Friday, February 12, 2010

Fed's "Red Bull" Party Drawing to a Close...If Only Temporarily

In March 2009, with stock markets swooning towards a bottomless abyss, the Fed decided to throw a party. Their theme was Quantitative Easing and they proceeded to pour out $1.75 trillion of freshly minted greenback "Red Bull" for market participants. The party was launched with the announcement that the Fed would purchase $1.25 trillion of agency mortgage backed securities, $200bn of agency debt and $300bn of long term treasuries (a grand total of $1.75 trillion).
Add a comfortable 3-4x leverage on $1.75 trillion and you can see the enormity of the cash that got pumped into the asset markets. Here is how the Fed's Red Bull pump worked:


PIMCO's Classic Pump and Dump Scheme
Now one interesting point to note is that the Fed's $300bn purchase of U.S. Treasuries ended in October 2009. At that time, most sensible people (including us ;-)) had speculated that yields on the long bond would widen (as prices fall since the government bid disappears from the market). However it was not until December 2009 that U.S. treasury prices actually began to fall. Even now the U.S. Treasuries have rallied somewhat as a "flight to quality (i.e. trash)" trade has reemerged on account of the PIIGS crisis. So what happened?
Bill Gross of PIMCO provides the explanation. According to him, although the Fed stopped buying U.S. Treasuries in October, they nevertheless continued buying MBS from the likes of PIMCO etc. And PIMCO, like the old faithful dog was funneling this money provided by the Fed right back into the market to buy what else...U.S. Treasuries. So the U.S. Treasury prices were supported quite well until December 2009.
Of course what PIMCO was actually doing was buying from one hand and quietly offloading with the other. As we have reported earlier, in January 2010, PIMCO announced that it had offload most of its U.S. Treasury portfolio and was now looking to invest in German bonds. This announcement came within 3 months of PIMCO announcing to the world (in October 2009) that everyone should BUY U.S. Treasuries. Talk about pump and dump!

Even the Old Faithful Dog Can Get a Rabies Attack
Ever since January 2010, knowing that the Fed's Quantitative Easing party is coming to a close, PIMCO the Fed's trusted hound has been getting a case of rabies every time someone mentions U.S. Treasuries. Bill Gross is steering clear of them completely and offers a logical explanation, and we believe him this time:
Here’s the problem that the U.S. Fed’s “exit” poses in simple English: Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. The Chinese bought a little ($100 billion) of that, other sovereign wealth funds bought some more, but, foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve.
Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds. The conclusion of this fairytale is that the government got to run up a 1.5 trillion dollar deficit, didn’t have to sell much of it to private investors, and lived happily ever – ever – well, not ever after, but certainly in 2009. Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance. Not likely.
To REPEAT that again: The federal deficit for 2009 was financed by issuance of $1.5 trillion in U.S. Treasuries. Of these only $300bn was purchased by foreigners including the Chinese. The REST $1.2 trillion of U.S Treasury issuance were purchase by OUR OWN GOVERNMENT through the Fed's Quantitative easing pump.
Is this CRAZY or WHAT? And the media says Greece has a problem?
But Fear Not Folks...the Fed Will Soon Throw Another Party
The asset markets propped up since March 2009 by the Fed's gargantuan money supply have off late begun to swoon as the Fed prepares to temporarily shuts off the tap. Stock and commodity markets have already dived and high yield and corporate bond markets will soon follow. However do not expect a repeat of 2008's nose dive performance. If stock market dives too far (say the S&P dives below 1000), the Fed will throw another party. Actually regardless of any stock market dive the only way to finance the never ending stream of $1+ trillion of annual deficits, is for the Fed to throw many more Quantitative Easing parties.
But What About an Economic Recovery?
Anyone still left in the economic recovery camp only have Geithner, Summers and Bernanke for company. Yikes! Everyone else has left that camp, knowing full well that there is going be no recovery because the U.S consumer is completely tapped out. We leave the explanation to Bill Gross who says it best (yeah we dislike PIMCO, but he makes sense here, so bear with us):
There have been numerous changeups and curveballs in the financial markets over the past 15 months or so. Liquidation, reliquification, and the substituting of the government wallet for the invisible hand of the private sector describe the events from 30,000 feet. Now that a semblance of stability has been imparted to the economy and its markets, the attempted detoxification and deleveraging of the private sector is underway. Having survived due to a steady two-trillion-dollar-plus dose of government “Red Bull,” Adderall, or simply strong black coffee, the global private sector is now expected by some to detox and resume a normal cyclical schedule where animal spirits and the willingness to take risk move front and center. But there is a problem.
While corporations may be heading in that direction due to steep yield curves and government check writing that have partially repaired their balance sheets, their consumer customers remain fully levered and undercapitalized with little hope of escaping rehab as long as unemployment and underemployment remain at 10-20% levels worldwide. “Build it and they will come” is an old saw more applicable to Kevin Costner’s Field of Dreams than to today’s economy. “Say’s Law” proclaiming that supply creates its own demand is hardly applicable to a modern day credit-oriented society where credit cards are maxed out, 25% of homeowners are underwater, and job and income creation are nearly invisible.
There is no point in corporations producing any goods if no one has money to buy them. And jobs are certainly not coming back unless Obama decides to move U.S. industries back home from China. There is no other way to create jobs en mass to employ the jobless millions.
From 2000 onwards the entire U.S. economy was running on real estate fuel. Real industrial jobs displaced to China were filled by the growing ranks of real estate brokers, home flippers, home decorators etc. Think of all the people who lost jobs in real estate and related industries. Is there ANY other industry that can absorb the unemployed mortgage brokers, real estate agents and construction folks? Not to mention the jobs lost in peripheral sectors: home appliance, home improvement and finance sectors? We think not. And you certainly cannot retrain real estate brokers to do green jobs, most of which require highly skilled engineers.

2 comments:

dagnygromer said...

Perhaps the next Fed par-tay will be powered by methamphetamine. An order of magnitude step up? But remember what meth addicts wind up like.

Anonymous said...

The first shot of the second American Revolution has already been fired.

When will the true Partiots in this country stand up and say enough is enough?