The Fed Chairman is beginning to sound more defensive these days. Normally the picture of serenity, Ben Bernanke and his trademark stoic fortitude have been put to the test in the wake of the Fed's historic September decision to implement open-ended, monthly purchases of mortgage backed securities to help jump-start the faltering economic recovery.
In a speech delivered to the Economic Club in Indiana Monday, Bernanke appeared noticeably perturbed (and periodically annoyed) during the question and answer session. One of the most serious charges facing Bernanke and the Fed is that the central bank is enabling excessive government spending by monetizing the deficit. Regarding this charge, the Chairman again offered the standard disingenuous defense:
"That's not what's happening, and that will not happen, ...we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates."
As I noted in an article published over the weekend, this logic relies on a technicality that no serious observer accepts as evidence that the Fed isn't enabling government spending. The Fed claims that because it isn't making purchases directly from the Treasury, it isn't monetizing the deficit. Of course, when the Fed takes Treasury bonds away from banks and replaces them on the banks' balance sheets with cash, the banks can either choose to sit on that cash and earn next to nothing, or buy Treasury bonds with it to replace those just purchased by the Fed. The fact that bank holdings of Treasury bonds are near all time highs seems to suggests which option the banks have chosen.
Additionally, it should be noted that one of the main arguments made by the ECB regarding allegations that its bond buying program amounts to the funding of governments is that by focusing on the short-end of the yield curve it is acting within its mandate. That is, central bank actions at the short-end can be justified by reference to monetary policy objectives, while actions at the long-end of the curve are more open to charges of state financing. This would seem to suggest that Operation Twist is highly susceptible to charges of state financing as the whole point of the program is to extend the average maturity of the Fed's portfolio of government debt.
Indeed, the Fed is robbing the market of duration at a breathtaking pace. Consider the following two charts. The first shows how much in 10-year equivalents the Fed has been extracting from the market per month and how much that number is expected to increase going forward. The second graphic shows that the Fed now owns nearly 30% of outstanding 10-year equivalents and that percentage is rising at an alarming rate:
Source: Stone McCarthy
If you believe that banks buy new Treasury bonds with the money the Fed pays them for their old Treasury bonds and if you also believe that the longer the average maturity of the central banks' bond portfolio the more vulnerable it is to charges of deficit monetization, then there is little doubt as to whether the Fed is enabling government spending and engaging in state financing.
Another important thing to note about QE3 is that it isn't helping Main Street. In fact, it is increasing the divide between Main Street and Wall Street. As the Financial Times notes,
"although the average rate on a fixed 30-year mortgage reached 3.4 percent this week - a record low...the interest banks pay on mortgage bonds has dropped... to as low as 1.65 percent last week"
In other words, banks are not passing along the savings to borrowers. In fact, when it comes to mortgages they are making more money off Main Street than ever. The spread between the rate Main Street is forced to pay and the wholesale rate is at record highs. Additionally, as the following chart from ZeroHedge shows (bottom pane), the ratio of the retail rate to wholesale rate is also at a record high, and by a mile:
As you can see from the foregoing discussion, the Fed's policy has accomplished four things: (1) it has enabled government spending by creating artificial demand at banks and supplying the cash to satisfy that demand, (2) it has increased the average duration of the Fed's holdings, leaving the central bank increasingly susceptible to charges of deficit funding, (3) it has enriched banks at the expense of borrowers, and (4) it has artificially inflated the prices of Treasury bonds and MBS.
Ultimately, this discussion provides yet more evidence for my contention that this is not sound policy, and while it is busy not working, it is inflating an asset bubble. The long-term trade is short U.S. Treasury bonds (iShares Barclays 20+ Year Treasury Bond ETF: TLT).