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The Federal Reserve Bank is in a very serious box as it pertains to the current financial system. The banks need profits or their creditworthiness becomes suspect. They can only profit if they lend based on the sound collateral found on their balance sheets. The most sound collateral is liquid, AAA-rated treasury bonds that continue to keep their value, as yields decline or stay very low.

As it turns out, the Fed is necessary in creating that collateral through QE. The Fed swaps treasuries from their balance sheet, to banks who use it to fund traders in commodities and stocks, for the bad collateral that cannot be traded by the banks. There is no market for the bad collateral. Also, some of the bad collateral is mortgage backed securities for which there is no market. So, QE is instrumental in infusing banks with good collateral, which is used to fund traders.

However, there is a big problem. The Fed, in sustaining QE, is buying all the good, long-term collateral up itself. The Fed issues short term bills, up to 10-year notes, and buys long-term bonds. There is more demand for long term bonds than there are bonds because the Fed is buying them up. Not only do banks need these bonds, but so do pension funds and insurance companies. They have been forced to take on bad bank collateral in deals that will help the banks get good collateral, but put the insurance companies and pension funds under pressure as they hold bad paper. The pension funds and banks would prefer to buy quality paper but there is no return there, so they are forced to take unacceptable risk on opaque collateral that cannot be valued.

In a deflationary environment, which we are looking at, long-term bonds could go higher in value with lower yields. The treasury market is being held up in value, according to Zero Hedge, because there is a shortage of quality treasuries the world over for the $700 trillion derivatives market. As more derivatives go toward clearinghouses from direct swaps that proved suspect in the last credit crisis, more collateral is needed. The clearinghouses must have quality debt on their books that can be seized for losses.

Now, one would think that the Fed could stop buying treasuries and just let the banks buy them from the treasuries, since there is a shortage. However, it appears as if the banks have such a huge amount of bad collateral on their books that the Fed feels it is necessary to keep buying treasuries, swapping out the treasuries for the bad collateral onto a rapidly expanding balance sheet.

It has been reported, by Business Insider, that the Fed will not be replenishing the interest it gets back to the Treasury. Is this because the Fed has such bad collateral that it is being de facto bailed out by the Treasury? The Fed is a private bank being bailed out from its obligation to return the interest on the bonds it buys from the Treasury. This is not good, and if the Fed continues to buy the treasuries in order to swap them with crap bank collateral, doesn't that show how weak our TBTF banks really are?

Yet, the TBTF banks are selling the good collateral they have to the traders in exchange for more bad collateral. While I am not certain about the flow of this, it looks like the traders have bad collateral. They swap it to the banks for treasuries in order to be in the derivatives and speculation markets. The banks get rid of the bad collateral to the Fed who swaps it for the good treasuries it holds. Then, the Fed's balance sheet gets more rotten and more rotten as time goes on, so much so that it is unable to pay interest back to the treasury on the treasuries it holds. And the banks hide bad capital as well, as I wrote here.

The reason the Fed buys long-term bonds is to bolster confidence in the U.S. as the only nation that has not defaulted on its bonds. Even Germany has defaulted twice in the last hundred years, according to the article by Zero Hedge (linked to above). The longer the bond, the more confidence that the nation will not default. But more countries are being cut out of markets because their bonds are losing value because of fear of default. The pressure is on for the U.S. and the governments with highly rated bonds to spend more. Yes, that is right, to spend more. That may not be sustainable.

So, with only a certain amount of quality liquidity amidst a growing derivatives market, you wonder where all this is going. Supposedly, austerity secures the quality of the AAA bonds we issue. Or at least that is the thinking of many bankers. Yet, the bankers demand more quality AAA bonds only made possible by our government spending a lot more money. But either way, this fight for the AAA bond funnels capital towards speculation in derivatives futures, which undermines Main Street. One wonders how long this rising cost of living, which skims profits for the banks, will do in the real economy.

I view this state of affairs as being deflationary rather than inflationary. The real economy does not have an increase in money, because it all is going to this speculation. There may be too little money on Main Street as the economy grows very slowly, and wages decline. The velocity of money is simply not there. Yet, the Fed is making this problem with the real economy worse with the QE that provides liquidity to the very derivatives market that wrecks havoc on the cost of living.

So, the Fed is in a box in working to improve the profits of the banks through the creation of good collateral into the system, while the real economy suffers from the very same process. It is necessary for the nation not to default on its bonds; that it keep this demand for collateral up. Yet this is hollowing out Main Street. Inflation is caused by too much money created chasing too few goods with high velocity of money. The Fed actually wants the velocity of money at the Main Street level to remain slow and low. That insures that it can continue to keep bonds in demand. After all, like I said a long time ago on Seeking Alpha, Ben Bernanke is a bond salesman first and foremost. That is his job. Creating demand for treasury bonds is also his job. And he is doing it well. The question remains is whether the nation can survive the medicine.

As Matthew Boesler of Business Insider has correctly pointed out, a shortage of quality bonds will result in deflation, not inflation. Cash may be king after all. And austerity could come from a shortage of currency, which is created by lending against collateral, down the road. (I have compiled a list of articles on the subject of collateral upgrades and shortages.) If cash is king, stocks could be risky and risky assets could have heightened risk. Perhaps return of capital could be more important than return on capital going forward.

Source: How The Fed Is 'In A Box' In Terms Of Creating Sound Collateral