Why Bet on Treasury Securities?

First Warren Buffet and now Bill Gross, of Pacific Investment Management Company, have publically stated that buying United States Treasury securities is not a good bet. (See http://www.bloomberg.com/news/2011-03-31/gross-echoes-buffett-saying-treasuries-have-little-value-on-debt-dollar.html.)

Gross wrote, in his most recent monthly investment outlook, that Treasuries “have very little value.”

One could couch this in other terms: “What is the probability that long term interest rates will go up over the next twelve months?”; and “What is the probability that long term interest rates will go down over the next twelve months?”.

How many people do you know that believe that the higher probability can be applied to the second of these two questions?

Most people I know and respect are arguing over whether the probability that long term interest rates will go up is 75% or 80% or higher.

The only significant argument I hear about falling interest rates on long term Treasury issues is that the Eurozone might collapse and there will be a “run to quality”, a run to United States government securities. Almost all other arguments go the other way.

The economic recovery, however weak, is continuing. The banking system (and the housing industry) is not going to collapse even though the banking industry is going to continue to grow smaller and smaller in terms of the number of commercial banks that are in the system while the biggest banks, including large foreign banks, are going to control more and more of the banking industry itself. The Federal Reserve will continue to keep money flowing into the banking industry so as to keep banks open while the FDIC makes sure that the banking industry shrinks in an orderly fashion.

Are we going to get QE3? Depends upon the rate at which insolvent banks can be closed without disrupting the financial system. The strength of the economic recovery is not the issue. The issue, to me, depends upon what the FDIC can achieve.

The federal government is going to continue to add more and more debt to the total already outstanding.

There just is no credibility in Washington, D. C. concerning the reduction in the cumulative deficits over the next ten years or so. I still believe that the government will add another $15 trillion or more to the federal debt outstanding over the next ten years.

The Libyan situation is a case in point. The federal government is so over-extended fiscally that other demands on its resources are just going to stretch budgets even further and keep the cumulative deficits at near-record levels. Then the government ends up doing two things, neither desirable: the government is limited in what it can do in very important situations; and even if the government cannot do much, whatever it does will increase the cumulative deficit.

Then there are other issues, like the boom in commodity prices worldwide, the acceleration of the merger and acquisition business in America, Europe, and the emerging countries, and currency speculation throughout the globe.

As a consequence, I see no reason to back off my earlier thoughts on the future of the interest rate on long term U. S. Government securities. See http://seekingalpha.com/article/250838-long-term-treasury-yields-and-inflationary-expectations. This post was written when the yield on the 10-year Treasury security was 3.48 percent, roughly two months ago at the beginning of February. Yesterday the 10-year Treasury closed at about 3.46 percent.

At that time I claimed that a forecast of 5.00 percent to 5.50 percent was not out of reason for a Treasury security of this maturity somewhere in the next 12 to 18 months.

The basic reasoning for this: my estimate of the expected long run “real” rate of interest is roughly 3.00 percent, (Similar, I found out, to the belief of the Wharton School’s Jeremy Siegel.)

I further believe that investors will come to build in a premium for inflationary expectations in longer term interest rates in the neighborhood of 2.00 percent to 2.50 percent.

How strongly do I feel about this prediction? I believe that the odds are in the neighborhood of 3- or 4-to one that rates will move into this range over the next 12 to 18 months.

Thus, I would have to agree with Bill Gross (and Warren Buffet) that Treasuries “have very little value” and are not a good “buy and hold” at this time.

Federal Reserve QE2 Watch: Part 4.0

The Federal Reserve continues to pump funds into the banking system. Reserve balances at Federal Reserve banks reached $1.3 trillion on March 2, 2011. This is up from $1.1 trillion on
February 2 and up from $1.0 trillion on December 29, 2010.

These balances serve as a relatively good proxy for the excess reserves in the banking system which averaged $1.2 trillion over the two-week period ending February 23, 2011.

As we have reported before, there are two drivers of this increase in bank reserves. The first, connected with the Fed’s program of quantitative easy, is the acquisition of United State Treasury securities.

Over the past four weeks the Federal Reserve has added almost $100 billion to its portfolio of Treasury securities. Only about $18 billion of these purchases were offset by maturing Federal Agency issues and mortgage-backed securities.

Since the end of last year, the Fed has added $220 billion to its Treasury security portfolio. In this case the Fed was replacing a $48 billion decline in the other securities that were maturing.

And, in the past 13-week period, Almost $320 billion were added to the Treasury portfolio, replacing about $80 billion in maturing Agency issues and mortgage-backed securities.

The second driver has been the action surrounding Treasury deposits with Federal Reserve banks. Since these deposits are a liability of the Fed, a reduction in these deposits increases reserves in the banking system. There are two important accounts here, the Treasury’s General Account and the Treasury’s Supplementary Financing Account.

The Supplementary Financing Account has been used for monetary purposes and in the current case, the Treasury has reduced the funds in this account by $100 billion. All of this reduction came in February.

The Treasury’s General Account is used in conjunction with Treasury Tax and Loan accounts at commercial banks and is the account that the Treasury writes checks on. Generally tax monies are collected in the Tax and Loan accounts and then are drawn into the Federal Reserve account as the Treasury wants to write checks. When the Treasury writes a check, it is deposited in commercial banks, so that bank reserves increase.

Over the past four weeks, the Treasury’s General Account has dropped by almost $70 billion. Thus, between this account and the Treasury’s Supplementary Financing Account the Fed has injected almost $170 billion reserves into the banking system in February.

I need to call attention to the fact that funds moving into and out of the General Account can vary substantially. For example, since the end of the year (which includes the February change) this account has only fallen by $39 billion. Over the last 13-week period, the account has actually increased by $4 billion. Tax collections build up toward the end of the year and then are spent during the first quarter of the year preparing for another buildup around April 15, tax collection time.

The bottom line, the Federal Reserve is seeing that plenty of reserves are being put into the banking system. But, the commercial banks seem to be holding onto the reserves rather than lending them out.

Still, the growth rates of both measures of the money stock seem to be accelerating. The year-over-year growth rate of the M1 measure of the money stock was growing by about 5.5% in the third quarter of 2010. The growth rate increased to 7.7% in the fourth quarter and is growing at a 10.2% rate in January 2011.

The M2 measure of the money stock has also accelerated, going from a year-over-year rate of increase of 2.5% in the third quarter to 3.3% in the fourth quarter to 4.3% in January.

On the surface these increases in money stock look encouraging in terms of possible future economic growth. However, we are still seeing the same behavior of individuals and businesses in the most recent period that we have observed over the past two years.

The growth rates of both measures of the money stock still seem to be coming from people that are getting out of short term “investment” vehicles and are placing these funds in demand deposits or other transaction accounts, or in currency.

The first piece of evidence of this relates to the reserves in the banking system. The total reserves in the banking system have remained roughly constant over the past year. Yet, the required reserves of the banking system have increased by 10% year-over-year. This situation could only happen if demand deposit-type of accounts, which require more reserves behind them, were increasing relative to time and savings accounts, which have smaller reserve requirements.

Looking at the individual account items we see that demand deposits at commercial banks rose at a 20% year-over-year rate of growth in January. The non-M1 part of the M2 measure of the money stock rose by only an anemic 3% rate. Thus, the substantial shift in funds from time and savings accounts to transaction accounts continues. There is no indication of a speeding up of money stock growth connected with the reserves that the Fed is injecting into the banking system.

An even more dramatic shift can be seen if we include institutional money funds in the equation and look at what has happened in the banking system over the past nine weeks. The non-M1 portion of M2 increased by $22 billion over this time period. However, funds kept in institutional money funds declined by roughly $40 billion. This means that accounts that Milton Freidman would have labeled “a temporary abode of purchasing power” actually declined by $18 billion since the start of the year.

Demand deposits and other checkable deposits rose by about $21 billion. One could note that currency in the hands of the public also rose by $16 billion.

The public continues to move money from relatively liquid short-term savings vehicles to assets that can be spent by check or cash. This is not the kind of behavior one gets in an economy that is confident and expanding. This behavior can roughly be called “defensive”.

So, another month has gone by. The Fed is aggressively executing its program of quantitative easing. Yet, it still seems to be “pushing on a string.” Why is it I retain the feeling that the Federal Reserve’s effort is just spaghetti tossing, seeing what might stick to the wall?

The longer this policy continues, the less confidence people seem to have in both Ben Bernanke and the Federal Reserve. I shutter to think what Bernanke and the Fed will do to us when the banking system actually does start lending again.

Note that some members of the Fed’s Open Market Committee are suggesting that QE2 end abruptly at the end of June when the current program is slated to expire. (See "Policy Makers Signal Abrupt End to Bond Purchases in June": http://www.bloomberg.com/news/2011-03-04/fed-policy-makers-signal-abrupt-end-to-bond-purchases-in-june.html.)

Does everyone in the Fed seem “tone deaf” to you? They just seem to act on pre-conceived ideas and have no sense or feel of the banking system and financial markets. Another confidence raiser.

Federal Reserve QE2 Watch: Part 3.2

The Federal Reserve’s liquidity machine continues “full speed ahead”!

In the banking week ending February 16, 2011, the Fed injected almost $31 billion in new reserve balances into the banking system.

Over the past two banking weeks the Fed has pushed almost $140 billion in new reserve balances into the banking system.

Since the end of 2010 (the banking week ending December 29, 2010) the Fed has increased reserve balances with Federal Reserve Banks by almost $200 billion!

Thus, reserve balances at the Fed, a proxy for excess reserves in the banking system, have increased by a whopping 20% over the past six weeks.

The Federal Reserve is doing to the banking system what it said it was going to do.

In the fall of 2008 and winter of 2009, Chairman Ben Bernanke tossed as much Spaghetti against the wall as he could toss to see what would stick.

It appears that we are not necessarily in the middle of Quantitative Easing 2 (QE2), but are instead in the middle of Spaghetti Toss 2 (ST2)!

The Fed continued to buy more government securities last week, increasing its portfolio by about $23 billion. This supplied reserve funds to the banking system.

The big increase in bank reserves came, once again, in the U. S. Treasury Supplementary Financing Account. (For more on this account and its use see my post http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy) This account declined by $25 billion for the second week in a row. When this account increases it “absorbs” funds from the banking system. Therefore, when it declines it releases funds into the banking system.

Thus, over the past two weeks when reserve balances rose by almost $140 billion, $50 billion of the increase came from the Fed adding more Government securities to its portfolio and $50 billion came from the Treasury releasing funds to the banking system from its supplementary financing account.

Since December 29 when reserve balances rose by almost $200 billion the Fed bought almost $140 billion in government securities (about $34 billion going to offset maturing mortgage-backed securities), the Treasury reduced its Supplementary Financing Account by $50 billion AND reduced its General Account by almost $35 billion.

This last movement was the usual seasonal swing from the build up in tax revenues toward the end of a calendar year. It still puts reserves into the banking system.

To put things into perspective: Remember back in August 2008, the total reserves in the banking system were $46 billion and excess reserves were less than $2 billion.

Now, within the span of six weeks the Federal Reserve injected into the banking system four times the amount of total reserves that was held by the whole banking system at that time. The wave that is coming looks like it is a part of a Tsunami!

Federal Reserve QE2 Watch: Part 3.1

I usually don’t write up Fed actions within the month unless something seems to be going on. Last week, bank reserve balances at the Federal Reserve went up by $108 billion. I thought that this increase was significant enough to warrant some notice.



There was really only one “factor” supplying reserve funds this past week. This was a net increase in U. S. Treasury Securities held outright by the Fed of almost $30 billion, which brought the Fed’s holdings of Treasury securities up to $1.167 trillion. The portfolios of Federal Agency securities and Mortgage-backed securities did not change a bit.



Furthermore, Thursday afternoon, February 10, the Federal Reserve announced that it would purchase about $97 billion in U. S. Treasury securities in the upcoming week. This total would include about $17 billion to replace the runoff in the Fed’s holdings of mortgage-backed securities, implying that there would be a “net” increase in securities holdings that would be a part of QE2.





The question we can’t answer is whether or not there will be other operating factors on the Fed’s balance sheet that the Fed needs to deal with.



This past week, the banking week ending February 9, 2011, there were substantial movements in two of the Federal Reserve accounts of the United States Treasury. The first movement was in the Treasury’s General Account and this amounted to a little more than a $55 billion reduction in the account.



This movement seems to be seasonal in nature, but was not offset this year, as it often has been in the past, by offsetting sales of government securities. That is why the decline contributed $55 billion more to bank reserves.



In 2009 there was a seasonal year-end buildup in the Treasury’s General Account which peaked in January 2010 and then dropped off to its spring low in April. This year the General Account built up to a peak again in early January before beginning to drop off.



Year-end tax receipts build up at the Fed which causes the peak to occur in early January. From these accounts the Treasury pays out more than it receives thereby causing bank reserves to increase. The difference is that this year the Fed did not sell Treasury securities to withdraw the reserves from the banking system. That would be counter to QE2 if they did..



The other actor in this play is the Treasury’s Supplemental Financing Account. (For a discussion of this see my post of April 19, 2010 (http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy). The Treasury’s Supplemental Financing Account reached a total of $200 billion in May 2010 and remained at this level until the banking week ending February 9, 2001. The account dropped by $25 billion which reduced the balance in the account to $175 billion. Reducing this account, like reducing the General Account, puts reserves into the banking system.



The Fed allowed an amount of $80 billion to flow into the banking system in the banking week ending February 9, 2011, all from government checks from the Treasury’s deposit balances at the Federal Reserve. There were roughly $3 billion offsets to this on the balance sheet so that only a net of $77 billion actually ended up in the banking system through this activity.



So, the actions were relatively “clean” this week and they resulted in $108 billion going into bank reserves at the Federal Reserve, roughly $30 from the Fed’s purchase of securities and $77 billion coming from government checks from the Treasury’s deposit balances at the Fed going into the private sector.



To my knowledge the $1,187 billion of reserve balances at the Federal Reserve at the end of business on February 9, 2011 is that largest total this account has ever reached!



The question this raises is this…are the reserves being pumped into the banking system getting into the private sector? Is all this Federal Reserve activity having any impact on the money stock numbers?



I am afraid I cannot give any different answer to this question than I have over the past year. The money stock measures are increasing but the reason for these increases still seems to be that people continue to move balances from other earning assets into assets that they can use to transact with. That is, people, in general, are reducing asset balances that were held for a rainy day or were part of their savings and have moved them into assets that they can use for daily purchases of goods and services.



I continue to think this is not a good sign. It is a sign that people are drawing down savings to have cash on hand to pay for daily needs. It is a sign that many people and businesses do not have sufficient income or cash flow to maintain their transaction balances and so have to bring money in from their savings in order to buy food, housing and so forth.



The good new is that bankruptcies and foreclosures are not increasing as fast as they once were.


The bad news is that they are still increasing at close to record rates.



How does this show up in the monetary statistics. Well, currency holdings by the public were increasing in January at a rate, almost 7%, that was roughly twice the rate of a year ago. These year-over-year increases are not near the heights that were reached in the darkest period of the Great Recession, over 11%, but they are high historically.





Demand deposits are also increasing at a fairly rapid pace. The year-over-year rate of growth of demand deposits was about 14% in the fourth quarter of 2010. In January, this figure reached 20%. The highest it reached during the Great Depression was something over 18%.



Note that the growth of the non-M1 part of the M2 measure of the money stock has increased over the past year, but at a very tepid rate. In the fourth quarter of 2010, the year-over-year rate of growth of this component of the M2 money stock measure was slightly over 2%. In January 2011, the year-over-year rate of increase rose to almost 3%, the highest level it had been in several years.



The reason is that the rate of decline in small time accounts and retail money funds slowed dramatically. In the first quarter of 2009, each of these accounts were falling at a 25% rate. In January 2011, the rate of decline in small time accounts was 21% and the rate of decline in retail money funds was around 13%. So, the non-transactions account part of the money stock measures have not declined…have even picked up…but the accounts associated with savings have experience a decline in their rate of decline.



So where are we? About where we have been for two years or so. The Fed keeps trying to push on the accelerator…and the private sector continues to scramble for survival.



What is amazing is that consumer spending and consumer sentiment seem to be picking up. Again, I can only argue that the American society has split. The wealthier, those that are still employed, still live in their own homes, and still have sufficient cash flows are spending. Those that are not fully employed, that have lost their homes or businesses, and those that must rely on their past accumulations of savings are in pretty poor shape. This is the only way I can explain the statistics I see on a daily basis.

Federal Reserve QE2 Watch: Part 3

At the close of business on February 2, 2011, the Federal Reserve System recorded a total of $1.1 trillion of U. S, Treasury securities on its balance sheet. To be more exact, the number was $1,138,166 million.

Thirteen weeks ago, the Fed held just $842,008 million in Treasury securities. Thus, the Fed’s holdings of these securities have gone up by almost $300,000 million or $300 billion or $0.3 trillion over this time. QE2 seems to be in full swing?

Thus, in the last three months, the Federal Reserve has surpassed the holdings of U. S. Treasury securities of China, a little less than $900 billion, and of Japan, a little less than the China.
At January 31, 2011, the Total Public Debt of the United States Government was $14.13 trillion.

Thus, the Federal Reserve System currently holds a little over 8 percent of its government’s debt!

The QE2 program of the Fed stated that the Federal Reserve would buy $600 billion of United States Treasury securities over a six month period and would buy an additional $300 billion in these securities to offset the amount of Federal Agency securities and Mortgage-backed securities that resided on the Fed’s balance sheet and were maturing during this time period.

As stated above, the Federal Reserve added $296 billion of U. S. Treasury securities to its balance sheet. During this time period the Fed lost $91 billion in Federal Agency securities and Mortgage-backed securities reducing the net addition of $205 trillion to its overall portfolio of securities as a part of QE2.

Over the last four week period, the Fed acquired $107 billion in U. S. Treasury securities, but had a runoff of $30 billion in these other securities so that the “net” new purchases added up to $77 billion.

But, this was not all going on that affected the amount of reserves in the banking system. One very big “happening” was that the settlement of the AIG bailout as the Fed’s involvement in this effor. “The Board's statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," reflects the closing of the American International Group, Inc. (AIG) recapitalization plan, which occurred on January 14, 2011. The recapitalization plan was designed to restructure and facilitate repayment of the financial support provided to AIG by the U.S. Department of the Treasury (Treasury) and the Federal Reserve. Upon closing of the recapitalization plan, the cash proceeds from certain asset dispositions, specifically the initial public offering of AIA Group Limited (AIA) and the sale of American Life Insurance Company (ALICO), were used first to repay in full the credit extended to AIG by the FRBNY under the revolving credit facility (AIG loan), including accrued interest and fees, and then to redeem a portion of the FRBNY's preferred interests in ALICO Holdings LLC taken earlier by the FRBNY in satisfaction of a portion of the AIG loan. The remaining FRBNY preferred interests in ALICO Holdings LLC and AIA Aurora LLC, valued at approximately $20 billion, were purchased by AIG through a draw on the Treasury's Series F preferred stock commitment and then transferred by AIG to the Treasury as consideration for the draw on the available Series F funds.”

Basically, this adjustment, along with some other minor runoffs of other “financial emergency” management accounts, removed about $35 billion from the banking system over the past 13-week period and about $22 billion in the past 4-week period. Assuming the Fed offset this reduction in bank reserve with the open-market purchase of Treasury securities, this drops the “net” QE2 injections of reserves into the banking system to $170 billion over the last quarter and $55 billion over the last four weeks.

As always, there are the ordinary operating transactions the Federal Reserve must account for because these transactions, like movements in currency in circulation and movements of Treasury Tax and Loan monies, impact bank reserves. The Federal Reserve usually offsets these items so as to smooth bank adjustments in the regular course of business.

Over the past 13-week period, the Fed had approximately a net of $72 billion in operating transactions to offset. Over the past 4-week period, this total was approximately $7 billion.

Removing these amounts from the Fed purchases of Treasury securities, we find that the Fed bought $98 billion in securities that added to bank reserves over the past 13 weeks, and bought $48 billion over the past 4 weeks. In effect, these numbers reflect the “net” impact of securities purchased to increase bank reserves over this period of time.

Thus, one cannot say that over the last 13-week period the Fed bought almost $300 billion in U. S. Treasury securities as a part of the QE2 program because of all the other things going on during this time.

The Fed did buy over $90 billion in Treasury securities to offset the amount of securities that were running off in the rest of the portfolio, part of the $300 billion the Fed said it was going to do, but this cannot truthfully be considered a part of the $600 billion of new purchases it was supposed to undertake. And, one can make the case that the full amount of the almost $200 billion in purchases was not a part of QE2.

The real question concerns the effects this increase had on the banks and the economic system. Because of timing differences the following data don’t exactly foot. For example, reserve balances held at the Fed increased by $98 billion over this time period. The information we currently have from other sources indicate that the monetary base, which consists of bank reserves and coin and currency held outside of commercial banks, rose by almost $95 billion at the same time. So, we are roughly in the same ball park. One should also note at this time that all these data are non-seasonally adjusted!

Of the $95 billion, roughly $80 billion in the increase came in bank reserves and $15 billion came in currency held outside of banks. Of the $80 billion increase in bank reserves, about $12 billion of this was due to the increase of required reserves of commercial banks. Note that individuals and businesses are still moving their funds from money market accounts and small time and savings accounts, to demand deposits and other checkable deposits, and away from thrift institutions to commercial banks. (We will have more to say on this later this week.) The demand and checkable counts have higher reserve requirements than do the accounts that the funds have been moved from. This still remains the major reason why required reserves have increased over the past several years as well as currently.

So, $68 billion of the increase in total reserves went into excess reserves. Bank loans continued to decline in January (I will address this next Monday) so it appears as if commercial banks are still taking the excess reserves and putting them into “cash” rather than lending them. (Again there is a difference between the behavior of the big banks versus that of the smaller banks.)

The conclusion one can draw from this is that the Fed has been executing QE2, but has not been as aggressive as some people have thought when looking at just the aggregate dollar amount in the Fed’s portfolio of Treasury securities. The Fed still has other things going on that must be taken care of and this modifies any interpretation one can give to the aggregate figures. In terms of the banks: the banks still appear to be putting the “new” reserves the Fed is injecting into the banking system into excess reserves. So far, QE2 does not seem to be producing any substantial results in the banking system.

The Fed Acts!

Federal actions on QE2 have been relatively benign up to this week. (See my Monday post: http://seekingalpha.com/article/240375-federal-reserve-qe2-watch-part-1.)

Things were different this week as the United States Treasury issued a lot of bonds this week and longer terms interest rates rose to levels not seen since the middle of June 2010. The 10-year Treasury security got up to almost 3.30 percent on Wednesday, up by about 45 basis points over the past two weeks or so.

The Federal Reserve added over $32 billion in Treasury notes and bonds to its portfolio from Wednesday December 1 to Wednesday December 8. This move was not to replace mortgage backed securities as was the case over the past few weeks.

Also, this increase was not to replace reserves lost through operating transactions. Quite the contrary, deposits with Federal Reserve Banks other than reserve balances, which includes the General Account of the United States Treasury fell by almost $8 billion which also added reserves to the banking system.

All-in-all, over $50 billion was added to Reserve Balances with Federal Reserve Banks over the past week. Most, if not all of this will show up in Excess Reserves at commercial banks.

In August 2008, before the Fed started pumping reserves into the banking system, total reserves at all commercial banks totaled $46.4 billion!

The initial interpretation of this is that the Fed acted to keep long term interest rates from rising further. The ten-year bond rate was down slightly today, closing around 3.23 percent at 4:00 PM, New York time. This is what QE2 is supposedly all about!

Federal Reserve QE2 Watch: Part 1

Quantitative Easing, Part 2 has begun. As I wrote on November 4, 2010, “The Fed is going to purchase an additional $600 billion in US Treasury securities over the next eight months, or $75 billion per month, in order to get the economy growing again…over the same time period, roughly $250 to $300 billion will run off of the Fed’s mortgage-backed securities portfolio. This $250 to $300 billion in mortgage-backed securities will be replaced by $250 to $300 billion in U. S. Treasury securities. (See "The Fed's $850 billion bet": http://seekingalpha.com/article/234814-the-fed-s-850-billion-bet-negative-long-term-implications.)

The reason given for this policy is that the economy is not picking up fast enough and that unemployment is such a problem that the Fed must act in an extraordinary way in order to correct the situation. Nothing, however, is being said about the weaknesses in the commercial banking sector and the need to put a floor under asset prices so that the banking regulators can work out all the insolvent banks.

So, we are entering a new phase of monetary policy. It is very important to keep on top of what the Fed is doing so that we can try and understand how this quantitative easy is working and what impacts this policy is having on the banking system.

Remember, starting in July 2009, the Federal Reserve began to execute an “exit policy” to remove all of the excess reserves it had pumped into the banking system in the first round of quantitative easing. The Fed, in combating the “Great Recession” pushed the excess reserves in the banking system from about $2.0 billion to over $1.0 trillion. During this time, the balance sheet of the Fed grew from less than $900 billion to more than $2.0 trillion. The “exit policy” was an attempt to return the balance sheet to a size that was comparable to the earlier figure and substantially reduce the excess reserves in the banking system.

During the year or so that the Fed was engaged in its “exit strategy”, the Fed’s balance sheet actually increased and excess reserves in the banking system rose! (See http://seekingalpha.com/article/224085-federal-reserve-non-exit-watch-part-1.)

So much for an “exit strategy.”

Now for QE2! Given the directive mentioned above, there are three areas that we need to keep a close watch on. First, we need to watch what happens to the Federal Reserve balance sheet and what happens to the excess reserves in the banking system. This will tell us whether or not the Fed policy is expansive. Second, we need to watch the runoff in the portfolio of mortgage-backed securities (and Federal agency securities) to see whether or not the Fed is replacing the runoff with purchases of Treasury securities. Third, we need to see what “operational” factors are influencing the Fed’s balance sheet to determine whether or not the purchase of Treasury securities are going to support movements of funds connected with seasonal or other operation factors.

Over the last thirteen week period, Reserve Balances held by commercial banks at Federal Reserve banks actually declined by $2.0 billion.

In terms of the first point, it appears that the Fed did not act to aggressively expand bank reserves or the excess reserves held by the banking system.

In terms of the second point, during this thirteen week period, the Federal Reserve purchased roughly $131 billion in United States Treasury securities. However, the Fed’s portfolio of mortgage-backed securities and Federal agency securities declined by almost $90 billion. The net increase in Securities held outright by the Federal Reserve was more than $40 billion.

Two major “operational” events absorbed bank reserves during this period. These two events caused funds to flow out of the banking system and the Fed needed to inject reserves back into the banking system to replace them. This is what the above $40 billion in securities purchases went to do.

The first “event” that drained reserves out of the banking system was a flow of currency “out of” the banking system. This always happens as people prepare for the Thanksgiving and Christmas holiday seasons: people increase their holdings of cash for current spending purposes. Over the past thirteen week period, Currency in Circulation rose by almost $27 billion and had to be replaced.

The second “event “related to the recapitalization plans of American International Group (AIG). Pending the closing of the recapitalization plan, the cash proceeds from certain asset dispositions will be held by the Federal Reserve Bank of New York as agent. This account appears as a deposit (liability) on the Fed’s balance sheet and results from a flow of funds out of the banking system. Like currency flowing out of the banking system, this movement also has been replaced in the banking system through the Fed’s purchases of U. S. Treasury securities. This account rose by almost $27 billion over the past thirteen weeks.

These were the major changes in accounts over the past thirteen weeks. Other smaller movements of funds provided the balance of getting to the $2.0 billion decline in the Reserve Balances account.

Over all, excess reserves in the commercial banking system declined by about $2.2 billion from the first week in September to the first week in December. Thus, the initial move toward quantitative easing has not resulted in any major change in the banking system, although the Fed’s balance sheet rose by about $45 billion, to almost $2.4 trillion. This rise has occurred due to “operating transactions” relating to the seasonal rise in currency outside of commercial banks and due to the recapitalization of AIG.

So far, the major impact of the QE2 formula is the shift in the overall portfolio of securities held outright by the Federal Reserve. Here we got a major shift from mortgage-backed securities and Federal agency securities to securities issued by the United States Treasury.

We will keep watching.

One final point: I have never seen the Federal Reserve so blatantly political. Fed Chairman Ben Bernanke is now the “point person” for the Obama administration’s economic policy. Never, has a Fed chairman had to go out and sell the government’s monetary and fiscal policy like Bubble Ben has. To me, it’s embarrassing. As reported by Mike Allen in Politico Playbook, the FEDWATCH On 60 MINUTES - CBS News release: “In a rare and frank interview, Federal Reserve Chairman Ben Bernanke talks to Scott Pelley about the troubled economy and the measures the central bank has taken to improve it. Bernanke's interview took place in Columbus, Ohio, last Tuesday (30) and addresses several pressing economic matters..He also talks about the federal deficit and reforming the tax code. He explains why the Fed announced its intention to buy $600 billion in Treasury securities, defending against charges the move will lead to inflation and not ruling out the purchase of more. The Fed chair also addressed the federal deficit.”

Federal Reserve Exit Watch: Part 6

Debate seems to be picking up about the Federal Reserve exiting its current policy stance. Last week Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, and Charles Plosser, President of the Federal Reserve Bank of Philadelphia, spoke last week of the forthcoming need to wind down the Fed’s position. Hoenig said that the Fed should end its purchase program of mortgage-backed securities and Plosser talked about the recovery being sustainable even as existing fiscal and monetary stimulus programs recede.

Still, economists are pessimistic about when the Fed will begin to raise its target for the Federal Funds rate. The effective Federal Funds rate in recent months has averaged about 12 basis points. Bloomberg News conducted a survey of economists’ expectations and the median forecast was for the target rate to remain unchanged through September 2010 and then rise by a half of a point in December 2010.

Since the Federal Reserve finally realized in 2008 that there was a financial crisis and began to combat the unfolding chaos, the basic policy of the Fed has been to throw whatever it can at the wall so that a sufficient amount of what is thrown will stick so that a financial collapse can be avoided.

Can people who devised such a policy really be expected to move its target rate up until it is far past the time that a rise is needed? And, the Fed will then face a situation in which rising interest rates will put many holders of Treasury securities and mortgage-backed bonds underwater and the question will then be, “Can the Fed afford to raise interest rates too swiftly because of all the losses it will create?”

Right now, the Fed is subsidizing the profits of the large banks (and not the small- and medium-sized banks) by its interest rate policy (of course, the Obama administration has threatened to tax away a good deal of the profits). It is just amazing the contradictions in monetary and fiscal policy that are coming out of Washington, D. C. these days. Confusion reigns!

It is no wonder that businesses and banks don’t want to do much of anything these days. They don’t know what the economic policy and regulatory environment will be in three years, let alone three months.

Anyway, the Federal Reserve continues to add reserve balances to the banking system. In the past 13-week period ending Wednesday, January 13, 2010, the Fed has added about $84 billion in reserves to the banking system.

Remember in August 2008 when the total reserves of the whole banking system were only about $44 billion!

Of this $84 billion, $62 billion was put into the banking system in the latest 4-week period.

The major contributor to this increase was security purchases by the Federal Reserve in the open market. In the latest 4-week period, the Fed added almost $71 billion to its securities portfolio bringing the total new purchases for the last 13 weeks up to $233 billion.

A large portion of this increase went to offset the decline in several of the special facilities set up to handle the financial crisis. For example, the amount of funds supplied the banking system through the Term Auction Credit facility fell by about $80 billion over the 13-week period, by $10 billion over the last 4 weeks.

The swap facility with foreign central banks also continued to decline dramatically, falling by almost $38 billion in the latest 13-week period and by about $9 billion in the last four weeks.

In total, it appears as if the funds supplied the banking system through special financial crisis facilities fell by $42 billion over the past 13 weeks and by only $2 billion over the last two.

Thus, the Federal Reserve continues to let these special facilities wind down, replacing them in the banking system through open market purchases.

In terms of preparing for the Fed’s exit, there has recently been trading in reverse repurchase agreements with dealers, but there was no “practice” activity in the past four weeks presumably because of the seasonal Thanksgiving/Christmas churning in the banking system.

As of Wednesday, January 13, 2010, the Federal Reserve held $969 billion in mortgage-backed securities in its portfolio. The central bank has authorized purchases of up to $1.25 trillion going into March of this year. As mentioned earlier, there seems to be substantial debate within the Fed as to whether or not this program should reach the maximum total. We shall see.

The Fed now holds $777 billion in Treasury securities and $161 in the securities of Federal Agencies.

So, the Fed Exit watch continues. So far, the Federal Reserve has honored the path that it started out on: purchasing securities to add to its portfolio thereby replacing the funds draining away from the special facilities created to combat the financial crisis.

Obviously, the real test has not begun. Within the next month or two, if the recovery continues, the Fed is going to come under more and more pressure to start raising its target rate of interest. Until then, big banks will continue to arbitrage the Treasury market and the carry trade will continue to prosper. This behavior is based on the assumption that the Fed is not going to let short term rates rise for a while.

When this assumption is broken, expectations will have to be reset and there will be a re-adjustment in the financial markets as investors exit their arbitrage positions.

What the Fed does then remains to be seen.

However, by maintaining its current policy stance, if the economy doesn’t recover or goes into a double dip recession, the Federal Reserve cannot be accused of aborting the upswing by raising its target interest rate too soon.

The Future of the Dollar

We live in a global economy. And, unless we destroy the global economy that now exists the way the world destroyed the first global economy starting with the 1914 conflict and proceeding through the next fifty-five years or so, we will continue to face the duties and responsibilities of operating within a world economy. And, those duties and responsibilities begin with the currency of the country.

It is hard to have confidence that the United States accepts this fact.

I know that we are in a recession (depression?). I know that the immediate pressure on the Obama Administration is to “get the economy going again.” I know that the Treasury Department and the Federal Reserve, both dependent partners in the effort to get the financial system functioning, must provide whatever means it takes to avoid further deterioration of financial markets.

Still, there is a need to listen to what markets are saying about what the government is doing. And, the financial markets are saying that the United States dollar is in trouble. And, consequently, the United State government is in trouble.

The value of the Euro relative to the United States dollar climbed to 1.3768 at the close of business yesterday. This represents an 11.7% decline in the value of the dollar since Ben Bernanke became Chairman of the Board of Governors of the Federal Reserve System on January 31, 2006. It represents a 23.0% decline in the value of the dollar since Bush 43 became President on January 20, 2001 when Alan Greenspan was the Chairman of the Board of Governors of the Federal Reserve System.

The numbers are about the same if you look at a trade weighted series. The trade weighted value of the dollar versus major currencies has declined by 23.6% since Bush 43 was inaugurated, and, has declined 5.4% since Ben Bernanke became Chairman.

Of course, the figures look even worse if one focuses upon the lows in the value of the dollar which came about in March, 2008. Using this as the standard we find that the trade weighted value of the dollar declined 33.4% from the beginning of Bush 43 and 17.5% since Bernanke was sworn in. The current numbers look great compared with these, but the current figures benefit from the ‘flight to quality’ that took place following the September 2008 meltdown of the United States financial system.

All during the Bush 43 Administration, both the United States Treasury Secretary, whoever that was, and the Fed Chairmen gave lip service to the importance of the value of the United States dollar, yet no one did anything about it. And, the dollar continued to decline. Certainly someone should have understood that the decline in the value of the currency indicated something was wrong with the way the finances of the United States government were being run.

It is very apparent that the Federal Reserve System is NOT independent of the federal government of the United States. One has to go back to Paul Volcker and then back to William McChesney Martin to find Fed Chairmen that acted independently of the Executive Branch of the government. President Carter knew that Volcker would be independent of his administration if Volcker became the Fed Chairman but believed that he had to appoint him anyway. Certainly Arthur Burns and Bill Miller (remember him?), were not independent of the Presidents they served. And, people are realizing more and more that Alan Greenspan was nothing short of a water-carrier for the Presidents he served.

Not being independent of the Executive Branch means that the Federal Reserve is very subject to the position of the federal budget. Even Paul Volcker was eventually tainted with the huge (at the time) budget deficits run up by the Reagan Administration. Still, during his tenure as Fed Chairman, Volcker saw the trade weighted value of the dollar against major currencies rise by 6.4%.

Overall, during the time that Greenspan was Chairman of the Fed, the trade weighted value of the dollar against major currencies declined by only 16.7%. Greenspan’s grade improved in the 1990s due to the movement of the federal budget from a substantial deficit when the Clinton Administration took over in 1993 to a surplus by the time Bush 43 assumed office. In fact, this measure of the value of the dollar rose 13.9% during the Clinton administration.

The important thing to remember is that in the last half of the twentieth century world financial markets came to realize that substantial government budget deficits often got financed, one way or another, by the central bank of that country. As a consequence of this realization, participants in these world markets moved against the currencies of countries that began running large deficits if they believed that the central bank’s of that country were not fully independent of the government. The result was that governments became much more conservative in controlling budget deficits and central banks became much more independent of their governments.

The United States, in the latter half of the twentieth century, except for the early years that Paul Volcker was the Fed Chairman and during the 1993-2001 period, seemed to feel that they were exempt from this constraint. Yet, international financial markets responded to United States deficits and the possibility that they could be monetized in the same way that they responded to the “loose living” of other governments. They sold the dollar and the value of the dollar, for the most part, declined.

As participants in world financial markets perceive that things are beginning to settle down and that financial institutions are not going to completely self-destruct, they will continue to move out of United States Treasury securities and will continue to move out of the United States dollar. The foundational belief behind this movement is that the United States government is just putting too much debt out into the world. First, there were the huge budget deficits created by Bush 43 and now there are the huge budget deficits being created by the Obama administration. To people in the world financial markets, the lessons of the last fifty years still apply.

The path the economy and the financial markets follow relating to how the deficit problem works out is anyone’s guess right now. Who would have ever written the script for how the 2000s have evolved up until now? The historical evidence points to the fact that huge amounts of debt issued by governments cause dislocations. These dislocations have to work themselves out. How these dislocations work themselves out is different in every case. The general consequence of large budget deficits, however, is that large amounts of government debt are not good for the value of a country’s currency. I believe that this is as true for the United States as it is for any other country. The value of the dollar will continue to decline over the next several years.

My grades for the past three Fed Chairmen? Paul Volcker gets the best grade. I am assigning him a grade of plus 6.4. Ben Bernanke is second highest with a grade of negative 5.4 and Alan Greenspan comes in last with a grade of a minus 16.7. Unfortunately, when the grade is negative, we all have to pay for it!

The Fed's Quantitative Easing Goes Forward

Lots of transactions went on in central banking over the past month or so, not only in the United States but in the UK and Europe. Quantitative easing is the game and, at least, the central bankers are getting more and more comfortable with this.

Credit is given to quantitative easing for the drop in the dollar LIBOR rate. The three month LIBOR now ranges between 50 and 60 basis points over the target Federal Funds rate chosen by the Federal Reserve. This is the lowest this spread has been in a long time. For the five years previous to September 2008, the time the financial markets collapsed, this spread averaged between 20 and 30 basis points.

This move reflects the efforts of the Bank of England and the European Central Bank to push short term interest rates lower and to engage in monetary actions that pump more liquidity into the banking systems even though the interest rates do not show a proportional response. The drop is given as evidence that perhaps interbank lending is increasing in these nations and that this is possible evidence of a thaw in credit extension.

In the United States the Federal Reserve was particularly active in April although the total factors supplying bank reserves has increased only modestly in the last four banking weeks, rising just $21.2 billion. All of the action has happened within the balance sheet.

The interesting movement has come in excess reserves in the banking system, a series that is not seasonally adjusted. Excess reserves showed a huge rise, $100.0 billion, in April 2009 from March. I reported earlier that excess reserves in the banking system in April averaged $824.4 billion, almost the entire size of the Federal Reserve’s balance sheet one year earlier.

The combination of these two factors, basically the small increase in Federal Reserve sources funding the monetary base and the huge increase in excess reserves in the banking system, indicates that much of the activity was internal to the Fed’s balance sheet and not a source monetary expansion. Let me highlight the major changes.

Within the banking system itself, excess reserves averaged $771.3 billion in the two weeks ending March 25. This figure jumped to $804.8 billion in the two weeks ending April 8 and then rose to $862.4 billion in the two weeks ending April 22. This was tax time when funds flow into government accounts in the banking system but there were apparently other things going on as well in government accounts. In the two weeks ending May 6, excess reserves dropped back to $777.5 billion, roughly equal to the level they were at in the two weeks ending March 25.

One could argue that the April bulge was just “temporary”. However, a $100.0 billion increase in the excess reserves in the banking system is “eye-catching” when this measure only averaged around $2.0 billion for the eight months of 2008 before September of that year.

What was going on in the Federal Reserve? I can only describe the Fed’s activity as a part of its efforts to provide liquidity to different sectors of the financial markets and this is a part of the plan to provide quantitative easing to the financial system. Specifically, the amount of securities that the Fed holds outright jumped by $166.1 billion between the banking week ending April 15 and the banking week ending May 13. United States Treasury securities increased by $54.8 billion during this time, the largest increase in these holdings since the Term Auction Facility (TAF) was established in December 2007.

TAF was introduced to help allocate reserves into the banking system faster and more directly to the banks that needed the reserves at the time. It was an effort to increase the liquidity in the banking system to facilitate bank portfolio adjustments in the face of the “liquidity crisis” that occurred in December 2007. The Fed continued to use Term Auction Credit over the next 15 months or so to facilitate bank portfolio adjustment.

The “new” liquidity problem, however, seems to be connected with the Treasury bond market. Now, the Fed has entered into a program to supply funds to the Treasury market to help keep long term interest rates down, a goal it has not yet achieved. However, we see this shift in the quantitative easing strategy as the Fed is increasing its holdings of United States Treasury securities while at the same time letting the amount of funds allocated to the banking system through Term Auction Credit decline by $27.0 billion, the first substantial decrease in this total since the program began.

There is another sign of quantitative easing and this is in terms of the amount of Mortgage Backed Securities the Federal Reserve holds. During the four weeks ending May 13, 2009, the Fed’s holdings of these securities increased by $96.9 billion to $384.1 billion. Obviously, the policy makers at the Fed believed that there was serious liquidity problems in this segment of the capital market that needed their attention.

This huge increase brings the holdings of Mortgage Backed Securities up to two-thirds, 67%, of the Fed’s holdings of United States Treasury securities. Who would have ever imagined that this would have happened?

Again, reflecting the shift taking place in where the quantitative easing is being applied, the Commercial Paper funding facility at the Federal Reserve fell by $83.3 billion from the banking week of April 15 to the banking week of May 13. This decline can be interpreted as an indication that some easing is taking place in short term money markets, allowing the Fed to focus more upon the longer term end. The Fed, at its peak, had supplied over $250.0 billion to the financial system through this facility.

Furthermore, there was a drop in Central Bank Liquidity Swaps during this time period of $47.0 billion. Currency markets were apparently stable enough during this time so that these borrowings could be reduced. However, there are still about $250.0 billion in swaps still outstanding to other central banks.

This last month gives us a good picture of how quantitative easing seems to work. There was very little change in the total amount of funds that the Federal Reserve supplied the banking system, but there was substantial Federal Reserve activity within its balance sheet as it readjusted its focus upon which markets it believed needed the greatest amount of assistance with regards to the supply of liquidity. The crucial factor in this exercise seems to be that once the liquidity needs of a market are satisfied by the market itself, then the market participants that used the Fed’s facility pay back the funds that they have used. This allows the Fed to address other segments of the financial markets and, hopefully, satisfy the liquidity needs in these other areas.

Overall, the dream is that all the funds will be paid back to the Fed as the financial system and the economy turn around and begin to function effectively again. Not only will this allow the Fed to cease being the “fireman” that must run from fire-to-fire putting out the latest blaze, but will also get out of the “fire-fighting” business itself and allow its balance sheet to shrink back to an appropriate size. We are not there yet, but it does provide some comfort to see that the Fed can move from one current fire to another without another massive expansion of its balance sheet. However, whether this can really be accomplished remains to be seen.

The Fed Moves to Monetize

The Federal Reserve shocked the financial markets yesterday. The Fed released the results of its just-ended Federal Open Market Committee meeting and the response was immediate—stock market indices went up—and the value of the dollar went down!

The reason—the Open Market Committee approved a plan to purchase up to $300 billion of longer-term Treasury securities over the next six months. This is in addition to a plan to increase the Fed’s purchase of up to an additional $750 billion of agency mortgage-backed securities.

The stock markets took this surprise as a positive sign that the Fed was being true to what Chairman Ben Bernanke had indicated in recent speeches and interviews—“the Federal Reserve will employ all available tools to promote economic recovery.” (Oh, he also added “and to preserve price stability.”) Good news—right? Well, the stock market seemed to be “mixed” today.

The foreign exchange markets took another view and the value of the dollar dropped sharply, and the selloff was “widespread” according to the Wall Street Journal. Bad news—right? Well, the value of the dollar continued to decline today.

It is a complex story. I have been one that has continuously expressed concern over the long term prospects for the dollar in foreign exchange markets. See for example my post “The Obama Stimulus Plan and the Dollar: Is There a Connection (http://seekingalpha.com/article/114310-the-obama-stimulus-plan-and-the-dollar-is-there-a-connection). The concern is over the huge United States budget deficit and how this deficit is to be financed in future years. The long-run view of such large deficits is that a substantial portion of them will have to be monetized by the central bank. The fundamental effort of all Keynesian fiscal policy is to inflate or reflate the economy.

There are some complicating factors to this simple story. Through all the financial and economic turmoil of the past six months the dollar has not declined in value but has actually strengthened. If participants in the financial markets are so concerned about the deficits of the United States government and the possibility that the Federal Reserve will monetize a bunch of the debt, why has the value of the dollar gone in the direction it has? Why hasn’t the value of the dollar tanked, instead?

For one, the United States dollar is the “world” currency and it still is the currency of choice in times of uncertainty and turmoil. Thus, the strength of the dollar has, to a large extent, been the result of a “flight to safety” on the part of many investors in the world. It will, undoubtedly, continue to be a “safe haven” for much of the world’s wealth for a long while into the future.

Second, because most of the whole world is in some kind of a recession and are following similar fiscal and monetary policies, it becomes difficult to discern which currencies throughout the world are going to be the worst off. If changes in the value of currencies are a result of changes in the relative prospect for future inflation in different countries, then the exchange rates will ultimately be dependent upon just how each of these countries handles the pressures created by their own stimulus packages.

As for the United States dollar, the most important factor determining its value in the near term is going to be the “safety” factor. Still, other factors, like the aggressive posture of the Federal Open Market Committee cannot be ignored. And, this seems to be what is happening right now in foreign exchange markets. I would argue that even though this latter movement might be a short-run phenomenon, a person concerned with the future health of the United States economy should not ignore what the foreign exchange market might be telling us.

I continue to go to this statement of Paul Volcker: “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership,” (New York: Times Books, 1992), p. 232.) Consequently, what is happening or will happen to this price should be of major concern to investors. This price will carry with it the view of the world investment community about how the United States is conducting its fiscal and monetary policies.

This is something that the Obama administration and the Federal Reserve System need to pay attention to. The most recent example of ignoring information like this came during the years of the Bush administration. In 2001 a tax cut was passed by the government that took the government budget from a surplus to a deficit position. This was followed by increasing expenditures that went to support several military engagements around the world. The fundamental market response to this was that the value of the dollar began to decline early in 2002.

In addition to this the Federal Reserve System kept short term interest rates at very low levels (the effective Federal Funds rate was below 2% from early in 2002 until the beginning of 2005) for an extended period of time which resulted in negative real rates of interest during this interval. Participants in foreign exchange markets continued to put pressure on the value of the dollar into the summer of 2008. Even though officials in the Bush administration and the Federal Reserve System claimed that they were watching the value of the dollar and maintaining its value was an important goal, little or nothing was done about this decline and the market value continued to sink.

The value of the dollar is something that we need to continue to watch closely. The concern over the monetary and fiscal policies of the Obama administration is not misplaced. A warning shot was issued this week by the Chinese Premier Wen Jiabao when he indicated that he was a “little bit worried” about the safety of the U. S. Treasury bonds that his government owns. The reaction of the foreign exchange market to the Fed’s announcement about their plan to buy up to $300 billion of longer-term Treasury securities is another. And, there is also the concern of some analysts that the real financial and economic issue facing the United States is one of “too much debt” and that this debt overload is exacerbating the economic slowdown. As the historian Niall Ferguson, author of “The Ascent of Money” (see review at http://seekingalpha.com/article/120595-a-financial-history-of-the-world), has stated, “the solution to the problem of having too much debt around is not creating more debt.”

Is the decision of the Federal Open Market Committee to purchase up to $300 billion of longer-term Treasury issues the next step in the monetizing of the debt? Will the release of this information contribute to a further decline in the value of the dollar? There are, of course, a lot of “known unknowns” and “unknown unknowns” at this time. Obviously, it is a very risky time. However, in my view, eventually the value of the dollar will continue to erode. History has shown that this is what eventually happens in situations like the one we are in.