Seeking Alpha
What is your profession? ×
Profile| Send Message|
( followers)

No, this is not a post about a conspiracy theory. For everyone looking for that type of information, get in your van and head to Roswell. For all others, read on.

During the financial crisis, the Federal Reserve successfully lobbied for the right to pay banks interest on any reserve balances deposited at the Fed in excess of regulatory capital. While the banks were the beneficiaries, Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) (GSEs) were not given the privilege of receiving interest on excess reserves. This created an arbitrage opportunity.

The banks have been able to buy excess reserves from the GSE's at the overnight repo rate and then deposit that money with the Fed and earn the Interest on Reserves rate (IOER) - a risk free arbitrage. These deposits at the Fed become part of the banks' balance sheets and can be used to fund things like carry trades, and hedge funds, and other assorted evil speculators.

However, in April the FDIC changed the way it charges banks for insurance; the calculation was changed to include total assets rather than just deposits. This action made the Repo - IOER arb no longer profitable. Barclays (NYSE:BCS) calculates it had an immediate impact of ~$40b.

Overnight Repo Rate - the price banks would pay the GSE's for Reserves (Click to enlarge)

By the following week the FX carry trade began to unwind, once again removing liquidity from the market

Excess Return on going long AUD TRY BRL and NZD and short JPY , CHF. (Click to enlarge)

By the end of April, the Yen strength began to make the carry trade unprofitable. As traders unwound this source of liquidity, commodity positions needed to be paired back. That, coupled with the margin increases and... Voilà, a government-induced commodity crash.

To extrapolate: Is this what will happen to the economy when QE2 ends?

Disclosure: I am long SLV.