Bank Reserves Continued Improvement

Finally, non-borrowed reserve growth took a small drop. Two key interesting points about this: 1) the fed was still slowly creating money as new reserves in March and didn't actually stop agency debt purchases until the 31st. 2) The drop means bank borrowing of free reserves grew faster than the fed was creating money.

Meanwhile, total borrowings from the central bank continues the steady decline. This means banks are unwinding some of the facility loans and using more of their own capital as backdrop against troubled loans.

We still believe fed funds will remain low for an extended period, but we continue to watch these reserve metrics for evidence that a turn of events is around the corner.

Fed Funds Rate History

During the last interest rate stimulated stock market recovery after the dot-com bubble popped, the federal reserve raised it's fed funds rate in July of 2004 (click the 'all' label above the chart). At that time, the market was just a bit over 1 year from it's bull market starting point in the late winter of early 2003. Just before the rate rose, the market had stalled and moved sideways a bit before making it's long run to the 2007 top.

Currently we are about at the same time frame from this markets launch point in the late winter of early 2009. With fed funds still sloshing around at the bottom of the barrel, and unborrowed reserves at astronomical levels, there's no reason to expect the funds rate to rise any time soon. The fed would have to sell everything they have into the repo-market to pull the excess reserves out of the system and get the funds rate to budge even a little.

So if they do want to raise rates, they're going to have to start some serious operations of a different kind to influence this market. Given Bernanke's propensity to come up with creative facilities for implementing policy, there's no telling how or when we will get some insight into their approach. Nevertheless, we are at a juncture where one would expect some kind of policy shift soon, or at least a stock market that takes a breather.

Another reason to anticipate something soon is the closed-door meeting of the board of governors that happened on Monday the 5th. On the weekend that link had the announcement of the unscheduled meeting under special rules of privacy. As we write, it's been removed. Nothing special came out in yesterdays March 16 meeting notes, so we presume the consequences from that meeting won't be known now until the actions are ready to implement.

The Fed's Report Card, by The Fed

The federal reserve put out their assessment of Ben Bernanke's helicopter ride in a report titled Large-Scale Asset Purchases by the Federal Reserve: Did They Work?

Presumably it isn't surprising they conclude what one expects when demand rushes in like a flood:

We present evidence that the purchases led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.

Well of course! When demand for security jumps, so does the price. For a bond, rates fall when prices fall. And given the money to fund the purchase was created out of thin air, there was no decrease in demand for competitive instruments. The money that may have purchased those bonds was free to purchase others.

The reductions reflected lower risk premiums because it was made perfectly clear that there is no limit to the money available (since it doesn't come from finite pre-existing money) and hence no reason to expect lack of funding. It didn't reflect lower expectations of future short-term interest rates because it was also made clear it would end and the dilution effect was sure to increase the inflation premium in future markets.

One wonders if the authors actually expected any other conclusion. Imagine a rocket scientist being surprised that propelling an object at 200 MPH in an upward vector would make the object fly, but eventually fall to the earth as the applied acceleration source was stopped.

In spite of the humorous angle, it's a good piece of writing for one who wants to get a good look at how open market operations function.

Now YOU Can Have Bank Reserves, Too.

"As an additional means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers."
(Source: Ben Bernanke's exit strategy testimony)

We have to hand it to this guy, he is one of the most creative bankers in history. In just two sigmas the American people can sink their claws into Federal Reserve excess reserves. Now all we need are 15 million savers willing to lock up their full FDIC insurance allocation in these new instruments, which will probably pay diddly-squat interest.

Of course money market accounts will have direct access, too, so the consumer angle is actually not that important, provided consumers feel compelled to put their money into money markets paying diddly-squat instead.

The real problem with bank reserves is that they don't provide a rate of return. The only way to entice the free market to park their money in reverse repos is to make them more attractive to alternative investments. So this plan can only work if interest rates rise (to attract capital into these instruments) or velocity of money remains low (velocity being the basis for high reserve balances as a threat). If velocity picks up, price inflation will also, and rates will naturally rise. The trillion dollar question is how quickly can rates stifle inflation forces, or will the lag between price increases and rate increases be a kind of self-accelerant of velocity. The feed-back loop could be phenomenal.

But that's all just speculation, isn't it? No doubt the creative genius of Bernanke will devise a plan for that at the right time. Of course Greenspan didn't stop the dot-com bubble, and Bernanke didn't stop the real estate bubble, so it's pretty hard to imagine what will provide Bernanke with the incredible insight and forethought to recognize how to prevent the next bubble. One thing is for sure, it ought to be interesting.

In July of last year we had similar comments on the exit strategy. One might want to compare notes, both ours and Ben's, to see how things have changed.

The Fed Did Not Raise Rates

Did the Federal Reserve just come out and surprise the world with a "rate hike"? Technically, yes. It all depends on what "is" is. Read the official press release.

Notice this isn't really changing the fundamentals. What really happened was they removed some of the recent "emergency" measures.

On August 17, 2007, the Federal Reserve reduced the spread of the primary credit rate over the FOMC's target for the federal funds rate to 1/2 percentage point, from 1 percentage point, and lengthened the typical maximum maturity from overnight to 30 days.

As we pointed out in "Credit Spreads Expected to Narrow", the business cycle is alive and well. The Federal Reserve basically just sent out a press release to that effect. They've restored the spread and duration to pre-crash conditions. Yea, the spread is still not quite there, but hopefully you get the picture.

This is a change at the discount window and TAF, not fed funds. Bernanke is pushing up that rate to force banks to suck up the fed funds and entice other bond holders to find repurchase funding in the commercial paper markets. We predict it won’t have any impact on lending costs just as they say (since fed funds are still over-supplied), but to the extent the public believes this is something big, there’s some good shorting opportunities for the next day or two.

This is more to do with normalizing the old methodologies than a real rate policy change. The daily Fed Funds market shows no signs whatsoever of "improving conditions" as far as market interest rates in ring-zero financing is concerned.

All through the policy changes leading up to market collapse the Fed Funds data revealed policy changes in the days leading up the public announcements. Expect to see something move there, too, before any real rate increases happens in monetary policy. As it stands the current news is just getting a few markets back to pre-crash normality.

How Ben Bernanke Saved the World

Subtitle: "How I Learned to Land a Helicopter", by Ben Bernanke

The title is past-tense for posterity's sake. This link needs to be remembered in the future when reality testifies on Ben's behalf. Fortunately for Ben we can never know what might have been -- we only know what he claims would have been if not for his policy, and must believe reality is better no matter how bad it is in fact, when the facts are in.

This, though, is his expose on how he plans to keep the world from hyperinflation after the biggest creation of fresh dollars the world has ever seen. Download a copy for posterity before the Wall Street Journal archivists cut off the link.

This isn't very reassuring: "we can raise the rate paid on reserve balances as we increase our target for the federal funds rate."

It's reassuring if all one cares about is ensuring that interest rates rise. We'd really like to know how the next upward move in fed funds isn't going to create a financial shock like all the others in this present generation. Granted, inflation is under control as measured by CPI and a few other choice tools, but 9+% unemployment is approaching historic levels, so this last fed funds move failed on the employment objectives. And apparently wiping out American investors' wealth is an acceptable outcome (as happened in the dot-com bust and now the real-estate bust) since it isn't a policy mandate to target preservation of American 401(k) accounts.

Furthermore, it doesn't address the bank's fiduciary duty to shareholders. How are banks going to justify tiny ROI when fed-funds level of yields are earned on an ever growing pile of reserves? This is going to pressure banks to use reserves for higher-yielding assets. To keep bank stockholders from rebelling, the rate on reserves is going to have to be higher than fed funds. This program will create a ceiling for fed funds, not a floor. Small banks without large in-house investment departments like Goldman and Morgan (recently converted to banks) are going to demand yields that match ROI garnered from their securities market operations. Equity investors will not stand for ROI in single digits. If banks can't make loans to business, they will seek out returns in other markets like securities.

As taxpayers, we're not very reassured. It is certain this board of governors won’t make the same mistakes as their predecessors, but equally certain the mistakes they do make will be costly. One can always offer the blind assurance that it would be worse with any other option. But of course you can’t prove what might have been. You can only have faith. When it comes to faith in the central bank policies, our only faith is that they will create a boom-bust cycle just like they have for generations. As for us, we’ll prepare for the inevitable disaster in what ever form it comes in the next business cycle bust, including the potential of having to pay 80% tax rates on inflation-induced capital gains for the "rich" (where rich is defined as anyone not a ward of government social programs) to pay for the next Keynesian stimulus devised for the consequential bust of present-day quantitative easing.

Follow up on Fed Funds

Late in June we pointed out the Fed Funds market rates were rising, and had actually hit the upper limit of the target range. It appears to have been a normal month end, if not quarter-end, phenomena. Since then, fed funds have fallen back to the teens.

We can see from the Term Securities Lending Facility Options Program (TOP) that collateral pressures are expected at quarter-end dates (emphasis added).

The program is intended to enhance the effectiveness of TSLF (Term Securities Lending Facility) by offering added liquidity over periods of heightened collateral market pressures, such as quarter-end dates.

However, we can see also from the historical data that the TOPS program started out heavily over-subscribed, but has in the last two offerings been under subscribed. This is consistent with our June 16th observation that credit conditions have significantly improved.

We don't mean to imply the world economy is robust and healthy, but as Hussman often points out, we will take the facts as they come and adjust our opinions accordingly.

Fed Funds Hits the Upper Limit

On Tuesday June 16th we pointed out the banks don't think they need bailing out any more as no one asked for any money through the CMBS TALF operations. On Thursday, "Effective Fed Funds" hit the upper limit set by current monetary policy of 0.25%. The Federal Reserve provides daily Fed Funds Data. For many weeks now the high of the day has been 1/8 point above the effective rate (a type of average), with the effective rate steadily rising. On Thursday that affective rate "hit the limit." So what?

To the extent that people believe Fed Funds are important, and to the extent computer models make decisions based on interest rates, monetary policy, and the fed funds rate in particular, it's very important to the direction of your stocks, bonds, and currencies.

Prognosticators and speculators have been suspecting the Fed would raise the fed funds rate.

Traders’ expectations of a Fed rate increase in November surged to more than 70 percent on June 5, according to federal-funds futures contracts traded on the Chicago Board of Trade. Expectations have since fallen to show a 32 percent probability of an increase. (Source: Bloomberg, June 17)

Now you know why. The bank's reserve requirements are dictating that it should, and futures traders know what that means to interest rates, just as bond market king Bill Gross pointed out in his November 2008 Investment Outlook "So CQish". Furthermore, if the fed funds rate rises, it indicates diminishing excess reserves. In a nutshell, that means either bank lending or loan loss write offs have returned. In absence of news about the latter, we conclude it must be the former. The natural expectation then is that GDP, interest rates, inflation, and bond market prices will soon be returning to normal, and by normal we mean 10 and 20 year time frames, not 2006.

But you don't have to speculate on what the Fed will do. Their hands are tied by the market place as far as Fed Funds go. John P. Hussman, Ph.D., President, Hussman Investment Trust, pointed out years ago that market prices of federal funds force the hand of policy planners. While we can't find the exact article, we were able to find a compelling discussion of the market mechanics from 2006 titled "Superstition and the Fed":

I should note at the outset that yes, as long as investors believe the Fed matters, it is important to consider the Fed. The real issue, however, is whether the Fed actually has any impact, and my argument is that it does not. It's an argument that goes against what we're conditioned to take for granted (and even what I once used to teach my own economics students). Nonetheless, the evidence against an effective Fed, when you scrutinize the data, is fairly compelling.

We encourage you to read the full article carefully and apply it to a market moving in the opposite direction. Most notably, the federal reserve has been building its inventory of bonds like never before. We all know it's part of the Quantitative Easing policy to stimulate the economy and provide liquidity to refinance the comatose mortgage markets. The side effect is that it provides more assets to help them become more effective. Unfortunately, Congress is working against that benefit by creating a huge mountain of new debt.

Now you understand what Bernanke means when he tells Congress their deficit spending puts stress on the economy and monetary policy. Just when he has a chance to get a leg up on controlling the marketplace with a larger SOMA inventory, Congress provides Bernanke's market competition with a massive new influx of inventory of their own. One of the points Hussman made is that the size of foreign bondholders inventory outweighs The Fed's inventory 3-to-1. That was yeas ago. Only time will tell which way that ratio changes in the coming months.

If we are right and the fed funds rate continues rising, the fed will raise their target this year. The only other possibility in light of rising fed funds rates would be an announcement of yet another 'facility'. With the RMBS market still under pressure from a high level of mortgage resets on the horizon, Bernanke can't afford to let rates rise this year. Our bet is on a new facility or policy announcement that doesn't involve a target rate increase giving them some additional influence on fed funds that they desperately need.

For more on the Federal Reserve's ineffectiveness to control the marketplace, read Hussman's special study on the topic from their Investment Research and Insight, "Why the Federal Reserve is Irrelevant". First published in 2001, he provides in depth discussion of the history of American policy and the effects on the influence of The Fed on the marketplace. It may be even more important than ever as the size of other market forces grow larger. China's Treasury inventory is the most obvious, and the huge inflow of new reserves provided by quantitative easing, but those are topics for another day.

It is a common saying, one who does not learn from history is prone to repeat it. The ever-analytical C. S. Lewis explains why in his essay titled Learning in War-Time:

... the scholar has lived in many times and is therefor in some degree immune from the great cataract of nonsense that pours from the press and the microphone of his own age.

Don't be duped by the cataract of nonsense. Check back with us often, learn how to see below the nonsense that pours from the press, and post your insights and data sources here at Stocks, Bonds, and Currencies, Oh My!

FED Funds Rising

Recently Fed Funds futures have been predicting a rise in the target rate by the Federal Reserve. Many pundits talk about how unlikely that is, (especially our friends at Across the Curve).

However, few bloggers or news services point you to the actual fed funds market. The Federal Reserve doesn't control fed funds directly, they can only "help it along" with the purchase and sale of bonds (it used to be Treasurys only, but to legitimize the "full faith and credit" implied support of agency bonds they now buy those, too).

If you've been watching that market, you'll know the rate has actually been moving up toward the higher end of the range. If you are interested in the bond market, you should bookmark the Federal Funds Data.

Like the CBOE e-mail we pointed out today, you can also sign up for free e-mail alerts on Fed Funds. We always recommend you get your data direct from the horses mouth, rather than rely on some editor to tell you what it says. You might think they are experts and know how to interpret it better than you, but read this blog daily and you won't need them to think for you.