Interesting Fed intervention

Discussion in 'Economy' started by gonegolfin, Apr 12, 2008.

  1. gonegolfin
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    gonegolfin Member

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    The below describes some interesting intervention by the Federal Reserve on the short end of the yield curve that I have noticed in the last month ... something I have yet to see anyone write about, either in the Wall Street media nor in the alternative financial media.

    I have always monitored the Federal Reserve's open market operations, which are almost always temporary open market operations (TOMOs). But always of great interest are any permanent open market operations (POMOs) undertaken by the Fed since these are operations where the Fed permanently injects more money into the system (increase in the supply of money == inflationary) or removes/extinguishes money from the system (decrease in the supply of money == deflationary). The Fed conducts these operations by either buying securities (usually treasuries, but lately many more agency bonds (Fannie Mae, Freddie Mac, Sallie Mae, etc.) and mortgage backed securities) in the open market or selling treasuries in the open market from their portfolio. The Fed purchasing securities is essentially monetizing debt as debt is purchased (one would argue bad debt as of late) with newly created dollars (why private banks have the power to manipulate our money supply/currency is another topic). This results in an increase of the money supply and is thus inflationary. When the Fed sells treasury securities from its portfolio, it takes in existing dollars from the money supply and as such, those dollars cease to exist (extinguished from the money supply). In theory, the TOMOs will have a neutral effect on the money supply in the end as the borrowing banks must pay back their Fed loans (reverse repurchase agreements) and reclaim their collateral when the loans mature (the loaned money is extinguished). However, the Fed keeps rolling over these loans into new loans. So, the effect thus far has been only an inflationary one. But POMOs are permanent and is the focal point of the discussion here.

    These permanent open market operations began on March 7th with the last one being Thursday April 3rd. Now, while the Fed has engaged in many inflationary moves over the past several months (targets for interest rates cut aggressively, TAF, TSLF, more temporary open market operations, extending the discount window to the primary dealers, loans to JP Morgan for the arranged buyout of Bear Stearns), these permanent operations to which I refer are actually deflationary as they are selling T-Bills and T-Bonds from their portfolio. Twelve permanent open market operations have taken place during this period on eleven different dates. The Fed portfolio sales amount to a total of $144 billion in less than a month. $79 billion of this total is the selling of T-Bills, mostly of the one and three month variety. This leaves about $35 billion in sales of T-bonds, with some having a maturity of just over three years. The New York Fed Open Market Operations can be found here ... http://newyorkfed.org/markets/openmarket.html.

    What is the Fed doing? It looks as if they are attempting to force higher yields (lower prices) on these shorter term securities (1 mos. -> 3 years) by adding supply into the market. Why would they do this? Well, there has been a flood of money into short term treasuries (viewed as a safe haven - believe it or not), especially around the time the Bear Stearns crisis erupted. This pushed yields down to 0.61% on 3/19 for the three-month T-bill and just above 0.25% on the one-month T-bill. This is essentially as valuable as cash in the mattress and is not good for the US Dollar. Maybe the Fed views this situation as a must defense of the Dollar and is taking action, but in a targeted fashion as an overall deflationary policy would be catastrophic to the economy and the US Government. If you look at the three-month T-Bill today, it is back in the 1.35% range with the one-month sitting at 1.50% ... http://www.treas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml. The short end of the yield curve took quite a leap in only a few days. Again, the Fed selling these short term treasuries from its portfolio into the marketplace has a deflationary effect on the money supply and provides more supply of short term treasuries to meet demand. In addition to some defense to the Dollar, I am speculating that they feel they need to do this to bring the short end of the treasury yield curve back closer to where the federal funds rate is sitting. Doing so will also lessen expectations in the marketplace that the Fed is not close to finishing its cuts in interest rates and give the Fed some leeway to stop in the next quarter or so (this simply cannot continue). All of what is happening is an interesting mix of inflationary and deflationary forces (mostly inflationary), which is not unusual in an inflationary recession. But it also helps illustrate all of the different fires the Federal Reserve is fighting (which must be solved with different and often contradictory measures) as they are truly between a rock and a hard place. Of course, the Fed is the root cause of the problem.

    Brian
     
  2. Toro
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    Brian

    That's an interesting piece. You may very well be right in that the Fed is attempting to manipulating the short end of the curve.

    Could you please explain further the difference between TOMOs and POMOs.

    Thanks
     
  3. gonegolfin
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    gonegolfin Member

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    The TOMOs (Temporary Open Market Operations) and the POMOs (Permanent Open Market Operations) collectively implement Fed policy for achieving the target Federal Funds rate. TOMOs are by far the most common operation conducted by the Fed and are usually implemented several times a week. As with POMOs, the Fed buys (with TOMOs, these are called repurchase agreements or repos) or sells (with TOMOs, these are called reverse repos) government securities to affect the aggregate level of balances in the banking system. Except with TOMOs, there is a term limit involved in these transactions. Typically, the terms are a single day. But with the current credit/solvency crisis, I have seen terms of 28 days. Also, the collateral has traditionally been treasuries, but has been expanded to take in more agency bonds and mortgage backed securities. Finally, the Fed has been rolling over these loans. Here, they can claim that they are not permanently injecting new money into the money supply when they execute a repo. When the term comes due on a repo, they execute a reverse repo and then follow that up with another repo (and a new term) for the same amount (similar to what they have been doing with the TAF). Hence, the inflation introduced by the original repo is maintained until the Fed ceases to rollover the loan. But once it is called in for good, this has a counteracting deflationary effect.

    POMOs work the same way except that they are permanent operations (buy or sale of securities). Obviously these are quite noteworthy. We will know that things are really getting bad when the Fed begins executing permanent purchases of securities, adding to the Fed's portfolio. The Fed has shown through its TOMO operations that it is willing to purchase a variety of securities (not just treasuries). This means that it will not be a stretch for the Fed to monetize all manner of assets or debt if it feels it must. For example ...

    1) At some point the Fed may choose to monetize debt (permanent) to artificially prop up long term bonds and suppress yields on the long end of the yield curve. Temporary operations to purchase long term bonds will only get them so far.

    2) The Fed may choose to monetize other assets, such as mortgage backed securities, CDOs, CDSs, or homes themselves.

    Obviously, either one of the above would be inflationary, permanently adding money to the money supply.

    It should be noted that the TOMO and POMO operations are only conducted with member banks and are separate and distinct from the TAF (Term Auction Facility), the TSLF (Term Securities Lending Facility), and the PDCF (Primary Dealer Credit Facility).

    Brian
     
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  4. Paulie
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    Paulie Platinum Member

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    Brian, do you see long term inflation being brought on by the Fed's current policy?

    What you explained is what I've been reading about, but certainly not by mainstream media sources. The people I talk to and get my advice from have basically been saying what you just said.

    Although, it seems no one can really explain exactly what's going on. I personally don't agree with having a private bank that is for all intents and purposes, independent of our federal government, conduct our monetary policy. That money they are manipulating is supposed to be OURS, not theirs. But like you said, that's a different discussion.

    I'm banging my head against a wall trying to explain to people that inflation is in for the long haul, and how to protect their cash, but I'm looked at as a nut because of it.

    Do you follow Jim Rogers?
     
  5. Gunny
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    Gunny Gold Member

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    My questions to you would be, WHO is "people" exactly that you are trying to explain this to? I assume you aren't referring to the members here. While I have seen some alarmist comments made by you here and there, to this point at least, I have not seen an explanation from you.

    Did I miss it somewhere?
     
  6. Paulie
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    Paulie Platinum Member

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    No, I'm not necessarily talking about here. I interact with people in my community politically. I attend as many GOP meetings as I can, as well as other events. I also try to explain it to my friends and family.

    It's tough over the computer. I have talked about inflation here on numerous occasions though.

    The simplest "explanation" is that the Fed is adding as much money into the system right now as they can get away with, because it's the only option they have.

    One one hand, it's theoretically, and superficially, keeping banks afloat. On the other hand, it's not only devaluing our currency, it's delaying the inevitability of continued loss of Dollar value, thereby making the ultimate end that much worse.

    I'd much rather just let the failing businesses fail, and let the recession run its natural course. No economy is recession-proof, so why devalue our currency trying to avoid one?

    If you'd like to know the best ways to hedge your cash reserves against inflation, commodities are where to be right now. Gold, silver (I suggest physically owning it), agriculture, oil...

    I'd also suggest going out ASAP and stocking up on daily essentials while the prices are still where they are.

    Alarmist or not, doom and gloom or not, prices are still going to be rising. There's no possible way that it will not happen considering our current monetary policy, especially the way it's been run of late.
     
  7. Toro
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    Brian, is the Fed actually buying mortgages or are they only taking them as collateral in the TAF and TSLF facilities?

    Also, the Fed has a balance sheet of almost $900 billion. Before this crisis, almost all were Treasuries of some sort. By what you are saying, since repos are the primary instrument of open market policy, does this mean most of the assets are short-term bills?

    Here is an article on some options the Fed is contemplating.

    http://www.independent.co.uk/news/business/news/us-fed-prepares-to-replenish-war-chest-807075.html
     
  8. Delbert
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    Delbert Rookie

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    excellent post and discussion, per usual.
    thanks
     
  9. gonegolfin
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    gonegolfin Member

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    You have been reading about the deflationary actions conducted by the Fed on the short end of the yield curve as described in my original post? Where did you see this? I would like to compare takes.

    Yes, I see long term inflation as the most likely outcome due to the policy currently being implemented by the Fed. But this outcome is certainly not absolute. The Fed is not in complete control all of this. We have a scary large pile of outstanding derivatives in the world financial markets totaling over $500 trillion. It is certainly possible that despite the best efforts of the Central Banks (to monetize their way out of this mess), they may not be able to stay in front of this problem if an unwinding of enough positions were to occur quickly and we began to see a cluster of cascading defaults. Roughly ten financial institutions hold all of these derivatives. Thus, it is not like this risk is well spread. This is precisely what the Fed was concerned with when it helped orchestrate the sale of Bear Stearns to JP Morgan and backed it with loans.

    So, while I see inflation as the most likely outcome. I do chuckle a bit at the sound money advocates (of which I am one) that also feel that inflation is the only possible outcome. They do not understand the massive contraction of the money supply that *could* take place if the event I described above took place. I place my investment bets accordingly with most of my assets in gold, silver, foreign money markets in currencies that will continue to appreciate against the Dollar, and foreign energy/agriculture/mining/utilities/infrastructure equities in currencies that will also continue to appreciate against the Dollar. But I also keep a percentage of my portfolio in US Treasuries to guard/hedge against a systemic meltdown and sudden deflation. Knowing full well that if the inflationary scenario continues to play out, I will do quite well (so well that I do not care so much about my US Treasuries now being worthless). But if the deflation scenario takes place (without hyperinflation first), I will not be obliterated. You can think of it as a well out-of-the money put option being placed on a large long position that you are holding.

    Yes.

    Brian
     
  10. gonegolfin
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    They are not buying them ... yet. But they have made it clear that they can monetize just about anything ... and they can and I believe they will. Yes, to this point mortgage backed securities have been taken as "collateral only" in the temporary open market operations, the TAF, and the TSLF. But of course if the reverse repos never happen, it is the same as buying them.

    The Fed had a balance sheet of about $900 million. But I suspect with the recent permanent sales from its portfolio (outstripping the repos), it is probably in the $800 billion range.

    Yes, before the crisis, nearly the entire portfolio was treasuries. Now they have Agency bonds and MBSs in their portfolio. But it is still mostly treasuries. Of course, as I write this, the Fed executed repos today for $21.7 billion of MBSs with a bid-to-cover ratio of over 3.0. This mess is not close to being over.

    Most of the open market operations that have been taking place have been temporary and are repos. Thus, cash is being created and securities taken in to the portfolio (mostly treasuries, but a disconcerting amount of Agencies and MBSs). But the treasury maturities in its portfolio are spread around. If I had to guess (without totaling the numbers), probably half or a little more of half the treasury portfolio is three years or less.

    http://newyorkfed.org/markets/soma/sysopen_accholdings.html (note that the Agencies and MBSs are not disclosed here)

    Thanks.

    Brian
     

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