A few days ago I wrote an article - Things You Probably Don't Understand About Russia's Agenda And Why You Need To Understand Them - in which I made the following statement:
What I do know is that the US dollar is under immense pressure, largely as a result of the decision by China and others to bypass the dollar. What that means is that dollars are not being held as foreign exchange reserves to the degree they were prior to the decision to bypass the US dollar in foreign exchange transactions.
For the Fed to continue to flood the system with dollars at the same time dollars are being dumped into the market by China and others creates significant supply/demand imbalances, resulting in downward pressure on the US dollar. The truth is the Fed must withdraw QE, and I would not be at all surprised if the Fed isn't engaging in reverse repos right now to sterilize the QE purchases and withdraw as much liquidity through the reverse repos as they are injecting through QE.
You will note that I used the word "probably" as it pertains to the matter of the Fed using reverse repos to effectively sterilize QE asset purchases. At the time I wrote the article I was setting forth a supposition. That is not like me as I tend to be pretty thorough.
That said, I did know the immense pressure the Fed was under and the need for the Fed to avoid market panic by simply ending QE all at once. The better plan - now that investors were sufficiently desensitized to QE withdraw - would be to feed the public a slow withdraw of QE story predicated on the idea that the economy was improving and could now move off the Fed's QE life support.
I, of course, knew that such a story was nonsense as the economy is not improving and in fact the opposite is true. I also knew that the Fed and the US dollar had been under immense pressure ever since China began the process of entering into bilateral trade agreements with other countries back in 2013 and, in so doing, they were bypassing the US dollar.
My assumption was that the Fed was engaging in higher than usual levels of reverse repos but when I searched the web for a story that would inform me on this matter I found the coverage almost non-existent. I did find this article from Reuters - U.S. money funds put $72 billion into Fed's reverse repos: J.P. Morgan. The following is the text of the article in its entirety:
(Reuters) - U.S. prime money market funds parked $72 billion with the Federal Reserve in December as the central bank ramped up its testing of a program aimed to help the central bank achieve its targeted interest rate when it eventually begins raising rates, a report by J.P. Morgan Securities released on Monday showed.
The amount placed by prime money funds in the Fed's fixed-rate reverse repurchase agreement program last month was up from $68 billion in November, J.P. Morgan said.
The Fed's reverse repo test has involved money funds, banks and government-sponsored enterprises placing fund with the central bank overnight in exchange for Treasuries. These counterparties earn interests on the reverse repos.
The amount of reverse repos that prime money funds held at the end of December was equivalent to 5 percent of their $1.5 trillion in total assets, J.P. Morgan said.
On December 31, the Fed awarded a record $197.8 billion worth of fixed-rate reverse repos, paying an interest rate of 0.03 percent to 102 bidders, according to data from the New York Federal Reserve, which doesn't offer details on bidders.
The year-end spike in money funds' allocation into the Fed's reverse repo program "was not surprising given the typical tight supply conditions going into year-end as banks and dealers manage their balance sheets, while cash investment needs typically increase," J.P. Morgan analysts wrote in the report.
Not satisfied with that information, I decided to take a look for myself to see just how engaged the Fed was in their reverse repo actions. What I found was truly astonishing and much greater in magnitude than the numbers reflected in the Reuters article referenced above. We will get to that in a moment, but first a look at what the Fed provides in the way of data for each reverse repo action.
The table above is an example of the information the NY Fed discloses on each reverse repo and all the NY Fed's activity on reverse repos can be found by accessing their website here:
Here is the full list of the Fed's reverse repos for the calendar year of 2014:
Understand this - the Fed has done a total of more than $4 trillion in reverse repos in just a little over 2 months. That is a huge number and suggests they are more than a little panicked about something. We will get back to what that something is in a moment but for now let's do a little math to see what all this means.
There are a total of 50 reverse repos listed above so the average is $80.577 billion. What is important to understand is that a reverse repo withdraws liquidity from the banking system and has the opposite effect of an asset purchase under the Fed's QE program. Under the QE program the Fed injects cash into the system by buying a security and in a reverse repo the Fed withdraws cash by selling a security.
The Fed is effectively withdrawing on average $80.577 billion a month at the same time they are conducting asset purchases under QE. According to the Fed website their balance sheet assets totaled $4.02360 trillion on January 1, 2014 and $4.159972 on February 26. The difference between the two numbers is $136.322 billion. Using the average value of the reverse repos of $80.577 for two months the total value of the withdrawals from the system equal $161.114. In other words, the Fed has essentially reduced liquidity in the system from January 1st through the end of February by approximately $24.782 billion during that two month period.
To put the matter in perspective, the Fed conducted a total of $14.17 billion in total reverse repos from January 1, 2013 through August 14, 2013. On August 15, 2013 the Fed did a total of $45.14 billion in reverse repos in a single day - over 3 times the total of the previous 7 1/2 months combined. From August 15, 2013 through the end of 2013 the Fed did a total of $681.31 billion in reverse repos and the month of December alone represented $313.72 billion of the total.
So why is the Fed so aggressively clamping down on QE?
The answer to that question sure isn't the spin story we hear from the pundits - the one that says the Fed can finally start withdrawing QE because the economy is finally picking up. The chart below of the US dollar index is the reason. First, a look at the chart and then I will explain:
As the chart above reflects, the US dollar began a steep descent in July of 2013. The reason - China. Here is an excerpt from a Reuters article from August of last year - China, Japan lead record outflow from Treasuries in June:
(Reuters) - China and Japan led an exodus from U.S. Treasuries in June after the first signals the U.S. central bank was preparing to wind back its stimulus, with data showing they accounted for almost all of a record $40.8 billion of net foreign selling of Treasuries.
The sales were part of $66.9 billion of net sales by foreigners of long-term U.S. securities in June, a fifth straight month of outflows and the largest since August 2007, U.S. Treasury Department data showed on Thursday.
The next excerpt explains that China again dumped another round of US Treasuries in December of last year as reported by Bloomberg here:
China, the largest foreign creditor, reduced its Treasury holdings to $1.2758 trillion, and Japan trimmed its holdings for a third straight month to $1.0834 trillion. Combined, they accounted for about $40 billion in net Treasury outflows.
China, the largest foreign U.S. creditor, reduced holdings of U.S. Treasury debt in December by the most in two years as the Federal Reserve announced plans to slow asset purchases.
The nation pared its position in U.S. government bonds by $47.8 billion, or 3.6 percent, to $1.27 trillion, the largest decline since December 2011, according to U.S. Treasury Department data released yesterday.
So why has China been such an aggressive seller of US Treasuries? The following excerpt from a November, 2013 article - Harbinger: 23 countries begin setting up swap lines to bypass dollar - offers the only plausible explanation:
What started in September of last year, when an agreement between China and Russia ended the dollar's stranglehold over oil and how it was purchased, the past 14 months have seen a momentous rush towards setting up the infrastructure to replace the dollar completely in global transactions. And with 23 countries, including those from the BRICs nations and the Eurozone, preparing for new swap lines outside of dollar hegemony, the fuse has been lit on the dollar's death rattle, and the when has changed into the now.
Despite a number of my readers who continue to insist I am wrong on my conclusion that the US dollar is under attack, I would suggest to you that I am in fact right and the Fed's drastic actions - actions that they have concealed from the investing public by omission - attest to that fact. The sheer size of the reverse repos the Fed has engaged in since the first of the year - and they didn't miss a single day by the way - suggest they are fighting with everything they've got at their disposal to prevent a market panic and keep a floor under the dollar.
Will they win this war? I certainly don't know how they can. Of course they can continue to withdraw liquidity with reverse repos while moving as fast as they can to end QE but I'm not sure they can stave off disaster for much longer. $4 trillion in reverse repos in just a little over 2 months is a lot and the dollar index is still under pressure. My own view is that they must defend the 79.00 level. Here is the 30 minute chart of the dollar index showing that we came perilously close to that 79.00 level yesterday before again coming under pressure overnight:
And what is happening to those dollars that are being dumped. This is just a guess but as it pertains to China and most of the BRICS and emerging market countries are concerned my guess is they are buying gold. Perhaps a look at a gold (NYSEARCA:GLD)chart will inform us as to the accuracy of that guess:
I've noted on the chart the point where I made a call to go long gold in an article entitled Why A Gold Play Finally Makes Sense for those who are interested. More to the point though - gold put in its low in late December and has been on a tear ever since. Gold has moved up about $100 since I made that call but, in my opinion, it has a long way to go from here. The reason - the attack on the US dollar.
Bottom line - it's all about the currency war currently in play. The dollar weakness will drive gold and the USD/YEN will drive equities if my thinking is correct. Here is a look at the 5 minute USD/YEN chart:
And here is the S&P 500 (NYSEARCA:SPY):
The correlation hasn't been perfect but it has been close enough and the reason why the yen matters is the carry trade that is almost certain to come undone if the yen continues to gain on the dollar. And it isn't just US equities. Here is a look at the Nikkei 5 minute chart:
While we are looking we might as well take a look at the bond market. Here is the 5 minute (NYSEARCA:TLT) chart:
Summing it up
The truth is the dynamics of the markets have undergone major change since the turn of the century. Many of us have continued to cling to that paradigm that existed before the repeal of Glass Steagall - a decision that rendered traditional analytical tools ineffective. The truth is the sentiment of investors no longer moves markets. In fact, what does move markets is market movement itself and unaffected by human emotion.
The retail investor is so insignificant in terms of market volume today that one must understand the new paradigm in order to effectively forecast markets. What has driven stocks higher since the end of the recession has been a very unemotional process of momentum following, high leverage, machine driven bids in the market. The machine doesn't react to disappointing data in the same way that humans do and in fact just keeps buying as long as the metrics of the carry trade support that decision.
What are the metrics of the carry trade. It is really quite simple. Hypothecate an asset - for instance a bond - and borrow money against that asset at the lowest rate available and use those proceeds to buy another asset that yields a greater return than the borrowing cost. What makes the strategy particularly attractive is the ability to re-pledge that same asset multiple times and borrow many times the value of the collateral.
In other words massive levels of leverage are being employed and the only thing that can stop the train on its chosen path is a disruption in the metrics of the carry trade. In other words, if the borrowing cost begins to increase there comes a point where the cost exceeds the return and to continue to follow the strategy suddenly begins to produce losses - not gains.
More dangerous still is a freeze up in short term money rates - a refusal to loan at any rate based on the lenders perception that risks are simply too high. That is essentially what caused the crash in 2008 - a freeze up in short term borrowing liquidity.
When that occurs it happens to all the players at the same time as all the players are fully dependent on easy access to cheap credit. And of course the cheapest money is at the short end of the curve. In other words carry trade players are dependent on refinancing their trades over and over many times during the course of the year.
The problem with a carry trade driven bull market is that those who have bid the market ever higher based on favorable carry trade metrics are all dependent on one thing - cheap and abundant credit - and when that cheap credit is no longer cheap or abundant the only thing one can do is sell the asset. It becomes an involuntary decision as it is a highly leveraged trade.
What matters here is that the volume in the market today is substantially from that one source. That means that those who have driven stocks substantially higher based on the carry trade metrics must now exit and exit involuntarily and the problem is there is no one to sell to as everyone has gathered on the same side of the trade. That is what produces crash scenarios and why stocks fall much faster than they climb.
Today we have a situation that is very serious in that the dynamics of the carry trade are changing and that is reflected in the price action of various risk assets. It is also reflected in the fact that the Fed has been forced to engage in massive efforts to withdraw liquidity from the system while attempting to put on the face of optimism.
Understand this - the Fed is committed to doing everything they can to prop stocks. After all, their credibility is on the line, not to mention the impact of moving to another recession at a time where they have almost fully exhausted their policy tools. There has never been a time when so much is at stake or so great an effort has been taken to keep the status quo in place.
My own view is that they are losing this battle, and again - the sheer size of the effort to withdraw liquidity with a policy of unprecedented reverse repo action suggests they are indeed in big trouble. Equally informative is the ever increasing size of the reverse repo actions. In January the Fed did a total of $1.531 trillion in reverse repos and in February that number jumped to $1.881 trillion. During that time the US dollar index has fallen roughly 2.5% and the dollar has fallen against the yen by about 2.8%.
Maybe it's time to take some protection. There are still those who continue to ignore the signs and promote the bull argument but my contention is they are still operating in that old paradigm and simply don't see the risks. The risks are real though and significant. In my view capital preservation trumps any other consideration at this time.
Disclosure: I am long GLD, VXX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am also long puts in PCLN, AMZN, NFLX and FB