Sunday, May 8, 2011

5/6 Weekly Commentary

Has the Fed lost control of interest rates? 
QE2 has increased leverage on the Fed balance sheet by 25%, bringing it up to 50-1.  It will be higher at the end of the program.  Interest rate increases could wipe out the Fed's capital and require a bailout.  This is in the absence of any writeoffs, just the reduction in the market value as applied to the balance sheet.  The Fed operates to control interest rates, primarily.  In the past this was it's exclusive tool.  Currently it monetizes treasury debt issuance and for every dollar increase in the balance sheet the monetary base goes up about the same.  In addition, every dollar increase in the balance sheet has a direct and depressive effect on short term rates.  Hence, T-bills yield .05%, 1/20th of 1%.  There is an inverse law: Fed rate increases require sales of securities and a decrease in the monetary base.  In order for the Fed to increase rates a large amount of short-dated treasuries needs to be sold or repo'd.  A repurchase agreement is a contract with a private owner to sell at an agreed price with the commitment to repurchase at a later date. 
This requirement for the monetary base and balance sheet to contract does not preclude rate increases due to private market sales.  QE2 was leaked at Jackson Hole in late August but the operations did not commence until the first week of November.  T-bill rates fell from 1.85% at the leak to .9% to the start of operations.  However, the size and length of the program were already passed onto the market and the market will not alter the rate structure unless it knows that sufficient capital will be injected or removed.  So, it took $600 billion (or so) to crush rates from 1.85 to .06 today.  Short rates move due to the Fed or external events.  So, absent big-screen events affecting U.S. creditworthiness, flight to quality, or serious inflation it will take sales of $600 billion to normalize rates back to 1.85%. 

Flight to quality lowers rates, but it is hard to accept that flight to quality would lower rates much below .06%.  A change in the perception of U.S. creditworthiness would raise rates, as would a surge of inflation.  Any increase in rates would discount the securities that the Fed holds, almost all of it longer-dated treasuries and garbage.  Due to the leverage this would destroy the equity portion of the Fed balance sheet and require rescue.  As of 12/10 the Fed has equity of $53billion.  It is buying treasuries at historically high prices (low yields).  As of 5/4 the Fed held $2.55trillion in securities (including Maiden Lane, Bear Sterns).  At the end of QE2 their portfolio will be about $2.75trillion, almost all of it longer maturities (>5years).  The longer the maturity the more volatile the price, given any change in rate structure.  Contrast this will Fed policy prior to Ben, where the Fed concentrated almost exclusively on bills instead of notes and bonds, maintained leverage max of 15-1 and prior to Greenspan 10-1.  Currently the leverage is 50-1.  A swing of 1% in 10-year rates will reduce the value of the Fed's portfolio by $170billion, putting the Fed in negative capital position by $120billion.
So, the Fed is putting itself in a box,  steadily buying securities under QE2, expanding it's balance sheet and leverage, and making it harder for the Fed to escape the leveraged consequences if bond prices fall.  Inflationary perceptions or fears of downgrade would cause private sales of treasuries and kill the Fed.  The Fed is currently a hedge fund and must reduce it's leverage before the market starts selling. The only way to reduce leverage is to sell securities and at least to the tune of QE2's 600billion.

Currently the market believes that after QE2 the Fed will merely slow the growth of the monetary base, reinvesting maturing proceeds into more treasuries with a dramatically slower growth in the base.  However, the Fed has to quickly get ahead of the curve in order to avoid the destruction of it's equity. The Fed got the shot across the bow with the S&P negative outlook for treasuries.  The initial reaction was negative but treasuries soon continued their rally.   The market knows it has at least a year before a downgrade but I believe that, like sharks, bond holders will recognize these converging probabilities:
1) The threat of inflation is real and bonds are units of capital destruction in an inflationary environment.
2) The Fed is maintaining a 0% rate structure in the face of a worldwide rate structure that is over 1% higher and climbing.  This reduces the relative value of U.S. bonds.
3) The creditworthiness of the U.S. is declining.
4) The Fed's increasing leverage makes it increasingly probable that the Fed will sell down it's balance sheet in order to save itself.  Even a 1% rise in short rates will cause at least a 6% fall in 10-year treasuries, not to mention mortgage backed securities on the Fed balance sheet.  To savvy bond holders it is merely a question of who sells first, they or the Fed.

What can save the Fed?
First, a strong dollar will keep a floor under bond prices and would allow the Fed to maintain it's current portfolio.  However, the dollar will only gain strength if the stock market and commodities markets decline.  The decline in the stock market must continue, otherwise any dollar rally will prove fleeting.  Up to this time Ben was focused on increasing confidence by boosting the stock market.  The change toward focusing on his balance sheet and the increasing army of bond sellers arrayed against him will be a central fugue over the next couple of years.  It is not possible for the Fed to single-handedly prop up the U.S. bond market.  It is simply too big. To keep rates from rising in a self-reinforcing cycle after QE2 the Fed must enlist private buyers. To fight rising rates by starting QE3 would be an end to the Fed's autonomy, as there are now plenty of members of Congress who have the Fed in their sights.

I wanted to wait to post this analysis until after the I1 had turned.  This is a slow reversal of worldwide fiat expansion.  The Fed is now the only casino in town still extending credit to it's addicts.  Even the ECB is caving in to the Germans and is beginning to raise rates.  Rates have been going up in Asia, Australia, and South America in response to the dramatic surge in commodity prices.  Industrial commodities are still increasing at a 10% rate over 6 months, but that is down from 25% just recently.

Profits are set to fall due to the higher commodities costs of the past year and are on track to suppress margins starting in 3rd quarter.  Going forward from there the current declining commodity prices are in large measure due to increasing restrictive monetary policies overseas and slowing international demand.  The cinderella days of low costs and rising demand are over.  From here on, falling commodity prices will be reflecting weaker demand and will not have a net positive effect on profits.

The stock market has shifted to a bearish trend with weekly reversals in DJI, SPX, and COMP, weekly outside reversals in SPX and COMP, a break of the DJI critical support M/A, and a turn in the 30-day I1.  SPX 1318 appears a good initial target for trading purposes.
The strategic direction is down, as evidenced by 30-day I1:
The 30-day I1 does not appear to be affected by the lead/lag that developed during the Japan quake.  It goes flat Wednesday, which is the day projected by applying the lead factor to raw I1 and the short-term timing model.  So, SPX goes under 1320 by Wednesday and we stand aside for 4-5 days.  Here is raw I1:

Ned Davis pointed out that copper/gold correlates well with the stock market and has been wilting.

Silver is subject to a long downtrend as indicated by the PM1 sentiment gauge:

The short-term cycle model bottoms in 8 days:

I made money off of the top for silver via futures for the first leg, then via ZSL for the second down to $39.  I'm waiting for a rebound to the 90-minute M/A which is declining sharply.  It should intersect $40 late Monday.
The daily chart for silver shows price coming down to an important M/A:


  1. Steve,
    Excellent commentary. I had two points on it:
    1) John Hussman at hussmanfunds has an interesting article about just what you were talking raise rates from the 0-.25% to a more "normal" 1-2% would require undoing all of QE2...the point being that unwinding the monetary base is incredibly front-loaded as rates increase.
    2)The Fed has now changed their accounting so that if they end up with negative equity, they just enter it as a negative showing as money owed to the Treasury. So, it might take a bit before that has the ramifications that it should.
    On the counts: Every big thing i track shows a May sell at the end of the month depending on how we close the months, the S&P needs to close over 1325-7 but everything is set since we recorded those new highs. Small/mid caps and developed international all look the same. I need to look back in history but I havent ever seen this set up on a monthly basis in the last 30 years. We had a very similar setup on the weeklies right before the flash crash.

  2. Charles,
    It will be hard to just hand the Treasury a bill for $150 billion. The Tea Party/Ron Paul would have a field day.