This is a guest post by Precision Capital Management.
While much has been made of the expiration of the Federal Reserve’s $300 Billion quantitative easing program, there are still many more ways in which the Fed can pump the markets with liquidity that need never be paid back to the recipients. In this article, we take a look at the ramifications of some recent developments with regard to the Treasury and Federal Reserve that will again provide fodder to the equities markets, as well as revisiting our previous work on how money supply has impacted the economy and what it tells us of the potential correction down the road.
As we wrote two days ago, Treasury is effectively winding down its Supplemental Financing Program, the stated intention of which on its inception in September 2008 was to, “drain reserves from the banking system, and therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.” Delving into the mechanics of it, here is what happened:
Treasury announced special auctions for cash management bills, the proceeds of which were placed on deposit with the Federal Reserve in a special account (as opposed to the proceeds being kept by Treasury to fund the government). This allowed the Federal Reserve to use these funds (which topped out at $558.9 Billion in November 2008) to borrow or buy securities primarily from banks and broker dealers to help “unfreeze the credit markets.” The Fed could have simply borrowed or bought securities with money it printed, but this would have expanded its balance sheet by creating excess reserves in the accounts that banks are required to keep with the Fed. These reserves can be multiplied by at least ten times and used by banks for lending. At the time, the Fed was rightfully concerned about inflation becoming unmanageable once the credit markets thawed, and about being able to keep the Fed overnight lending rate (fed funds target rate) above zero. Accordingly, Treasury’s SFP helped to keep the Fed balance sheet under control (if you can call a multiple hundred percentage increase “under control”). The amount of money that flowed into the financial markets from the SFP was the same as it would have been had the Fed printed the money; however, SFP money could not be multiplied by banks.
Congress granted the authority to the Fed to pay interest on excess reserves held by banks on deposit with it as of October 1, 2008. This new tool obviated the need for the SFP as the Fed could now simply incentivize banks to not lend against their excess reserves (by paying them interest to keep their reserves at the Fed). Accordingly, in November 2008, Treasury announced it would reduce the SFP, and it has held steadily at $200 Billion for most of 2009.
On Wednesday, Treasury announced that it would allow the SFP to “decrease in the coming weeks to $15 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over.” As we wrote above, Treasury issued special cash management bills as opposed to its standard arsenal of regularly auctioned bills (such as the 4 Week, 3 Month and 6 Month Bills). We have identified these bills (all were 70 day duration) by their CUSIP, auction amount, primary dealer take (to be explained later) and maturity date (each of which is a Thursday):
Upon maturity, the SFP account at the Fed will be deducted by the total auction amount with the funds returned to the purchasers of the bills. The consequences of this are:
- Should the Federal Reserve require additional funds to finance its buying and borrowing of securities (Agency POMO, MBS purchase, TALF, etc.), it will need to print money in the amount that the SFP has been decreased. This is not too much of a long term issue since, as we wrote above, it is able to pay interest on excess bank reserves to keep inflation in check.
- Treasury can now issue longer term Notes and Bonds to replace the shorter term 70 day cash management bills. This is more important to Treasury’s long term objectives, especially as it quickly approaches the $12.1 Trillion debt ceiling this fall.
- Without the rollover of the $185 Billion in cash management bills, assuming constant demand for shorter duration bills, the regularly scheduled Treasury Bill auctions (4 Week, 3 Month, 6 Month, etc.) should experience increased demand, which will put downwards pressure on short term rates and keep the US Dollar carry trade alive and well (a topic for another article).
- Because primary dealers will not be expected to buy any more of these SFP cash management bills, they may use these funds for other purposes.
As to 4, above, what might these purposes be? As we have seen with the permanent open market operations (POMO), it appears that much of the stock market ramp (at least for the first half of the 2009 rally) was demonstrably accomplished with POMO funds paid to primary dealers that plowed the money into stocks. We have also correlated large increases in bank non-borrowed excess reserves (green in chart below) with stock market ramps. The chart from the previous post is updated here:
Indeed, because the major primary dealers are US banks, most of the $114.1 Billion returned to them upon maturity of the SFP bills will end up in this category of non-borrowed excess reserves. Some of it may be required to support future Treasury auctions, especially if Treasury ups the longer dated auctions that have less foreign support (primary dealers are required to soak up excess supply at auctions). Indeed, next week, the 2 Year, 5 Year and 7 Year offering amounts have each been increased by $1 Billion. However, the potential is for at least a sizable portion of the $30 to $35 Billion to hit the equities markets each of the next six Thursdays after having been leveraged by 10 to 100 times or more.
Also, though quantitative easing in the form of Treasury POMOs is ending soon as it approaches the $300 Billion ceiling, the Fed is compensating with increased Agency POMOs (another $4 Billion bought today, $285 Billion to date), not to mention a total of $651 Billion in mortgage backed securities bought by the Fed this year.
The above is our warning to the shorts. Now, our warning to the longs. Below is our updated chart of M2 Money Supply Volatility, that we first brought to our readers’ attention in late July 2009.
The unprecedented contraction in money supply, as measured by 13 week percent change M2 non-seasonally adjusted money supply(yellow in chart), only intensified into early September 2008, as evidenced by the double dip at the far right edge. What this tells us is that the equities rally is running on vapors (likely in large part from the bank non-borrowed excess reserves portion of M0), with nothing to back it up (in the form of money circulating in the broader economy) once the vapors disappear.
Interestingly, Wednesday’s rally to 1074 in the cash S&P 500 touched a crucial level in the heavily traded SPY (S&P 500 exchange traded fund), which is the volume weighted average price (VWAP) of the entire down move from the October 11, 2007 high. The bulls and bears are thus at a crucial equilibrium point, and the coming weeks will announce the medium term winner.
In short, traders should be mindful of the potential for massive buying sprees as the $114.1 Billion is returned to primary dealers over the next six weeks (along with continued Agency POMO and MBS purchases) and also of the potential for the floor to fall out from under this rally once the funny money dries up. The next downturn will not be instantaneous, and there will be warning signs, which we will report on as always.
We are neither perma bears nor perma bulls, but are fortunate to have the luxury of reevaluating the markets on a day to day basis and to be able to adjust accordingly. True to history, it will be the longer term investors that will ultimately bear the brunt of this monetary and fiscal malfeasance.
Disclosure: No positions as of time of publication.