Wednesday, November 04, 2009

Feds Forget Bread Crumbs, Have No Exit Strategy

Early in the morning came the woman, and took the children out of their beds. Their bit of bread was given to them, but it was still smaller than the time before. On the way into the forest Hansel crumbled his in his pocket, and often threw a morsel on the ground until little by little, he had thrown all the crumbs on the path. Hansel & Gretel

This afternoon (thanks to the good fellows at Zero Hedge) I found my way to the Minutes of the Meeting of the Treasury Borrowing Advisory Committee Of the Securities Industry and Financial Markets Association.

After debate on other issues, The Committee then turned to a presentation by one of its members on the likely form of the Federal Reserve's exit strategy and the implications for the Treasury's borrowing program resulting from that strategy.

The presenting member began by noting the importance of the exit strategy for financial markets and fiscal authorities...A critical issue will be the impact on the riskier asset classes as market interest rates move away from zero.

The presenting member then looked at the likely sequence of the Federal Reserve's exit strategy. The member acknowledged that the central bank must address the uncertainty and fragility of the economic recovery and the dependence of the housing market on low rates. It was suggested that the most likely sequence would be the draining of excess reserves from the banking system, the cessation of the mortgage-backed securities purchase program, and only then raising the Fed funds target rate.

There you have it, drain excess reserves, stop buying mortgage back securities and then raise Fed Funds.

Easy, right?

Not so fast.

Several members at this point asked why draining reserves before ending the MBS program made sense. The presenting member noted that the program was already set to expire, and other measures, such as a revival of the Supplementary Financing Program, could be utilized by the Federal Reserve at the same time.

The presenting member then addressed the options for draining reserves from the banking system. The problem of excess reserves could persist through the end of 2011 with up to one trillion in excess reserves remaining after liquidity facilities and on balance sheet securities have rolled off. One approach, raising the Fed funds rate to increase the opportunity costs of banks using their reserves, carries the attendant problems of increasing interest rates too soon in the economic recovery. A second option, taking in term deposits, lacks a clear mechanism for rate setting and bank use. Selling assets may run into difficulties if the public appetite for debt at that time is sated, especially considering the impact on the housing market and the major role the Federal Reserve currently plays in the market.

According to the presenting member, these less than optimal solutions leaves the Federal Reserve the option of reverse repurchase agreements (reverse repos) as the most likely option although the potential of the mechanism for draining reserves is unclear. If it is to undertake these reverse repos, the selection of counterparty is important. Depending on how the program is designed, whether it is made to work with dealers or money market funds or to pursue a TALF model with banks as agents, there will be different impacts on the scope of the program, the ease with which it can be set up, and the term of the contracts. In all cases, the program will compete with other short-term investments and put upward pressure on Treasury bill rates according to the presenting member. Moreover, draining excess reserves may dampen the demand for Treasury securities by banks given that banks are investing in securities – particularly Treasuries - in the absence of loan demand.

Several members noted the graph discussing net fixed income supply in 2009 and 2010, and how issuance will ramp up dramatically in 2010. Federal Reserve purchases have taken an enormous amount of supply out of the market this past year across fixed income markets, but next year, financial markets should expect even greater issuance with no support. Such an outcome could pressure rates.

"Pressure rates," now there's an understatement. 

It looks to me as if the Feds didn't consider an exit strategy before embarking on their journey into the liquidity swamp called Quantitative Easing. There seems to me to be no viable exit strategy that won't have severe implications for the real economy. Given that we will be having elections in 2010, and again in 2012, the odds of the liquidity swamp getting drained any time soon, which would surely sour the mood on incumbents seems quite small.
Tightening, I suspect, will be done by the markets, and, under that scenario, those excess reserve might come in handy. At least then the Feds will then have someone else to try to blame.
Alternatively, this meeting could be just a show to buy time before the US$ starts to really sink.
No wonder Mr. Buffett wants to get rid of his cash.


John said...

Hi Dave,

I havn't stopped by in months. I thought you were done posting. Stephen had a question for you over at his blog. Something about gold and stocks being connected even with fiat. Did yesterday begin the seperation? I'll have to take some time to catch up on the other posts. Glad you are back.


Dude said...

Equities and commodities tend to be correlated in countries with declining currencies although the beta (the rate of appreciation of one vs. the other) will differ.

As an example, in Indonesia during their crisis the equity market moved higher, but in real terms (vs. gold) fell.