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Last week, I penned an article that discussed the mysterious disappearance of approximately $83.3 billion from the Federal Reserve balance sheet. A week later, most of the money has returned just as mysteriously as it left. Section 8 of the "Consolidated Statement of Condition..." subsection, "Liabilities" indicates that more than $83.3 billion has returned.

Almost $71.9 billion has come back in the form of "Other deposits held by depository institutions". Another $14.8 billion has come back to the "other" category. A Federal Reserve official has disclosed to me that the "Other" category includes "balances of international and multilateral organizations with accounts at FRBNY, such as the International Monetary Fund, United Nations, International Bank for Reconstruction and Development (World Bank); the special checking account of the ESF (where deposits from monetizing SDRs would be placed); and balances of a few U.S. government agencies, such as the Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC)." Finally, the US Treasury withdrew about $39.7 billion from its account.

Summing up the numbers, about $47 billion flowed back into the Federal Reserve since two Wednesdays ago. But the Treasury withdrawal should not really count. Even though that money will flow into the economy through US government program spending, it does not have the immediate effect on stock and commodity prices that other changes in the Federal Reserve balance sheet often have. So, if we negate the Treasury withdrawal, about $86.7 billion flowed back into Fed reserve coffers this week. That is well in excess of the $75 billion or so that flowed out last week.

We do not know the exact dates upon which money is deposited and withdrawn from the Federal Reserve. This creates ambiguity as to the effect the perturbations in its balance sheet have on markets. We do know, however, that to offset the loss of $83.3 billion on November 2nd, the Fed entered into very large reverse repo agreements with someone other than its primary dealers, as noted in the prior article. We don't know who these people were but guessed that they were foreign central banks.

These reverse repo actions are "open market operations", or, in this case, "closed market operations" wherein the central bank borrows cash and gives securities, such as bonds, as collateral to its counterparty. By taking "cash" out of circulation, a reverse repo will usually have the net effect of reducing market liquidity depending on from whom the cash is taken. It is quite interesting that in the first part of last week, stock markets across the world saw deep losses while the dollar soared. Then, in the second part of the week, stock markets sharply rebounded, and the dollar tanked.

These movements were all attributed to the ups and downs of Europe and unsustainable interest rates on debt being faced by Italy, but are also consistent with the perturbations in the Fed balance sheet. It is not entirely clear, but the pundits may have it all wrong. All these earth-shaking movements may have been due simply to changes in liquidity by the Federal Reserve. We have no way of knowing for sure. That is because we don't know the exact date on which cash was withdrawn from Federal Reserve deposits two weeks ago, who withdrew the money, why they needed it or what they did with it.

If someone had used the withdrawn "cash" to buy stocks, it might have sterilized the reverse repo operations, or we would have seen a huge rally. But we didn't see that at the end of the week before last. If, on the other hand, they needed it to prop up their balance sheet, or backstop some non-market oriented bet that looked like it was about to go bad, the Fed's reactive reverse repo action, as a withdrawal of liquidity, would have caused markets to go down. That is what we saw.

Assuming the withdrawn money was not bet on the market, and was simply withdrawn to create some sort of balance sheet veneer, if the reverse repos were unwound toward the end of the day on Wednesday last week, that would have been likely to cause a massive rally starting the next day. That is very close to what happened last week. We saw huge declines early in the week, and a tremendous two day rally at the end of the week. And it was all blamed on Italy.

More complete disclosure by the Federal Reserve as to who, what, when and why would allow for much more accurate predictions on market movement, but it is doubtful that the Fed wants us to be able to do that. One thing is sure. Liquidity, rather than fundamentals, now drives asset markets. Before the Fed became a Politburo-like micro-manager of the economy, it was easier to understand the ebb and flow of liquidity. The biggest money flows were a function of private money coming in and out of the markets. Now, however, the stock, bond and commodity markets ride on a wave of Fed liquidity and are completely dependent upon it. Whether, how and when cash is released or removed determines whether and how far asset prices rise or fall, and the movements of the US dollar.

The Federal Reserve Bank of New York manages these operations. It once issued daily information as to how much and when the open market window was going to be used. That allowed independent traders to get a handle on how much was moving in and out of the Fed. Since open market operations were almost always with primary dealers, you knew that any influx of cash would result automatically in a market pump, whereas big reverse repos would result in the market going down that day. Now, however, with a myriad of other cash windows operating in the shadows, the level of precision in predicting market movements from Fed data has dropped considerably.

Only the tentative buying schedule for treasuries is disclosed on a daily basis. Other cash windows, as well as operations undertaken with non-primary dealer entities, are also profoundly affecting asset prices. Detailed information on these operations are no longer disclosed to independent traders. Only Fed staffers and perhaps some of the firms who have managed to place operatives on the New York Fed Board of Directors have access. And if they are doing that, it is of course, illegal inside information. The bottom line is that while liquidity theory still works, for the independent investor who lacks the detailed knowledge to implement it, these markets have become mine fields of volatility.

Short term trading is best avoided. Even long term bets on the stock market are dangerous because ever-increasing money printing is causing oil and other commodities to skyrocket. Once the ECB becomes more like the Fed, and starts increasing its already substantial levels of money printing, the commodity inflation problem is going to get worse. Stocks may rise along with liquidity increases, but that appreciation will be held back by increasing pressure from consumers having an increasingly difficult time making ends meet. Meanwhile, the high likelihood of heavy inflation ahead, makes buying bonds similar to buying toilet paper.

The increasing price of oil, for example, is essentially a tax upon the middle class of both Europe and especially, car-centric America, reducing the ability to buy goods and services of other kinds. Only long term investing independent of consumer spending, preferably outside of stocks, is a relatively "safe" method by which capital can be preserved or increased. Independent investors should concentrate on assets that tend to rise in price with the trend of ever-increasing money printing operations. In other words, investment should be in things that have demand which, more or less, automatically rises whenever the monetary base rises. One prime example is gold.

Source: Last Week's 'Missing' $83.3 Billion Returns To Fed Balance Sheet