FED Devil In The Details?

by: The Nattering Naybob

Discussion, critique and analysis of the potential impacts on equity, bond, commodity, capital and asset markets regarding the following:

Last Time Out; The Howling Man; FOMC Minutia.

Tapering; Effects: Treasury and MBS; Costs.

Banking and Economics; Asset Markets.

Last Time Out

Of late Bitcoin and Crypto retracing their parabolic rise, we expressed our concerns May 22nd....

The contraction of 98% of BTC trading volume (in CNY), created volatility and an amplified "demand" squeeze. If one wonders are these Crypto tulips? One must ask, is there enough intrinsic value within Crypto currencies? If yes, could the price highly exceed the intrinsic value of real purchasing power? TBD and for now, we toss three Bitcoins into the fountain of Ethereum and Out. - Money or Crypto Tulips?

With regard to Chinese Bank Non Deposit Liabilities in Dollar Woes: Big Trouble in Little China? ...

We could also be witnessing a big problem with bank credit circulating back into the banking system as non deposit liabilities... those holding WMP's or acting as SPV's, leveraged or otherwise, including risky equities, high yield bonds and commodities, could be creating a self reinforcing vortex of selling and margin calls which could rapidly drain systemic liquidity with little to no PBOC backstop.

With the Fed raising the short end, we Nattered suspicions as to why commercial whales have gone net long ED eurodollar (betting on lower LIBOR rates) to the tune of $3T notional....

Not a harbinger of good economic times, but perhaps a hedge against a flight to safety, in the bond market. And a flight from what? Economic decline and or a correction in equities valuations? Should the FOMC indicate in its minutia when the big punch bowl is getting taken away (tapered bond buying, reduction of balance sheet)... Watch for Beezlebub in the minutia of the FOMC June 14th announcement and/or the release of those notes on July 5th, then witness what could be History Repeating?

As predicted, history repeating with Beezlebub appearing in the minutia...

The Howling Man? Part 1

This Twilight Zone classic written by Charles Beaumont, is told in a flashback by an American called David Ellington who while on a walking trip through post World War I Europe (circa 1925), becomes lost, drenched by rain, and seeks shelter in a nearby castle, in which he collapses.

The prostrate form of Mr. David Ellington, scholar, seeker of truth and, regrettably, finder of truth. A man who will shortly arise from his exhaustion to confront a problem that has tormented mankind since the beginning of time. A man who knocked on a door seeking sanctuary and found, instead, the outer edges of The Twilight Zone.

Upon waking inside the castle, Ellington hears a disturbing wolf like howl coming from somewhere in the castle and investigates. In the bowels of the castle, he finds a bedraggled but cultured and intelligent man in a cell. The man claims to be a prisoner of an insane religious order, locked up because he kissed his sweetheart in public.

The leader of the order, Brother Jerome explains that the prisoner is not a man, but rather the devil himself. He has been locked up in the room using the "Staff of Truth" to bar the door since shortly after World War I. Ellington becomes convinced that Jerome is insane, yet sees that the staff which holds the door shut is easily within reach of the imprisoned man, Ellington briefly wonders why he hasn't simply removed it himself.

At the prisoners urging, Ellington removes the staff and releases the prisoner. After the prisoners exit, Jerome finds the collapsed Ellington and sadly explains that the inability to recognize the devil has always been Man's greatest weakness.

The Staff of Truth?

The Committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated. This program, which would gradually reduce the Federal Reserve's securities holdings by decreasing reinvestment of principal payments from those securities, is described in the accompanying addendum to the Committee's Policy Normalization Principles and Plans.

The Committee intends to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.

For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.

For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

And here is Beezlebub chapter and verse.

Treasury Taper?

Below, Fed Treasury Note and Bond purchases over the last 10 years.

The Fed will start allowing up to $6B in Treasury securities and $4B in mortgage bonds to roll off without reinvestment every month, and let those amounts rise each quarter.

Treasury roll offs caps in Q1=18B; Q2=36B; Q3=54B; Q4=72B; Q5=90B for a total of $270B in extra bond market float over the next 15 months.

Fed reinvestments in Treasury Notes and Bonds (not Bills) came to est. $250B in 2016. Averaging over a 15 month term these purchases would total $313B.

In the last 15 months, total Treasury Note ($2.6T) and Bond ($230B) issuance = $2.830T. Over the 15 month term $313B in Fed purchases would be an est. 11% of the float based on current issuance. Only an insane religious order might think this not benign?

Above, the Fed Treasury float effect would be distributed as follows: Q1= 3.1%; Q2=6.3%; Q3=9.5%; Q4=12.7%; Q5=15.9% ; resulting in potential additional market float of 16% and rising cost of loan funds.

Source: Sifma US Treasury Issuance

MBS/Agency Taper?

The Fed holds about $1.75T in MBS, approximately 40% of the outstanding securities issued by Fannie Mae and Freddie Mac.

MBS roll offs caps in Q1=12B; Q2=24B; Q3=36B; Q4=48B; Q5=60B; for a total of $180B in extra MBS and agency market float over the next 15 months.

Fed MBS reinvestments came to $387B in 2016, averaging over 15 months equates to $486B.

Over 15 months (Q1 2016 - Q1 2017), total Agency MBS ($2.1T) and Non Agency ($191B) issuance = $2.3T. Based on current issuance, over the 15 month term $486B in Fed purchases would be an est. 21% of the float. Like kissing one's sweetheart in public, seems benign?

Above, the Fed MBS/Agency float effect would be distributed as follows: Q1= 7.8%; Q2=15.6%; Q3=23.5%; Q4=31.3%; Q5=39.2%; resulting in potential additional market float of 39% and rising cost of mortgage loan funds.

Sources: Sifma US Mortgage Related Issuance; Fed MBS purchase history

Treasury Effect?

Below, there are $782B in Treasury holdings maturing in the next two years, and a total of $1.3T maturing between now and 2021.

Every Fed dollar used to purchase Treasury securities at auction is one less dollar that the Treasury does not need to borrow from other investors. Lacking said Fed reinvestment, the Treasury will have to decide how to raise those missing dollars.

If the Treasury chooses to increase bill issuance and/or draw down on cash balances, then there would be little impact on the net supply of Treasury duration. If the Treasury increases coupon auction sizes, the lack of Fed reinvestment would result in an increase in the net supply of Treasury duration.

MBS and Cost Effect?

The portion of MBS/Agency gross issuance previously purchased by the Fed will need to be absorbed by private sector investors. This would increase the supply of mortgage duration held in investor portfolios, which could affect yields and/or spreads.

Bonus points, think rising cost of loan funds and all things tied to LIBOR viz. rising mortgage rates, ARM hike, or floating bonds, say used for stock buy backs. Also, depending if you are long (hold em and collect) or short (issued them and must pay), a dream to some, a nightmare for others.

Banking and Economic Effect?

The Board of Governors of the Federal Reserve System voted unanimously to raise the interest rate paid on required and excess reserve balances to 1.25 percent, effective June 15, 2017.

In this current cycle, when the FOMC raises, they also raise the IOER (interest on excess reserves). This remuneration of deposits causes further disintermediation for the banks.

In the week prior, in addition to the net long eurodollar commercial whales, we Nattered to friends.... There may be flight to safety in longer duration bonds (lowering long end rates), especially if the stock market corrects, economy stalls further and/or there is a dearth of cash. Anyone notice the mad rush into bonds pre and post FOMC announcement?

What does borrowing at higher short term rates (LIBOR, FF) and lending at lower long term rates mean? Spread and margin compression for banks, viz. further disincentive, disintermediation, contraction in lending and available funds. Said squeeze could affect volatility, the dollar, equities, asset markets and the economy.

Asset Market Effect?

William McChesney Martin, Jr. was the ninth and longest serving Chairman of the United States Federal Reserve Bank, serving from April 2, 1951 to January 31, 1970 under five presidents.

The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up. (October 19, 1955 Address)

At the end of the day, either the Treasury or others must step up to fill the gaps. Thus taking away that previously filled punch bowl (whether excess reserves or not, a diversion of resources), some of which are utilized for off balance sheet speculation in equities and commodities.

The Committee also anticipates that the caps will remain in place once they reach their respective maximums... Gradually reducing the Federal Reserve's securities holdings will result in a declining supply of reserve balances....

QE purchases ending in October 2014, were telegraphed in the July FOMC minutes release, which precipitated a 75% collapse in oil prices. This was the last time a death cross (50 dma crossing below 200dma) was seen in Brent or WTI Oil, until last week that is, when it's howling was heard again.

As opposed to the way we were, these days the banks are NOT so much in the LENDING business, because they have been forced into the SAVINGS and speculation business.

Even well intentioned and intelligent individuals, still believe that the commercial banking system must have deposits or savings (and do utilize them) for loans. Unfortunately the reality is, and as our faithful readers know, that assertion has been proven an urban myth.

Along those lines, does one believe those aforementioned bank non deposit liabilities or off balance sheet (shadow banking) shenanigans, which are not subject to reserve requirements, are strictly a Chinese problem?

As much as a jubilant penetration, when the biggest bond whale pulls out of the market, as exemplified above and visually below, the withdrawal can have much worse effects and affects.

The Howling Man? - Conclusion

The flashback ends, and we find Ellington explaining to a hotel maid that he has spent the time since then hunting for the devil to atone for his mistake, through World War II, the Korean War, and the development of nuclear weapons.

After decades of chase, Ellington finally succeeded; he has Beezlebub locked in a closet barred by a similarly shaped staff, and intends to return him to the castle and Brother Jerome's keeping. He warns the skeptical housekeeper not to remove the staff under any circumstances while he goes to make his final preparations.

As soon as Ellington leaves, the maid hears a disturbing howl from behind the door, and in her curiosity and disbelief of Ellington's story, removes the Staff of Truth....

The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.

Point in fact, much to the benefit of the 1%, the demons of QE, NIRP and ZIRP have created massive global reflation bubbles in all assets, while tightening monetary policy to the point of economic strangulation and asphyxiation, much to the detriment of the rest.

Ancient folk saying: "You can catch the Devil, but you can't hold him long." Ask Brother Jerome. Ask David Ellington. They know, and they'll go on knowing to the end of their days and beyond....

Given the havoc that has already been wreaked by letting this central bank Devil loose, in attempting to stuff him back into a bottle, perhaps for the sake of all, said learning curve might be a accelerated one? and Out.

Happy Trails?

Hope you folks enjoyed yourselves, catch you later on down the trail. Would like to thank you folks fer kindly droppin' in. You're all invited back again to this locality. To have a heapin' helpin' of Nattering hospitality. Naybob that is. Set a spell, take your shoes off. Y'all come back now, y'hear!

This is our 121st in a series of thematically related missives which will attempt to identify the macroeconomic forces with potential to adversely affect capital, commodity, equity, bond and asset markets.

I wish to dedicate this missive to one of my mentors, Salmo Trutta, who is a prolific commenter on SA. Without Salmo's tutelage, and insistence on not masticating and spoon-feeding the baby ducks, as in learning the hard way by doing the leg work and earning it, this missive would not have been possible. To you "Proximo"... "win the crowd and win your freedom" - Spaniard.


Investing is an inherently risky activity, and investors must always be prepared to potentially lose some or all of an investment's value. Past performance is, of course, no guarantee of future results.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of an investment vehicle. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from the principal or a financial adviser. Prospective investors should read the prospectus carefully before investing.

Market Plays?

As for how all of the above ties into the potential and partial list of market plays below... the market as a whole could be influenced, and this could tie into any list of investments or assets. Those listed below happen to influence the indices more than most.

There are many macroeconomic cross sector and market asset correlations involved that affect your investments. Economic conditions, the eurodollar, global dollar debt and monetary policy all influence the valuation of the above and market plays below, via King Dollar's value, credit spreads, swap spread pricing, market making, liquidity, monetary supply and velocity, just to name a few. For a complete missive series listing covering those subject and more, click here.

The potential global economic developments discussed in this missive could affect numerous capital and asset markets, sectors, indexes, commodities, forex, bonds, mutual funds, ETFs and stocks.

A List of Potential Market Plays (Long or Short?):

Apple Computer (NASDAQ:AAPL); Google (NASDAQ:GOOG); Facebook (NASDAQ:FB); Microsoft (NASDAQ:MSFT); Citigroup (NYSE:C); General Electric (NYSE:GE); Cisco (NASDAQ:CSCO); Bank of America (NYSE:BAC); Amazon (NASDAQ:AMZN); Tesla (NASDAQ:TSLA); SP 500 Trust ETF (NYSEARCA:SPY) ; Ford (NYSE:F); Starbucks (NASDAQ:SBUX); Intel (NASDAQ:INTC); ATT (NYSE:T); IBM (NYSE:IBM); Exxon Mobil (NYSE:XOM);

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.