Monday, October 05, 2009

Graham Summers: The Next Major Crisis Brewing

As I've tracked the Federal Reserve's operations this summer I've become increasingly uncomfortable with what I saw. Instead of writing what would turn out to be a highly technical and probably boring piece about debt monetization, failed treasury auctions and open market operations I'd like to point you to a piece by Graham Summers that I think explains my concerns, you can click on the title above to access the entire piece, I'll give a few tidbits below:

For the Fed to hint at raising rates (let alone raise them) would kick off a systemic implosion that would wipe out the very guys the Fed has been bailing out. Suffice to say the Fed won’t be raising interest rates now or anytime too soon (within the next 3-5 years, unless inflation destroys the dollar).

The Fed also announced it would be slowing its purchase of Mortgage-Backed Securities (what I call the Fed’s “cash for trash” program). The Fed has stated previously that it will buy $1.45 trillion in mortgage-backed securities from US banks and that this program will end by the end of 2009. However, last week the Fed said it will be extending the program (but not the amount of money spent) until the first quarter of 2010.

The Fed did announce that it would let its Quantitative Easing program end in October. If you’re not familiar with this program, it’s basically a fancy way of saying that the Fed has been buying US debt in order to finance Obama et al’s massive deficit.

This particular development is key. A little known fact (and one totally ignored by the mainstream media) is that the Fed accounted for nearly half of all Treasury purchases in the second quarter ($164 billion out of $339 billion). In fact, the Fed bought more Treasuries than the next three largest purchasers combined!!

The Fed’s purchases outnumber foreign holders (foreign governments), US households, and Primary Dealers (mega banks) combined. One should also note that foreign holders reduced their purchases of US debt from $159 billion in 1Q09 to $101 billion in 2Q09 (a 40% decrease).

In simple terms, these numbers indicate that if it were not for the Fed, the US Treasury market would have almost assuredly had numerous failed auctions in the second quarter.

I’ve often stated that the Fed will have to sacrifice stocks or the US dollar. If the Fed does in fact end Quantitative Easing in October (as it has stated it will in last week’s FOMC), then we’ll see what the market really thinks of US debt as an investment class. It’s clear from the above data that foreign holders want higher rates (yields) in order for them to start buying more heavily. However, as I’ve stated before, the Fed cannot afford higher interest rates without blowing up US banks.

The Fed is no longer walking a tightrope, it is now attempting to keep the box it is standing on front tipping over....which would tighten the noose around its next and....well you know how that ends. The rope is no longer what the Fed is walking on, its what is around their neck.

Scott Dauenhauer CFP, MSFP, AIF