Funding a Rally Extension

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):

CUSIP	Total Amount	Primary Dealer Amt	Maturity Date
912795S36	$35 Billion	$24.3 Billion	Sep 24 2009
912795P54	$35 Billion	$16.7 Billion	Oct 1 2009
912795P62	$30 Billion	$12.6 Billion	Oct 8 2009
912795P70	$35 Billion	$23.3 Billion	Oct 15 2009
912795S44	$35 Billion	$14.3 Billion	Oct 22 2009
912795P96	$30 Billion	$22.9 Billion	Oct 29 2009
Total	$200 Billion	$114.1 Billion

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:

1. 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.
2. 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.
3. 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 U.S. Dollar carry trade alive and well (a topic for another article).
4. 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 U.S. 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.

Comments

[Michael Clark:]

Very interesting article.

Sep 19 12:51 PM

[SecretaryNo...:]

Assuming the 114 billion returned to the equity market via the primary dealers...anyone know what that would translate to on the S&P, DOW indexes etc? What percent is the 114 billion of the current equities market total capitalization?

Sep 19 12:57 PM

[Roger Knights:]

SecretaryNo: If you follow the links to the author's blog you'll find links to his other articles, in one of which he avers that large financial institutions can leverage these amounts by 100-to-1. That's what it would take to goose the market so much. (That, plus whisper-awareness among insiders on WS that in some manner "the fix is in.") If so, the unwinding, when it comes, could proceed at warp speed. I.e., SPROING!!!!

PS to my comment above: It's not out of the question that the Fed would engage in some such hanky-panky, because they've already done a little. It's been revealed, by Chris Martenson on this site, that the Fed is engaged in a shell game with Agency bonds held by foreigners, buying them on the QT in exchange for their buying Treasuries.

Sep 19 01:26 PM

[Albertarocks:]

There's one element to the market run-up that I started to notice right at the beginning in March, and has continued every step of the way. And that's the incredible number of stick saves and sudden explosive surges that are just mind boggling. There basically hasn't been a single week where these haven't occurred. They've been so big, and involve so much money that the retail investor obviously isn't causing them. That only leaves the big money players and I doubt any of the fund managers have the foresight (knowing when to pull the trigger), nor the ability to hit every single index at the exact same time. It's the tentacles of the FED who are doing it. And as long as the FED and its minions are feeding this monster, simply to keep it climbing regardless of logic... it's just going to become more and more dangerous with each passing day.

When I see every single sector take a sudden massive spike all within the same single second on the clock, somebody out there is manipulating. This is creating an environment so damned dangerous for the retail investor that we'd all better just stand aside now. IOW, walk through the exit now... before it gets jammed up with fund managers and piggybankers.

Sep 19 02:22 PM

[Michael Clark:]

We've all known in our guts and in our powers of deduction that this 'fixing' has been going on. It's a way to make sure that the government gets paid back by the banks and insurance companies, those that got all the bailout money. If the market rallies, if worthless companies can look smart again, make a profit, and pay back the government, the government can them go back on the campaign trail without getting hit everywhere they go with rotten eggs or worse (by government I mean both parties -- this mess belongs to both parties).

Now we seem to have the smoking gun.

But why would we ever trust the stock market again? If the government can make it go up when it wants, it can also make it go down. Who is going to be the first to know when it's time to sell? Well it won't be you and I, mister and missus small, average investor. The banks and the government are in bed together, exchanging toxic fluids...so they might as well have a good time.

We should not forget that this fix is immoral and should be illegal -- and the next government that's elected should clean house and send the fixer's to prison for insider trading. How much more inside can it get -- the Fed Chairman is working with the banks to fix a profit flow in what were supposed to be independent, free, neutral markets. They are gone now. The stock market is a ponzi scheme; and Bernanke is another Bernie Madoff.

Sep 19 03:52 PM

[Burticus:]

In summary, thanks to the coup of 1913, we live in a fascist oligarchy where a bunch of gangsters with paper and green crayons now puppeteer everything for the profit of their Illuminist masters. There are no markets any more, only interventions and manipulations. By comparison, these scum make Al Capone look like a schoolyard bully stealing kids' lunch money.

Forget fundamental and technical analysis. Based on the "interventionals", rope futures should be the next 10-bagger investment opportunity.

We now return to the corporate media cartel's regularly-scheduled reruns of the elephant and jackass show...

Sep 19 08:40 PM

[Jan Paul:]

On Sep 19 02:22 PM Albertarocks wrote:

When I see every single sector take a sudden massive spike all within the same single second on the clock, somebody out there is manipulating. This is creating an environment so damned dangerous for the retail investor that we'd all better just stand aside now.
====================

Marc Faber said that today in an interview on Financial Sense I listened to.

Sep 19 10:32 PM

[JeffDB:]

Here's a chart of the reserves at the Federal Reserve Banks from Jan 1,1984 to 9-16-09 (updated 9-18-09).

www.scribd.com/doc/199...

There's definitely a pretty large jump in 2008 onwards. I don't know if the Treasury's account you are talking about is included in there or not.

M1 had a strong jump in late 2008 & early 2009 as well.

research.stlouisfed.or...=,


M2 has been going up steadily, with only a slight dip as of the 9-7-09 date of this Fed chart:

research.stlouisfed.or...=,

Sep 20 12:16 AM

[JeffDB:]

On Sep 19 01:26 PM Roger Knights wrote:

>... PS to my comment above: It's not out of the question that the Fed would engage in some such hanky-panky, because they've already done a little. It's been revealed, by Chris Martenson on this site, that the Fed is engaged in a shell game with Agency bonds held by foreigners, buying them on the QT in exchange for their buying Treasuries. >

I believe it was this article:

How The Federal Reserve Is Monetizing Debt

seekingalpha.com/artic...

Chris Martenson's other articles:

seekingalpha.com/autho...

Sep 20 01:26 AM

[Roger Knights:]

Thanks for providing those links. Here's a speculative example of what might be going on. Let's say that a State Owned Enterprise in China is about to default on a derivative it signed with a Western bank. If the Fed were to buy this toxic asset, the China would say, "OK, we'll buy Treasuries for awhile," and the bank would say, "You want us to prop up the stock market? Can do." This would explain the action in the markets, if a lot of this sort of stuff were going on. (And it would also explain why the Fed doesn’t want to be audited.)

The Fed wouldn't feel it was doing anything wrong. It would feel it was saving the system. It would feel the choices are between letting GD2 occur and taking a chance on a recovery by kicking the can down the road and playing for time. Even if they are dubious about their prospects for success, they know they'd be blamed for doing nothing by mainstream opinion if they didn't act and an immediate depression occurred. They may feel they have run out of good options at this point. The clock may have run out in 2002 or so, when the Fed failed to follow the Taylor Rule.

Sep 20 08:42 AM

[Bob English:]

Correct. Should be September 2009. Thanks.


On Sep 19 08:46 AM lower98th wrote:

> "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"
>
> 2009?

Sep 20 12:51 PM

[Michael Clark:]

It's nice to hear that someone with Faber's exposure is saying what many of us know and say to be true.


On Sep 19 10:32 PM Jan Paul wrote:

>
>
> When I see every single sector take a sudden massive spike all within
> the same single second on the clock, somebody out there is manipulating.
> This is creating an environment so damned dangerous for the retail
> investor that we'd all better just stand aside now.
> ====================
>
> Marc Faber said that today in an interview on Financial Sense I listened
> to.

Sep 20 12:55 PM

[Bob English:]

Thanks to everyone for your thoughtful comments and the new follows. We're new to SA and look forward to bringing you more articles in the near future.

Sep 20 01:05 PM

[beaux:]

Interesting analysis. Well done. I think you may be on to something.

But it must be said that the posts following the article are so consistent in their vitriol and cynicism for this rally one could be forgiven for concluding that they find themselve among those who have missed this move (or have even played it from the short side) and are experiencing an associated emotional reaction. It reminds me of the emotional outbursts that the longs expressed on the meltdown. Perhaps melt-ups provoke the same responses.

Could it be that the posts, as a contrarian indicator, suggest that the rally may indeed have some way left to run?

Sep 20 08:47 PM

[willynill:]

The author said there will be an additional six weeks of "funny money" going into the market, but then watch out as the funny money runs out. It's going to be an interesting fall! (autumn)


On Sep 20 08:47 PM beaux wrote:

> Interesting analysis. Well done. I think you may be on to something.
>
>
> But it must be said that the posts following the article are so consistent
> in their vitriol and cynicism for this rally one could be forgiven
> for concluding that they find themselve among those who have missed
> this move (or have even played it from the short side) and are experiencing
> an associated emotional reaction. It reminds me of the emotional
> outbursts that the longs expressed on the meltdown. Perhaps melt-ups
> provoke the same responses.
>
> Could it be that the posts, as a contrarian indicator, suggest that
> the rally may indeed have some way left to run?

Sep 20 09:41 PM

[Albertarocks:]

On Sep 20 08:47 PM beaux wrote:

> But it must be said that the posts following the article are so consistent
> in their vitriol and cynicism for this rally one could be forgiven
> for concluding that they find themselve among those who have missed
> this move (or have even played it from the short side) and are experiencing
> an associated emotional reaction. It reminds me of the emotional
> outbursts that the longs expressed on the meltdown. Perhaps melt-ups
> provoke the same responses.
>
> Could it be that the posts, as a contrarian indicator, suggest that
> the rally may indeed have some way left to run?

You appear to be missing the point here. I think most of the posters here who are expressing their concerns with a certain amount of "vitriol" have in fact made money on the long side during this rally just as you apparently have. That's not the point. The point is that the market has evolved into a rigged game where all the cards are marked and only the FED and it's puppets have access to the playbook. That's the point. The market has become too dangerous even for bulls like yourself.

Sure we are spewing venom here, but it's not because some of us might have lost some money shorting at the wrong time. It's because of the insanity of the whole game. Why these thugs aren't already strung up from the nearest lamp post is beyond me. I swear, if they keep pushing all these wrong buttons and stealing money, futures of children, lives and the lifeblood of humanity itself... they might face the Ceaucescu treatment sooner than they think.

I've made money being long this market. And I'm still spewing vitriol because I want to be alive 10 years from now. How does that grab ya?

Sep 20 11:45 PM

[Barbarous R...:]

M2 growth is collapsing largely because it wrongly includes money market mutual funds (MMMFs) as money. Thus when people are nervous and buy MMMFs as in late 2007/early 2008, M2 treats this as money creation and surges -- an exercise in double-counting. Then when people become more comfortable and redeem their MMMFs (as they are now), M2 reverses the double counting and treats this as money supply destruction. Money is neither created nor destroyed by buying or selling MMMFs.

In reality, U.S. money supply growth is down from explosive rates earlier this year, but is still growing rapidly. M2 paints an inaccurate picture.

I do agree, however, that financial assets (bonds, stocks, commodities) are being bid up almost entirely as a result of money supply growth. I'm just not sure this will end any time soon. As long as money supply growth stays high (as I expect it will, for as long as the Fed can point to a benign CPI), I believe any selloffs will be modest and that there will be a constant bid from "cash on the sidelines".

Sep 21 04:24 PM

[Albertarocks:]

On Sep 19 08:40 PM Burticus wrote:

> We now return to the corporate media cartel's regularly-scheduled
> reruns of the elephant and jackass show...

That's such a good line, with your permission I'm going to enter it into my book of "best one liners".

Sep 22 12:15 PM

[dennyob:]

Hi Bob,

great article.
we live in Naples.
are you on the east or west coast of So FL?
cheers,

Denny O'brien
email: [e-mail]

On Sep 20 01:05 PM Bob English wrote:

> Thanks to everyone for your thoughtful comments and the new follows.
> We're new to SA and look forward to bringing you more articles in
> the near future.

Sep 24 08:19 AM

[Old Rick:]

beaux wrote: But it must be said that the posts following the article are so consistent in their vitriol and cynicism for this rally....
----------------------
I didn't detect as much vitriol for the rally as for the Fed and the folks who are fueling/manipulating this faux bull

Sep 28 03:30 PM