Sunday, December 02, 2007

An Irrelevant Fed: Thimbles of Water in a Forest Fire / Hussman

Always good to start the week with some rational thoughts from Hussman

Immer eine gute Idee die Woche mit erhellendem von Hussman zu starten

An Irrelevant Fed: Thimbles of Water in a Forest Fire
Pop Quiz
How much “liquidity” has the Federal Reserve “pumped” into the $12.7 trillion U.S. banking system since March 2007?

a) $1.2 trillion, which banks have used to firm up their balance sheets

b) $600 billion, which banks can now use to make new loans

c) $16 billion, all of which has been drawn out of the banking system as currency in circulation

If you answered c, move to the head of the class. Investors who answered a or b have not only been misled by analysts and media stories, but have no idea how irrelevant the Fed's actions are likely to be, except on short-term market psychology. More charts and data below. ....

The Fed can certainly penalize savers by pressuring deposit rates lower, but it isn't having a measurable effect on the market-determined interest rates that borrowers actually face. Nor can the Fed significantly affect the solvency of the mortgage market.

As for stocks, I noted a couple of weeks ago (extending Jim Stack's analysis) that in each instance that the market declined materially after successive discount rate cuts, S&P 500 earnings were down sharply a year later. Given that a large portion of S&P 500 profits are from financials, that profit margins in other industries are well above historical norms, and that profit margins have always collapsed during recessions, my impression is that S&P 500 earnings could easily fall by 40% over the next 18 months (investors who view this as impossible haven't examined earnings history). This could become far worse than a 5% decline off the high, which is where the S&P 500 is now.

FT Equity investors: Denial is not a river in Egypt

Suppose three years ago, they said, you had been given the following scenario for November 2007: oil close to $100 a barrel, the dollar at $1.50 to the euro, corporate profit margins at a record high but starting to turn, house prices falling in the US and the UK and the global banking system in chaos. Would you have predicted that European equities would be only 6 per cent off their peak?

It's possible that investors could adopt a fresh willingness to speculate on the hopes and eventuality of a Fed rate cut (the economic news this week will determine the likelihood of 25 vs. 50). Regardless, given the economic backdrop, my impression is that any such speculation would be short-lived - as it has after other Fed cuts this year. For now, we don't have evidence to support any amount of bullish speculation. ..... In any event, historically, investors would have considered themselves lucky to clip off their excess risk so close to all-time highs, even after market action and economic news began to sour.

The Fed – thimbles of water in a forest fire
My greatest concern at present is that investors are being bombarded with empty hope that the Fed will save them by “injecting liquidity” into the banking system. Time spent examining these false perceptions is not time wasted.

Very simply, the impact of Fed actions is sorely exaggerated. The amount of liquidity that the Fed provides is minuscule in relation to the U.S. banking system, and also in relation to the volume of capital inflows (about $2 billion daily) that the U.S. relies on from foreigners, thanks to our massive fiscal deficits and low savings rate.

What strikes me as particularly absurd is that the analysts who wax rhapsodic about “Fed liquidity” speak in a way that makes it obvious that they have no understanding of how these Fed operations work. Then again, it's precisely because we do understand how they work that we're convinced that they're irrelevant (aside from boosting short-term market psychology and accommodating short-term spikes in the demand for currency).

Let's start with a basic fact. There is only one monetary aggregate that the Fed directly controls: the monetary base – consisting of currency in circulation plus bank reserves. Here's the data.

Monetary Base : = Currency in Circulation : + Total Reserves :

In the early 1990's, reserve requirements were abolished on everything but demand deposits (checking accounts). Since then, the quantity of bank reserves has gradually declined, and has no relationship with the volume of bank loans or total bank assets – again look at the data. In recent months, as has been the case since the early 1990's, virtually all of the increase in the U.S. monetary base has represented the gradual and predictable increase of currency in circulation, held outside of the banking system.

So how does the Fed increase the monetary base? There are three sources of “liquidity” managed by the FOMC: permanent open market operations, temporary open market operations, and loans through the discount window. Let's take a look at each. Again, here are the Fed's own statistics:

Permanent Open Market Operations:
Temporary Open Market Operations:
Discount Window Borrowings:

The Fed uses permanent open market operations primarily to finance the gradually increasing stock of U.S. currency in circulation. The Fed buys Treasury securities (which become an asset on the Fed's balance sheet) and pays for them by printing money (a liability of the Fed, as evidenced by the words “Federal Reserve Note” on top of the pieces of paper in your wallet). The Fed has not engaged in any permanent open market operations since May.

Next, the Fed can use temporary open market operations to vary the amount of day-to-day reserves in the banking system, in order achieve the targeted Federal Funds rate (which is the interest rate that banks charge to lend reserves overnight to other banks that are temporarily short). What's important is that these are temporary operations, in the form of “repurchase agreements”: the Fed provides reserves to the banks, usually for periods of 1-14 days. It purchases Treasuries or government-backed mortgage securities from the banks as collateral, and at the end of the period, the banks are obligated to buy them back from the Fed, at the purchase price plus interest.

What's important here is that every time a repo matures, the Fed generally enters a new one for a similar amount. The average maturity of these repos is only about 7 days, so there is a lot of activity. These transactions are constantly reported by the media as if they are “new injections” of liquidity – but they are just rollovers. If the Fed does a $20 billion 7-day repo one day, you can pretty much bet that the Fed will be doing another $20 billion in repos a week later when the outstanding one comes due. What matters is the total amount of repos outstanding. The chart below presents the 30-day average of Fed repos outstanding since March (see the above link for source data - thanks to Brooke Steinau for tying all of these figures out).

Note that the total amount of liquidity added by the Fed since March is only about $16 billion (it turns out that all of this has been drawn out of the banks as currency in circulation, probably for good, so at some point in the coming months, the Fed will undoubtedly do about $10-$15 billion in “permanent” open market operations to recognize this withdrawal, and will simultaneously reduce the outstanding amount of these “temporary” repos).

The third way the Fed can “inject liquidity” is to make loans to banks through the “discount window,” for which it charges interest at the “discount rate.” While market participants behave as if changes in the discount rate are wildly important, the fact is that even at their peak last summer, total loans to banks through the discount window only rose to about $3 billion. Currently, the total amount of “liquidity” being lent by the Fed through the discount window is $55 million. Yes, million.

FT Fed considers steps for money market

The Federal Reserve is considering measures to make liquidity more readily available to financial institutions. Analysts close to the Fed believe it is considering a cut in the discount rate, at which it lends directly to banks, and steps to reduce the stigma associated with such borrowing. The Fed could announce plans to cut the discount rate by 25bp to 4.75%. That would halve the interest penalty on discount window borrowing compared to the main, Fed funds, rate of 4.5%. The reduction of the discount rate penalty could come before the next FOMC meeting on Dec 11 if credit market conditions remain stressed. Alternatively, the Fed may cut the discount rate by an extra 25bp over and above any reduction in the Fed funds rate at that meeting, the analysts said.

> Maybe this could bring the amount back over $ 100 mio...... Watch for the spin if this move happend outside the regular Fed meeting ....I´m pretty sure that almost nobody will mention that the entire discount window borrowing is almost nonexistend despite the latest cuts...

> Evtl. könnte dieser Schritt die Summe ja über 100 Mio hieven..... Sollte dieser Schritt ausserhalb des regulären Fed Meetings stattfinden dürfe das als Anlaß genommen werden die Spinmaschinerie heißlaufen zu lassen..... Ich vermute das die Tatsache das diese Art der Kreditversorgung trotz der bisherigen Senkungen keinerlei Rolle gespielt hat mal wieder "unterschlagen wird"......

Last week, investors made a great deal about an $8 billion 43-day repo that the Fed initiated. While this was reported as an extraordinary measure to stabilize the financial markets, the fact is that the Fed regularly enters a long-dated repo every year, just before the holidays, in order to accommodate a moderate increase in the demand for currency (in 1999, the amount was massive because of year-2000 fears, and was quickly reabsorbed after the new year). The $8 billion repo the Fed entered last week amounts to roughly $25 per American in extra cash to carry around the malls. To frame this as some sort of extraordinary effort to stabilize the banking system is absurd.

Again, the problem with the U.S. financial system here is not liquidity, but the solvency of mortgage loans and securitized debt. The Fed's actions are not likely to have material impact on this. To believe otherwise is mindless sheep-like superstition. Do investors really want to bet their financial security on the hope for “Fed liquidity” promised by uninformed analysts who don't understand monetary policy because they can't be bothered to look at the data?

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Anonymous Worried said...

If Hussman is correct then more or less it is the end of the world as we know it. He is implying an unstoppable credit collapse that will destroy more or less everybody and probably everything by the time it has played out with wars and famine and so forth.

The world will be saved no doubt.

10:45 PM  
Anonymous SPECTRE of Deflation said...

Bravo to Hussman for providing facts, and to you for pointing out his great piece. Wall Street is clueless concerning Repos, and the sheeple are happy not knowing the facts. It will end very badly.

6:26 AM  
Blogger guyon said...

Doesn't banks borrow reserves from the FED through repos & the discount window?
What I mean is these reserves can support roughly 10x as much in actual loans, n'est-ce pas?

1:30 AM  

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