Author Archives: Kevin

On to the Next

David Kotok of Cumberland Advisors (and his Chief Economist Bob Eisenbies) are friends of mine. Bob and I met at a meeting with Sec. Geithner and he introduced me to David. They are both class acts and their notes are regular reading for me. David has just penned a missive on a shift in Tapering as Tightening. I have a slightly different view but the details are important.

As we know, the pace of Fed buying continues to drop toward a goal of zero by Fall. The size has now crossed under the net new issuance of the shrinking deficit creating “free radical” Treasuries for the first time in quite awhile. Also, and more importantly in our opinion, the duration of the Fed’s balance sheet has approached 6 years. This was the target bucket of QE and longer than I was comfortable with (see older rants). Cumberland’s conclusion is these factors will amount to a shift in rates that results in the initial “tightening phase.”

I may agree with that idea in theory. However, I believe the significant event upon us is/will be the coming market shift to these new realities. The calibration of monetary policy is not adjusting, yet. In a cycle a violent correction after a long trend ,that fades back to trend is a common pattern. The taper tantrum was that event for us. Tops are long protracted frustrating affairs, unlike market bottoms. That a significant community has embraced fanciful new age thinking to justify their lengthy holdings makes us happy.

Thus, the question for us is not whether Tapering (or halting LSAP) is Tightening, or whether or not rates will rise – they will. The focus should be on the fashion in which the shift manifests itself on the curve. The Fed, to the extent they will matter at all, will be an observer of those shifts. We believe the curve is too flat now. We also think the initial adjustment will be embedded in a higher medium term nominal growth path. We continue to believe the 30 year bull market in Treasuries ended 2 years ago and a generational top is being formed.

Equity Futures

Yesterday, the NQ hit a downside pattern and the Dow future tagged an upside pattern. The SP held in above a big weekly level for us. The long stability run may be starting to weaken. A new high will most likely be accompanied by a bearish divergence. We are watching 1964 on the weekly. The daily pattern recalculates on a 1980 trade (almost this morning).

Day traders are packing it in in droves. The Stability has frustrated many. The media is groping for a story and incoherent reporter tirades are going viral. The change is getting close.

These are not the Fed Funds you’ve been looking for

The minutes produced a wave of short covering in color coded Eurodollar strips well beyond the notion of “dovish.” Practitioners were forced to adjust the term structure as Fed staff hinted at revamping the calculation for the Fed Effective Rate. In simple terms, The Committee desires to keep FF an important signaling tool and thus MUST solidify the Death Star spread to ensure that result.

I have been of the camp that FF role could be diminished and replaced by the RRP. The Fed has now made clear that they are NOT going to head in that direction unless forced. Instead, tweaking the Fed Effective calculation to include “other” money market TRANSACTIONS (direct hit to “old” LIBOR) will allow the S/T rate known as FF to maintain its place in the hierarchy of policy change shifts.

In practice, the management of the balance sheet will become more cumbersome. The Minutes entrench a “wide spread” between the Death Star rate and the IOER rate. The testing has run at about 20bp. Our usual radically delusional opinion has been to move the D-Star rate toward 12bp and CUT IOER toward that level. The Fed has now confirmed that they are content to solidify the spread, re-enforce FF effective and create a “sub-floor”. The trick will be inducing participants to utilize the RRP facility to the tune of oh, lets say $400B/day with the spread structurally wide.

My jaded view comes down to this:

1) The Fed was mistrustful of participant and public understanding of the revamped Money System with the Fed now a long(er) term large B/S player in it.

2) They have opted to give a face lift to an old friend, Fed Funds, rather than replace it with a new and potentially nasty toy that is the RRP.

3) Back month Eurodollars (and the Tar Pit of FF futures) are adjusting and being diminished to bland consensus reflections of FOMC forward guidance with little feedback loop input.

4) The shifting, when it eventually unfolds, will not be as benign as the Fed (or its band of subsidized constituents) hopes.



The number one topic since Thursday’s Employment Report has been inflation. Depending on who you listen to, the US is either about to, or already experiencing an inflationary cycle. The idea of inflation – rather than the actuality – is easily attached to in “Sounds right Macro” as virtually everyone can point to something that’s price is higher than before as evidence. The truth is creating inflation is much harder than most think.

In the developed market space, disinflation (and even flashes of deflation) have been far more common over the last 30 years. Asset price inflation has filled the void and created a safe harbor for the Neo-inflationists. The recent drop in the Unemployment rate has sparked a flurry of inflation sightings.

Although we believe this cycle will be scored nominally, we are not convinced a general inflation cycle has emerged. Central Bank(er) focus and QE have promulgated the impending inflation story. Remember the “Dollar crashing” hype of 2010? The reality is the widespread development of derivative contracts act as a huge impediment to a CB that wants more inflation. Consider the economic blowback to the Taper last Spring. Futures markets were able to fast forward to multiple tightenings at the first hint of Fed adjustment.

Volcker showed incredible resolve in cracking the 70′s inflation spiral. His success is highly correlated – but rarely linked to – the invention and use of financial futures. The ability to create inflation in the developed world since the use of these products has become widespread has been spotty, at best.

Even after last week’s solid report, FI futures have rebounded into the growing inflation meme. The energy complex retreated sharply. If and when inflation gains some traction in the US, we fully expect the Bond Vigilantes to ride into town “a whoopin’ and a hollerin’ ” as Slim Pickens used to say, and scare the daylights out of the citizens of Rock Ridge. (#GIK)

All You Need to Know

As readers are well aware, I’ve been fixated on the development of the Fed’s Death Star (and Term Deposit Facility TDF). I have tried to push back against “other” more respected bloggers as to the sanguine nature of these NEW tools. I continue to believe that many analysts are still calibrating their prognostications to a financial system plumbing that died with the credit super cycle,

Here’s a Primer: CBs that “offer” IOER are -by definition- impaired or beholden to systemically important entrenched interests. The Death Star is a Financial System 2.0 operation to help manage big number “on balance sheet” assets. The D-Star and thus, the TDF ,need to be primed beyond OMD “call-arounds” for participating counterparties to play along. Academic side line Pollyanna’s have been telling you the rate should be even with IOER and little collateral damage would occur.

We believed the rate would need to be slightly ABOVE IOER for participants to play along. Others we have respect for have felt the spread could be closer to 15bps. Meanwhile, media pundits yammer on about the Funds Rate and FF futures concept of “the first rate hike.” Dino….meet the Tar Pit.

Here’s the latest from long time market watcher Ray Stone of Stone McCarthy fame (#GIK): The Fed did just shy of $125B in 7 day TDF yesterday at 29bps (4 over IOER) to 58 counter-parties (read minions). The levels needed for sufficient Death Star efficacy is more like 400 to 500B. Remember, the Fed has “electronically produced” nearly $2.7T in balances. Cut to Mr. Stone’s analysis: ”

At some point, the premium will serve to distort the money
    market yield curve, a development that may have adverse
    implications for CP issuers, and ultimately macroeconomic

Don’t listen to me, I’m just a dog watching TV, maybe you should listen to him.

On the Next Day

You make money 364 days, and on the next day you go broke.

- Old Vol selling strategy line

The Central Bank “stability mandate” is starting to give people the willies. Bill Gross extols the virtues of picking up nickles in front of steamrollers at the Morningstar Conference.  The IMF responds with a warning today. Basic market dis-function is apparent with the recent spate of 5 Year specials and creeping increase in “fails.”

Jim Grant wrote a book on the subject in 1996 called The Trouble with Prosperity. On Dec 5 of that year, Greenspan gave the infamous “irrational exuberance” speech (wow even that needs a #GIK now):

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

Mr. Bubble himself was worried about a bubble.
I feel the problem is seeded in the false goal of “stability”. There is a critical difference
between low volatility resulting from well calibrated policy and policies designed to
suppress volatility, compress credit spreads and guide the duration of those activities.
Someday, the capital markets will break loose of these CB objectives. There will be a
 of pundocats “Nailing it.” The reality will be that significant players will be caught out by the
adjustment. I am not convinced “Day 365″ is upon us but we are certainly long in the count.

Paid With What?

Yesterday, the WSJ posted an article on the pending BNP Paribas “deal” to settle US sanctions. The fines could amount to $9B and a guilty plea is attached. A temporary ban on clearing “certain dollar denominated transactions” is a possibility. Deutche Bank, Credit Ag and Unicredit are watching closely. That BofA and JPM have already forked over $12 to $13B here at home is a shockingly under analyzed fact.

The “fines” are “paid” through a little sleight of hand known as QE/IOER. As Bernanke openly stated in the historic 60 Minutes interview of the crisis, “We just electronically mark up the balances.” In a closed loop silliness only Rube Goldberg could love, EU officials now worry that the fines could endanger the capital and operations of the institutions the largess was designed to help. A frank threat to the US by French Economics Minister Montebourg mentioned “economic warfare” and said, according to the WSJ, “Maybe we should imitate them (USA).” Get ready for EU regulatory pushback while foreigners amount to over half of the reserves on the Fed’s balance sheet.

This, ladies and gentlemen,  THIS is what a Structural Trap  looks like from the inside. Inefficient, entrenched and lax industries are propped up by government subsidy then publicly dressed down. The quip that the Obama Administration’s economic plan was “Full Employment for Lawyers” proves un-funnily true.

Pay Attention…like minded

David Schawel for the CFA Institute

Is It Time for the Fed to Contract Its Balance Sheet?
By David Schawel, CFA
Categories: Economics, Fixed Income
US Federal Reserve building in Washington, DC
The Federal Reserve can keep their balance sheet at the current size (and keep the risk asset party going) or it can position itself to be able to hike rates — but it cannot do both.

Last week, the Fed announced that purchases of agency mortgage-backed securities and US Treasuries would fall to $35 billion per month. If they continue reducing their purchases by $10 billion per month, the incremental purchases should be finished by October.

So what will happen? Their current policy is to reinvest principal runoff and maturities from existing holdings, which means their balance sheet will stay roughly the same size once they stop buying new bonds. As we consider the future of fiscal policy in this country, one of the key questions will be what the Fed is capable of doing.

JP Morgan’s CFO Marianne Lake recently described the impact on the industry, saying, “We should note that a significant portion of the growth in deposits that the industry has experienced has been as a direct result of the Fed’s QE policy and reserve bills. So if you look at JP Morgan, since the end of 2009, the firm’s deposit rate has grown by about $350 billion and we believe a significant portion of that growth has been a direct result [of] QE.” In that same call, she noted that JP Morgan (JPM) has estimated it may experience a deposit outflow as large as $100 billion in the second half of 2015.

How Does QE Work Again?

It’s often mentioned that the Fed buys bonds in asset swaps. This is true. Where many people get confused is that it is not an asset swap for the banks. When the Fed buys bonds, they typically buy them from non-banks. The bonds are removed from circulation and put on the Fed’s balance sheet, while the Fed pays for these bonds with newly created reserves. Now these reserves must be deposited at a bank, so they will show up at a bank as new deposits.

For the bank, these deposits are liabilities and the corresponding assets are the reserves sitting at the Fed earning “interest on reserves” of 0.25%.

So think about this: Every dollar of QE purchases must end up at a bank in the form of a new deposit. This is not a theory, it can be seen by viewing asset and liability data from the Fed’s H8 report. As you might notice, the difference between the deposit over loan excess ties almost exactly with growth in the Fed’s balance sheet.

Deposits Less Loans of All Commercial Banks versus Fed Balance Sheet
Deposits Less Loans of All Commercial Banks versus Fed Balance Sheet

Source: Federal Reserve H8 Report

Comments from Federal Reserve members indicate they are reluctant to cease the reinvestment of principal runoff. I would assume this reluctance stems from their belief not only that the size of the Fed’s balance sheet gives credibility to “forward guidance,” but also that contracting the balance sheet could begin an unwind of various risk asset trades.

Recently, the Fed has introduced two tools to drain reserves from the system: the reverse repo (RRP) and term deposit facilities (TDF). With the TDF, for instance, a bank would have a term deposit (right now one week) with the Fed and earn a few extra basis points (bps) over interest on excess reserves (IOER). The first question is how much compensation would a bank need over the current IOER rate (25bps) to entice them to utilize these tools? Is it 10 basis points? 20? 50? Nobody knows.

Maybe a more fundamental question is this: Is there a big difference to the market in terms of whether they drain reserves by cutting off principal reinvestment or by utilizing RRPs and TDFs? My answer is an unequivocal yes. The goal of RRPs and TDFs is to ensure that enough reserves are removed from the system so that demand will exist to borrow Fed funds. I might be naïve, but I am skeptical that a bank would voluntarily tie up too many reserves only to have to go right back into the market and borrow from someone else.

Meanwhile, if the Fed ceased reinvesting runoff, then reserves would automatically leave the system as bonds paid down and deposits left. Put another way, I have a hard time believe removing reserves temporarily via RRP/TDF will get the overnight markets to a “normalized state.”

Moreover, can the Fed do this in a great enough size to achieve its goal? The most recent TDF auction on 16 June raised a bit over $92 billion, which is insignificant in terms of the Fed’s whole balance sheet.

This is all so important because it is my belief that the Fed cannot raise interest rates with such a large amount of reserves in the system.

Alternative Option: Stop Reinvesting Principal Runoff

The recent year-over-year (YoY) consumer price index data pushing past 2% led some to argue that the Fed should take a more hawkish stance. Much to that group’s dismay, higher inflation projections were not present in the Fed forecasts and Federal Reserve Chairperson Janet Yellen did not seem overly concerned about the spike in her subsequent comments.

Whether or not inflationary pressures are building is debatable. I believe, however, it’s in the Fed’s best interest to start reducing the size of its balance sheet in advance in order to reduce reliance on reserve draining via repos and term deposits. The Fed is currently not in a place where it can raise rates with trillions of dollars of reserves in the system. Thus, if inflationary pressures somehow do arrive, then the Fed has real problems.

The other reason to start taking down the balance sheet is to be proactive in preventing excessive risks in the markets. It’s well documented that the chase for yield continues, and now that even the most esoteric instruments have been bid up, leverage is being employed to hit yield targets.

Shrinking the balance sheet would likely send a shock to carry traders, maybe even similar to last summer’s “taper tantrum,” but it’s probably a healthy thing to do. Opponents of this philosophy might say that such a strategy might risk disrupting one of the only benefits of QE, which is the rise in wealth through rising financial asset prices.

This raises some interesting questions: If you assume risk assets could sell off with a contraction in the balance sheet, would the underlying economy be strong enough to withstand a shock? Would a move sabotage the economy’s momentum and be hurtful in the end? Nobody knows, but there’s a limit to the rise of financial asset prices and excessive risk taking, and leverage buildup has to be considered in terms of the cost-benefit analysis for the Fed. Manmohan Singh of the IMF believes that it could cause great disruptions, but it is all speculation at this point.

It’s more important for the Fed to be in a position to raise rates than it is for the party in risk assets to continue at its current feverish pace. I have real questions about the efficacy of RRPs and TDFs on a large scale, and believe the better option is to “reverse” the purchases through natural runoff. RRPs and TDFs can have some impact, but the “heavy lifting” will be accomplished through runoff and sales. I estimate the average life (time it takes to get half your investment back) of the Fed’s holdings to be about five years, so this wouldn’t be an immediate process. But in my opinion, if the Fed believes inflation and credit creation are starting to take hold then ceasing runoff reinvestment is the optimal choice at this stage of the game.

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Interesting day as ME over took strong data from housing. We continue to believe the importance of shelter is over held in players minds but the improvement was welcomed. The Naz future hit an up pattern and the Dow completed a down highlighting the divergence of the session. The SP is turning through the bearish POC (point of control).


Back in Feb we suggested watching a few clues for the grain market. The Peruvian anchovy harvest. The Maverick’s surf competition. Some rain on the PGA west coast swing. The lofty prices have retreated most of the Spring. Now take a look at the Mid-West. the flooding from Nebraska to Minnesota has reached record levels. Corn popped on 2 good sessions to end the week. As we signaled to begin the year, we are looking to spend the Summer buying corn and selling bonds. If you’re looking for a year to compare try 1988 !