Terminal Velocity (27) “Held Hostage By a Fortune” explained how President Obama had turned the Republican soldiers of fortune from hostage takers to hostages. Then the President emerged from captivity to signal that the Debt Ceiling can of worms had been kicked down the road. By employing accounting sophistry the can will land circa the Congressional Mid-Term elections of 2014[i]. On opening said can, the Republicans will find that it is a grenade; and that they will be politically eviscerated if they adopt the same partisan positioning. The Federal Reserve will also find its balance sheet is similarly held hostage by the fiscal uncertainty which now extends as far as the Mid-Terms. The infamous “Fat Lady”, identified in the previous report, is now audibly eulogising the demise of the Republicans; who have been politically “disintermediated”.
As always, the political imperative creates a reciprocal monetary imperative from the Fed to enable it. The monetary “disintermediation” in this case involves the Fed “disintermediating” the banks. The Fed now owns more securitized debt than all the banks.
In fact, the banks are scaling back their exposure to securitized debt at the same time that the Fed in increasing its own balance sheet exposure.
The banks are replacing their security exposure with “less risky” Federal Reserves. The Fed is therefore “disintermediating” the banks from balance sheet exposure to securitized debt; and hence the US economy. In addition, this “disintermediation” has become a systemic programme; by the Fed’s continued application of rigorous capital adequacy ratios, which go above and beyond those proscribed by Basel III. Banks are not only bearish on the US economy, they also can no longer afford the cost of capital to participate even if they were bullish on the prospects for growth. In practice, what this means is that the Fed is now intermediating between the US financial system and all the economic risk in the American economy. The banks are cutting back exposure in anticipation of the next recession; and the Fed is simultaneously protecting them from the P&L consequences. This is consistent with our thesis that the Fed is in the process of expanding its balance sheet indefinitely. In Terminal Velocity “Goldilocks Economy and the Three Bear Markets” this process by which the Fed “disintermediates” the banks was explained[ii]. The recent political shenanigans have driven the Fed even further into this role as the great “disintermediator”. This “disintermediation” means that the Fed has taken control of what we termed the pro-cyclical “Leverage Cycle”. In doing so however, the Fed has become both the sole creator and sole beneficiary of the “Leverage Cycle”. What this of course means is that the Fed can never leave its own party; because it is both drunken host and profligate guest. The best the Fed can do is to disguise its schizophrenia with “Guidance” and meaningless words like “Taper”, in the hope that the audience never catches on to the party trick.
The latest head-fake from the Fed involved the unveiling of a new Reverse Repo tool; which was framed as being capable of allowing the Fed to drain liquidity using its balance sheet securities as collateral. If one pauses to think about this, it will become clear that in order to drain more liquidity (i.e. to tighten) the Fed will need more collateral (i.e. bigger balance sheet). The size of the potential tightening therefore is directly proportional to the size of the Fed balance sheet. The absurd situation has been created in which the Fed now needs more new securities in order to remove all the liquidity that it has created. The Fed is now in the process of acquiring this collateral by “disintermediating” the banks from the securities business. We believe that this “disintermediation” process is the effective replacement of the banks’ fractional reserve monopoly on credit creation with the Fed’s monopoly. In the “Housing Smoke and Mirrors” sister series we have identified the use of the Federal “Acronyms” , such as “HARP” and “HAMP”, to create new issues of collateral which the Fed can buy. We would suggest that this “Acronym” process supports the “disintermediation” thesis. We also suggest that this “disintermediation” is in effect the permanent creation of new currency, which is a key element of the “Helicopter Money” process. It was interesting to hear Bull Dudley confirm this analysis in a speech, at the Bank of Mexico conference, which audaciously asserted that the size of the Fed balance sheet itself made a premature rise in interest rates unlikely. Dudley just signalled that the Fed can’t tighten because it will incur all the financial losses associated with a tightening. The only solution he foresees is for the Fed to let the assets on its balance sheet mature. The significance of his analysis seems to have been lost in all the headlines surrounding the Debt Ceiling; however it was profound and worrying. If these maturing assets are securities backed by the modified mortgages of American citizens, then it is logical to conclude that permanent new currency has been created.
In “Goldilocks Economy and the Three Bear Markets” we said that:
“Fundamentally speaking, the policy makers have reached the point at which they have conceptually understood that monetary stimulus has pulled forward the valuation of future economic growth to the present in asset prices.”
The implication was that there is some point in time at which the present meets the future where the growth has been taken from. At this singularity a Depression occurs, which cannot be addressed through the creation of more credit that pulls growth forward. Some of our readers opined that this theoretical construct was without basis and merit. At this point, we would like to address this criticism.
We have chosen this point, because recently OPEC celebrated its fortieth birthday. The birth of OPEC will serve as the basis for this assertion. The birth of OPEC was enabled by the Western central banks, particularly the Fed. Had the Fed not created the new currency to pay for the higher oil prices, these prices could not have risen. In this scenario however, OPEC would have accumulated Gold instead of US Dollars as consideration for Oil exports. Oil is a “must buy” for a Developed Nation at any price. The Developed Nations would then not have had any Gold to back their currencies, so ultimately they would have then resorted to the monetary presses. The outcome therefore, was always going to be the same; so that by 1976 the Gold Standard was dead. This episode in monetary history illustrates what has happened and what will happen again, when a central bank is taken prisoner by the government of the day that wishes to settle its energy bills with IOU’s.
Captive central banks always resort to currency debasement as the last resort. Currency is less important than energy in a Developed Economy. Currency debasement has the effect of making energy more expensive and hence even more important. As a result of its increased price, energy therefore becomes an economic headwind. It is this rise in the energy price which reflects the pulling forward of growth from the future. If the price of energy does not fall, it then guarantees that there will be no growth in the future. Developed Economies have used technology to become more efficient in the use of energy; but in this case the cost of energy remains high. The growth of Emerging Economies has contributed to the sustained rise in energy prices, especially when these economies have used energy subsidies to sustain their own economic growth. Up until 2008 these subsidies were funded by the consumption of exports by Developed Economies, which went into debt in order to consume. After 2008, these subsidies were funded by Quantitative Easing that leaked out of Developed Markets looking for alleged Emerging Market growth. Currently these subsidies are being rolled back as capital flies back to Developed Economies. Developed Economy central bankers totally ignore the impact of their policy on energy prices at best. At worst, they actually opine that rising energy prices are an economic headwind which must be mitigated with more liquidity. Today, the Shale Oil and Gas revolution is sighted as making the USA the new Saudi Arabia. In practice, this Shale Oil and Gas is several times more expensive to extract than that from Saudi Arabia. Despite all the hype, energy is therefore still a costly economic headwind. Money spent on energy is money that cannot be used to service debts or consume. The high energy cost therefore undermines the debt position and growth fundamentals of the economy. At this point the Fed has nobly decided to assume the entire energy cost and growth burden, by expanding its balance sheet to take on the private debts of the banks. It is only fair that the Fed should do this, since it is the agency through which the high energy cost has been levied on the American economy since 1973. One wonders if the Fed understands what it is really doing though. The only way out for the Fed is if energy prices fall. Does the Fed know something we don’t about “something” that is going to drive energy prices lower? What the Fed is signalling is that it can never tighten until energy prices have fallen significantly enough to stimulate growth on their own. The problem is however that the Fed can’t exit because it believes that its balance sheet is the only thing holding up the economy. Unfortunately by holding up the economy, the Fed is holding up the Oil price which is holding down the economy, which is causing the Fed’s balance sheet to be expanded etc. etc. etc.
How do you think the Fed feels?