goldman’s clients and other followers of Goldman’s analysts almost certainly positioned themselves for treasuries to be pressured lower the day before the FOMC meeting,

  21. But What do I Know?

    Great analysis, Yves, and I think one which was missed in the “Fed is helping the economy” euphoria. In reality all they are doing is substituting for the drop in foreign central bank demand. Everyone used to wonder what would happen if the Chinese, Japanese, etc. would stop buying Treasuries–well, this is it. BTW, the national debt exceeded $11 trillion the other day for the first time–less than six months after it went over $10 trillion. That sounds like a pace of $2 trillion a year to me, so Mr. B’s $300 billion won’t go all that far. He’s hoping someone joins him. . .

  22. Anonymous

    yves — actually, by long-term I mean anything that is not a bill, i.e. all coupon paying notes over 2 years. i work off the BoP data, and the only breakdown in the bop data is beteeen bills and notes/ bonds (i.e. everything else), with in effect anything with an original maturity of over a year considered long-term.

    cheers

    bsetser

  23. Anonymous

    The Wake

    Uncle Sam is in the casket,
    The scamerican family grieves,
    The FED still administers life support,
    But no one in the family believes …

    Its another shock and awe,
    Now billions to the heart,
    The family watches incredulously,
    As Uncle Sam is torn apart,

    Its the same old policies,
    But now they’re aimed at you,
    The people of the ‘homeland’,
    Will soon be living in a zoo …

    The same elite regime,
    Is still “kicking ass”,
    Serving up macho deception,
    From the financial class …

    Its the same evil policies
    Of extra-judicial killing,
    Its a wholesale slaughter,
    Of the ignorant and unwilling …

    The prep school puppets,
    Still administer the secret beatings,
    They are hidden in the words,
    Of their disingenuous bleatings …

    Will the people of the ‘homeland’,
    Once again sit silently by,
    Now that they are being tortured?
    Now that they will have to die?

    Will scamericans now accept,
    Their own ‘extraordinary rendition’,
    From the state of middle class calm,
    To the state of a poverty condition?

    It is time to do now,
    What you should have bravely done then,
    Rip up this hijacked ‘rule of law’,
    And start over again …

    Deception is the strongest political force on the planet.

    i on the ball patriot

  24. Stevie b.

    @ pigeon re Prof. Hamilton “When things turn better, the inflationary impact of that massive liquidity injection can be mopped up easily and be converted into real government debt by selling the treasuries to the market”

    How much, at what price, over what period of time and to whom exactly?

  25. Anonymous

    And I suspect the unintended Iraq-Fed analogy is apt.

    Unintended? This is no time to lose your cynicism, Yves!

  26. lineup32

    Many sidebars to the “shock and Awe” but oil pricing will be a large factor as commodity players game the trade pushing oil to new highs even though inventory will reach record levels. Mr/Mrs consumer will be paying higher prices for fuel along with the AG industry further killing demand.

  27. Anon1

    I don’t know about buying gold…I bought physical gold 8 months ago and it’s average value over that span has been flat. Yesterday it dropped into loss territory and then popped back up to where it was when I bought it. Net even.

    I assume the pop was in response to the Fed announcement. The gold bug response is predictable on this sort of thing. They have been predicting the Fed will start printing money for centuries (ok, hyperbole, YEARS) and their response: “This is it folks. The beginning of the end! Buy gold. Fiat money is finished.”

    Reading all the back and forth analyses on the various sites (calculated risk, nekkid capitalism, Mish’s, etc) I am still no more certain about a good move here than I ever was. For every “reasoned” argument that the Fed move is a good one, there is one that states the opposite.

    I think I’ll stick with real science (my day job) and do what the rest of ya’ll are doing on the non-science front (economics): throw darts at a board after consulting the Magic 8 ball. I can’t do any worse than the AIG wizards, BoA wizards, Citi wizards, Lehmann wizards, etc, etc, etc.

  28. Anonymous

    Perhaps the obvious is being overlooked here with regards to Ungentle Ben buying treasuries in order to mainly prop up housing.

    The Chinese have been steadily scooping up prime U.S. real estate at fire sale prices. If they won’t commit to buying up our treasuries the least we can do is assuage them by inflating their real estate holdings. In effect we need them to buy as much distressed property as possible because in reality the feds know that its citizenry can only buy so much over time.

    What Ben has done is principally done for the Chinese to mollify them and get them to consider their RE holdings as a viable hedge against future treasury purchases.

    SM

  29. hbl

    QE seems most likely to "work" to help keep longer term interest rates low without being able to "work" to prevent deflation or prop up asset values.

    People who are not bearish on treasuries are a shockingly small minority. I think that it's much easier to understand and estimate the huge supply of treasury issuance in the pipeline (given that it results from explicitly defined bailouts, guarantees, deficits, etc) than it is to visualize the future sources of demand… But I continue to believe demand will surprise to the upside.

    For example… As fast as treasury supply is growing, toxic assets in the system are probably imploding or being swallowed by the Fed/treasury at least as fast, so in the big picture the new treasuries fill in an asset "hole" and are contenders for purchase by all the new dollars. I know it's more complicated than that (marginal demand & supply, expectations of value, etc), and that this is just a superficial summary of one example. But I could add more.

  30. Bonesetter Brown

    This had to happen. It is necessary to fund the federal deficit and the programs outlined in Yves’ excellent post.

    If the deficit is ~$1.75T this year, FCBs could only fund $500B of that in a nominal-to-best-case scenario. That looks less likely, given shrinking trade surplus and diminished appetite for long term gov bonds.

    The funding gap gets closed one of two ways: (i) crash more asset markets to drive further flights to safety or (ii) print. There are not income/savings streams big enough to close the gap by itself.

    Given the gov funding needs this year and next, this $300B could be a mere 10% to 20% of the ultimate printing over the next 24 months.

    I agree with Richard that the Brad Setser post makes for good companion reading. These are the most significant new data of 09. I recommend reading Janszen’s most recent posts at iTulip, one of which is his take on the Flow of Funds data. It has some interesting questions at the end.

  31. Curlydan

    Does the Fed use the BofE just as a trial balloon? It seems like the BofE will begin something new (like printing money), the Fed waits to make sure that the world does not blow up, then they do the same action three weeks later.

    It’s getting to be an annoying trend, yet something one could start to make some money on if they had the guts.

    Also, with regard to the analysis above on Prof Hamilton’s ideas, where is the talk about the value of the dollar? There are some serious consequences.

    With regard to future interest rates, the Fed’s move seems like it will at best mitigate the increase in rates. My nightmare scenario is if the Fed really wants to _lower_ rates because I don’t think there’s enough money or fast enough printing presses to accomplish that feat.

    The pressure for interest rates to increase is immense and is a natural outgrowth of this crisis. Every attempt to make them decrease will only increase the eventual blowback.

  32. Anonymous

    These stpuid fools, devalue the dollar, drive commodity prices up into a slowing economy with rising unemploment, driving down demand as prices rise increasing the deflationary spiral and increasing the unemploment adn a further colapse of the tax base as goverment spending skyrockets. Cool

  33. john bougearel

    @ hbl

    You are spot on, demand for the treasury auctions have been stupendously strong thus far in Q1 09, even b4 the Fed announced its QE measures yd.

    For example, the week of March 9th there was $63 billion worth of auctions.

    The 30 yr $11 billion auction on March 12 drew “the most bids in 3 years” said BN. The actual bid-to-cover ratio was 2.40, much stronger than the 2.18 average of the past 10 sales.

    The 10 year $18 billion auction bid to cover ratio was a bit soft however, “which fell to 2.14 from the 2.21 Feb 11 auction.

    After last weeks auctions, one analyst suggested the demand indicated that treasuries were still the safest place to be. But following the FOMC announcement yd, no doubt, mkt participants view treasuries as a bit less safe than a week ago, even though they are higher today.

  34. Anonymous

    http://www.rgemonitor.com/globalmacro-monitor/256056/evaporflation

    Evaporflation

    Rich Hartmann – Miss America | Mar 18, 2009

    Today I will argue that the standard measures by which we assess our economic health no longer apply to our current situation. The most common terms "Inflation" & "Deflation" are based on the general price level of goods and services. Inflation is the increase in price, thus limiting the purchase power of your money. Deflation is the decrease in price, and increase in purchasing power. My argument is that the general price level of goods and services is temporarily not price-able, and the purchasing power of all currencies is unknown due to due to the lack of transparency of overall credit and debt at all levels of the economy (from Countries and Governments through companies and households) due to known and unknown variables and their known and unknown ripple effects. The broad systemic risk of commingled good/toxic assets in the globally interconnected financial world has now limited the ability to accurately measure factual and fictional wealth based on fusion of such infinite variables of destruction. In addition, the unknown levels of wealth creation, extraction and destruction, coupled with actual consumption leave us with a decreasing denominator in relation to the increasing nominator of debt.

    As we teeter on the edge of an economic abyss, pricing goods like an automobile becomes impossible. The factory says it cost $18,000 to produce. The retailer said it costs $25,000 to move. The buyer, based on the current status of the market, their employment, and the availability of credit will be willing to pay between $0 – $25,000 for the automobile. This is obvious and has always been the case, but unlike past situations, when the person walked out without buying the car, there was the assumption that someone else will walk in and buy it. That pricing mechanism is based on the fact that there will be a buyer to finance the cars production, and their purchase would fall somewhere between that $18,000 – $25,000 range. Depending on the strength or severity of the economy, that price level (inflation/deflation) would be found. That is not the case anymore! In the current environment, there are many more cases where there is no bid at all. The new price model needs to include $0 – $25,000

    For that same reason, hedge commodities are sitting on a plateau where they could either fall off the cliff, or shoot to the sky. Oil sits at $40-45 with the risk of dropping to the $20's and the risk of rocketing to $200 a barrel. Gold sits at $900, with a $2,000+ ceiling and a sub $500 basement. Milk and Orange Juice may be $4, or they may be $20? At the same time, the purchasers of all goods and services are sitting on the brink of having an income, house and various other assets or having nothing at all except existing debt obligations.

    With that said, how do you price a CDO? How do you price GM? How do you price the USD? How do you price a house? How do you price a car? How do you price eggs?

    At the moment, we have economic history pricing goods and services since there is no transparency, confidence or consistency to attain current supply/demand price. Without these factors secured, all you have is a risky wager that borders on being an extremely explosive or implosive bet that could play itself out in a couple of days time. That kind of volatility leaves us stabbing at prices that are nothing better then guesses based on dogmatic review rather then the actual consumer's current reality. Those kinds of shocks don’t bring about the price discovery that supply and demand in a capitalist market would accurately set.

    Evaporflation, Vaporflation and Condenflation occur when natural economic factors like inflation and deflation meet with such an immense artificial force, that direction of price and purchase power become temporarily unattainable. They can be immeasurable due to the ambiguity of the calculating factor of: time of creation, synthetic composition, velocity and size.

    Evaporflation – is the disappearance of debt, or increase of credit to bring about a net debt reduction. (Disappearing debt also brings about the destruction of credit creation) It occurs as there is an increase in the difference between overall credit/cash/liquidity in relation to the overall debt obligations at a rate where the difference grows at a perpetual rate of motion. Through debt reductions and credit infusions, the pressure on the economic system can be vented in a manipulated fashion. If obstructed or without a large enough release valve, Evaporflation will lead to Vaporflation.

    Vaporflation – is the rapid disappearance of debt, or increase of credit to bring about a net debt reduction. It is hyper inflationary and hyper deflationary. It can easily lead to combustion during the venting process and if not contained would lead to a complete meltdown / collapse.

    The difference between Evaporflation and Vaporflation is the level at which the debt outpaces the credit. If debt outpaces credit beyond the sustainable levels of vaporflation, we will reach combustion (collapse). We have seen some of the early bailout packages (venting) combust. Bear Stearns, Lehman, and the first $350billion from Bush/Paulson bailout are samples of combustion during the venting process. Recapitalization, cannibalism, and self preservation absorbed all available liquidity, thus vaporizing institutions or programs that had nowhere to sit when the music stopped.

    Whenever there is a large decrease in overall wealth being met with less then needed reduction of overall debt obligations, no reduction of debt obligations, or an increase in debt obligations in relation to the overall credit/cash/liquidity it would lead to either evaporflation or vaporflation rather inflation or deflation. This is why we have not seen any favorable direction in inflation or deflation. The reason for this anomaly is due to the fact that the lead up to the crisis was also misdiagnosed. What preceded this was a phenomenon called: Condenflation.

    Condenflation – Is the self propulsion or positive feedback loop of credit creation through debt, where un-vented credit does not accurately reflect the actual inflation/hyperinflation of the credit cycle, due to the offsetting (real) long term debt. This can be and was attained through fractional reserve banking, leverage and unregulated markets meeting with the giant pools of liquidity and the circular loop of alchemy that led to more credit creation without yet another venting of inflation. The recycling of fractional reserves and leverage went well beyond their intended safe levels as the ratio of risk became immeasurable, and small shocks could lead to systemic risk due to cross pollinating and counterparty risk.

    Ill transparent markets acted like a pressure cooker. Liquidity/credit became trapped (unable to inflate) in a system that was not letting the vapor escape. The gradual release of this pressure would've deflated overheated markets (that were severely understating the short term credit/gain, and long term loss/debt) where an equilibrium of loss and gain could have been attained (and thus contained.) …but instead, a collusive cycle between Financial, Political, and Media outlets was born for short tem profit. The short term upside became so easily attainable for the malfeasant, that the downside risks falsely appeared to be non existent. The trap itself, became self propelling through manipulation, greed, and misguided confidence. The false sense of confidence permeated every country, market, and home where the expectation of gains bordered on entitlement, and created a temporary self fulfilling loop.

    On the upswing, the liquidity in the markets pressure cooker had gone well beyond the boiling point. Real inflation was being severely understated as it did not weigh the short term credit versus long term debt properly. Redemptions, consumption, poor investment decisions, excess and larceny started to finally extract the credit (liquidity/liquid) from the pressure cooker. (The release of pressure was never properly reflected in the inflationary upswing so disinflation did not occur in the release.) When the markets pressure cooker reached what appeared to be a saturation point, (equilibrium) it was too late to realize that this was not the actual case. The unrealized exit of liquidity, coupled with the growing wave of debt obligations led to the immediate downside pressure of evaporflation (which was happening on the surface) and vaporflation (which was occurred beneath the surface). This pressure needed a release valve. Subprime became that escape!

    Within the “pressure cooker” analogy, the size of the pressure cooker has grown (debt), and there is less liquid (credit) in the pot. The pressure (the actual “pressure” is “the market” i.e. supply/demand, inflation/deflation, etc…) continues to build at an accelerating rate as there was less “liquid” in the pressure cooker, and the pressure cooker’s surface area continued to grow (which lead to a point beyond boiling) The stimulus plans, rate cuts, TARP, etc have added little bits of liquid to the pot, keeping us from vaporflation, but leave us in the current unique phase of evaporflation. The attempt to saturate the market, and reach equilibrium will be better achieved when a larger batch of liquid is poured in, and the size of the pot is reduced.

    With that said, the size and scale of artificial economic forces that we have created, was overlooked and underestimated which has left the price discovery mechanism flawed. …thus technically (and in reality), leaving the natural forces of inflation and deflation directionless as their driving forces (the price of goods and services, and purchase power) are inaccurate.

    The rest is present history.

    All the best,
    Miss America

  35. MyLessThanPrimeBeef

    You not miss Russia? OK, Miss America, I miss America too. And I think evaporflation goes well with seppukunomics and kamikazenomics.

    By the way, and this is no illusion, but I walked into a car dealer’s showroom the other day and immediately they notified the proper authority that they had spotted a member of that endangered species known as ‘car buyer.’ Against my will, they locked me in a room no phasers could penetrate, tried to give me food and sent in many attractive women, something about reproducing more animals like me and once they had enough, they would release me back into the wild…

    Oh, Cpt. Kirk, Bin Lackey is taking us to where no man has gone before and without Mr. Spock, I think we are doomed.

  36. Anonymous

    Thanks for the insightful posting Yves.

    We need to kill most if not all of investment banking. The derivative insurance scam is keeping price discovery from happening.

    Wheeee, such a ride into hell.

    psychohistorian

  37. Juan

    Richard Kline said:

    So the idea is to get the system breathing again, kinda like artificial respiration. To me, they just expect the patient to sit up and get back to normal if they keep pounding on the chest and breathing down the conduit of all these corpses on gurneys in the Treasury’s ER. These guys are _that_ stupid, and also that close to the problem. They just can’t bring themselves to accept that all those Moneybags are dead, _dead_, DEAD.

    So they’ll kill our currency too trying to prove the Reaper wrong. *sigh*

    And a long dead German guy said:

    the most complete fetish is interest-bearing capital. This is the original starting point of capital-money and the formula M-C-M’ is reduced to its true extremes M-M’, money which creates more money. It is the general formula of capital reduced to a meaningless résumé.

    Interest-bearing capital is the consummate automatic fetish, the self-expanding value, the money making money, and in this form no longer bears any trace of its origin. The social relation is consummated as a relation of things (money, commodities) to themselves.

    ‘These guys’ are not that stupid but absolutely caught up in the need to save ‘a meaningless résumé’. ‘They’ were/are absolute and true believers in the power of form without content consistent with a rentier capitalism.

    So yes, ‘their’ efforts to save [what cannot be saved] necessarily become increasingly destructive, terminal.

  38. Sammy

    There actually was some meaning behind the phrase “shock and awe”, it wasn’t just a made up propaganda phrase.

    Traditionally, you defeat a military opponent by destroying his center of gravity. Specifically you destroy his military capability so as to remove his ability to fight back.

    World War II expanded that concept to attack the enemy’s means of production. Since the industrial countries were all busily sending as many tanks and planes to the front as they could, destroying the ability to produce more tanks and planes would mean the enemy fighting force would whither away.

    So, what was “shock and awe” supposed to me about? The idea was that instead of removing the enemy’s ability to fight, you would remove their will to fight. This was to be done through several techniques, including a display of overwhelming force, removing the means of command and control, and destroying the infrastructure that a modern society depends on.

    Imagine you are the commander of an army. Half of your top officers are dead because their homes were specifically targeted by missiles. Your city has been without water or electricity for a week. All electronic means of communicating with your forces are gone, and you are reduced to sending messengers. Television news is full of reports of your enemy’s troops traveling at will through your country and capitol.

    In this situation, while your forces may technically still be in place (and you therefore have the ability to fight), the idea was that you and your forces would be so demoralized that you would not have the will to fight effectively.

    Not sure what this has to do with fighting the biggest economic catastrophe in living memory, but that is another question altogether.

  39. JenM

    Finance Noob here (boning up best I can on my own)…

    So these Agency MBS the Fed is buying, what exactly are these? MBS issued by Fannie and Freddie? Yet to be issued or already issued?

  40. Anonymous

    Treasury Secretary Timothy Geithner said Thursday that he takes responsibility for knowing the stimulus legislation had a loophole that would allow bailed-out insurance giant American International Group to keep its bonuses.
    In an interview with CNN’s Ali Velshi, Geithner said the Treasury Department did talk to Sen. Chris Dodd about a clause he put forth that would have strictly limited executive bonuses.

    So Dodd was telling the truth – he was pressured by Treasury, and apparently, Geithner didn’t bother to tell his boss (the President, of course) about it up front.

    Tim, there are mistakes and then there are really big mistakes. The latter demand resignations.

    This is one of them.

    Time to resign Tim; cheating on your taxes is bad enough, but funneling over $100 billion of taxpayer money to your banking friends, and over $160 million to the employees who blew up the financial world, is a bridge too far.

  41. Anonymous

    Bernanke’s botox injections, even if done properly, won’t last long, will have to repeat sooner and more often to diminishing effects. Better accept fate and hope the next generation Americans can have fresh start with renewed vigor.

  42. Anonymous

    Sammy:

    It has everything to do with this.

    There is simply no will to stand up to the U.S. When the U.S. decides to devalue its currency, it hurts all major holders of U.S. Dollars as reserves and trading partners i.e. everyone else.

    They might want to fight back by not devaluing their own currency, but that would only hurt their own economy. Instead, they sock it to their people in the form of a devalued currency causing lowered living standards.

    Being the guys with the military bases and the reserve currency certainly has its privileges.

    =======================================

    There has been a lot of posturing going into the G20 summit in April. The propaganda campaign to try to convince other countries to spend more hasn’t been working so well, so Bernake decided to do a little more nudging.

    The Europeans seem to feel that bretton woods is going to be renegotiated then. I think they’re in for a surprise.

  43. Anonymous

    ” These stpuid fools, devalue the dollar, drive commodity prices up into a slowing economy with rising unemploment,

    March 19, 2009 11:30 AM “

    Yeah this basically comes down to blinking game between the Fed money printer vs. World willingness to swallow dollar debasement.

    Things are going to get nasty after asian central bank “diversify” and raising interest. China is already reducing dollar and buying hard asset instead.

  44. Anonymous

    The Real AIG Scandal
    It’s not the bonuses. It’s that AIG’s counterparties are getting paid back in full.

    By Eliot Spitzer

    Posted Tuesday, March 17, 2009, at 10:41 AM

    Everybody is rushing to condemn AIG’s bonuses, but this simple scandal is obscuring the real disgrace at the insurance giant: Why are AIG’s counterparties getting paid back in full, to the tune of tens of billions of taxpayer dollars? …

    http://www.slate.com/id/2213942/

  45. Doc Zero Holiday

    Mental Note: “The 10-year did a 50 basis point flip, taking the yield off to ultimately tag the 2.466% level, in the biggest one day move in nearly 50 years according to Bloomberg data. (One longtime dealer notes, however, “Eh. We were just here back in January.)”

  46. Anonymous

    HAHAHA, Doc Zero, I just found the sound track for this hole drama.

    Johnny Cash, One piece at a time.

    Grosse Pointe….Ok I’ve lost the plot now.

  47. Anonymous

    The math on the post is assuming that all wew treasuries are bought by foreigners, yet deleveraging implies that US consumers are spending less thus saving more.

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