Fed Planning 15-Fold Increase In US Monetary Base



http://www.marketskeptics.com/2009/03/fed-is-planning-15-fold-increase-in-us.html

The fed is planning moves that would more than double its balance-
sheet assets by September to $4.5 trillion from $1.9 trillion. Whether
expressing approval or concern over the fed’s intentions, most
commentators fail to understand the real magnitude of the projected
expansion of the US monetary base because they don’t take into account
the amount of dollars circulating abroad.

At least 70 percent of all US currency is held outside the country,
and this means the US monetary base is considerably smaller than the
fed’s overall balance sheet. Take, for example, the true US domestic
money supply at the beginning of September 2008, before the fed
started its quantitative easing. From the Federal Reserve’s website,
we know that currency in circulation was 833 Billion. This translates
as 583 Billion dollars circulating abroad (70 percent), and 250
Billion dollars circulating domestically (30 percent). Since the bank
reserve balances held with Federal Reserve Banks were 12 billion, that
gives us a 262 Billion domestic monetary base as of September 2008.
Now compare that to the projected US domestic monetary base for
September 2009 which is 3,818 billion (4,500 billion – 583 billion
(dollars circulating abroad) – 99 billion (other fed liabilities not
part of the money supply)). The fed’s planned balance sheet expansion
results in a 15-fold increase in the base money supply.


262 Billion = US monetary base as of September 2008 (minus dollars
held abroad)
3,818 Billion = projected US monetary base in September 2009 (minus
dollars held abroad)

3,818 Billion / 262 Billion = 15-Fold Increase in US monetary base


This is a staggering devaluation of the US currency! It means that for
every dollar in America in September 2008, the fed is going to create
fourteen more of them! Below is a rough sketch of what this increase
in US monetary base would look like:

The fed is planning moves that would more than double its balance-
sheet assets by September to $4.5 trillion from $1.9 trillion. Whether
expressing approval or concern over the fed’s intentions, most
commentators fail to understand the real magnitude of the projected
expansion of the US monetary base because they don’t take into account
the amount of dollars circulating abroad.

At least 70 percent of all US currency is held outside the country,
and this means the US monetary base is considerably smaller than the
fed’s overall balance sheet. Take, for example, the true US domestic
money supply at the beginning of September 2008, before the fed
started its quantitative easing. From the Federal Reserve’s website,
we know that currency in circulation was 833 Billion. This translates
as 583 Billion dollars circulating abroad (70 percent), and 250
Billion dollars circulating domestically (30 percent). Since the bank
reserve balances held with Federal Reserve Banks were 12 billion, that
gives us a 262 Billion domestic monetary base as of September 2008.
Now compare that to the projected US domestic monetary base for
September 2009 which is 3,818 billion (4,500 billion – 583 billion
(dollars circulating abroad) – 99 billion (other fed liabilities not
part of the money supply)). The fed’s planned balance sheet expansion
results in a 15-fold increase in the base money supply.

262 Billion = US monetary base as of September 2008 (minus dollars
held abroad)
3,818 Billion = projected US monetary base in September 2009 (minus
dollars held abroad)

3,818 Billion / 262 Billion = 15-Fold Increase in US monetary base


This is a staggering devaluation of the US currency! It means that for
every dollar in America in September 2008, the fed is going to create
fourteen more of them! Below is a rough sketch of what this increase
in US monetary base would look like:

2) As a reserve asset, treasury bonds will face enormous selling
pressure in 2009

There is the mistaken belief that the role of treasuries as a safe
haven is bullish for treasury bonds. It is not. This logic ignores the
reality that reserve assets, such as treasuries, are accumulate in
good times and sold in bad times:

Federal and state agencies will be selling treasury reserves. For
example, the Deposit Insurance Fund (a.k.a. FDIC) will be selling
treasuries to pay back depositors of failed banks, and the
Unemployment Trust Fund will be selling treasuries to make payments to
the unemployed.

State and local governments will be selling treasury reserves. As an
example, states have already begun drawing down reserves as their
budget troubles worsen. The bulk of those reserve remain, and they
will be sold over the course of this year.

Banks and insurers will be selling off their treasury loan-loss
reserves. Financial institutions have been building their treasury
loan-loss reserve for the last year in anticipation of growing
defaults. In 2009, this process will reverse as loans go bad and
insurers make good on claims.

Foreign central banks will be selling off their treasury foreign
reserves. Saudi Arabia, for example, is projecting a 2009 Budget
Deficit, which it intends to finance by selling off its US holdings.
Russia, meanwhile, has already sold over 20% of its $598.1 billion
reserves, and India's central bank has been forced to sell off its US
holdings to curb its currency's decline, and its total reserves have
decreased by $62.2 billion. Japan, which is now running a record
current account deficit, can also be expected to sell treasuries.

Even China could become a seller of treasuries as it mobilizes its
dollar reserves. The Chinese government has sent clear signals that it
is shifting from passive to active management of its reserve and is
exploring more efficient ways to use its reserves to boost its
domestic economy.

3) Retirement inflows into treasuries are over

The steady accumulation of treasuries by government retirement funds
has helped absorb the supply of treasury bonds for over three decades.
This accumulation of government debt to secure the retirement of baby
boomers helped drive down treasury yields and fund deficit spending.
As of September 2008, the four biggest of these funds held 3.3
trillion treasuries:

2150 billion (Federal old-age and survivors insurance trust fund)
615 billion (Federal employees retirement fund)
318 billion (federal hospital insurance trust fund)
217 billion (federal disability insurance trust fund) (for more on
these four funds, see where social security tax amounts are deposited)

3300 billion total

Today, the accumulation of treasuries by government retirement funds
is over. Baby boomers are beginning to retire, increasing outflows,
and unemployment is rising, cutting inflows. More importantly, the 3.3
trillion already accumulated in these funds provides an enormous
political incentive to prevent treasury prices from collapsing. Faced
with a run on treasuries, politicians, rather than explaining to baby
boomers that their retirement savings are gone, will instruct the fed
to monetize treasury bonds. This alone will prevent the fed from
reversing its current balance sheet expansion.


4) Deleveraging in credit-default swap market will drive up risk
premiums

If you have been following the credit crisis in any detail, you might
have heard that the 53 trillion credit-default swap market threatening
the solvency of the financial system. What you might not have heard is
the other dire threat posed by the CDS market: drastically higher risk
premiums on all forms of debt.

These higher risk premiums are the result of reversing the process by
which credit-default swaps were leveraged up and packaged into
investment vehicles. Some examples of these horrors are:

Synthetic CDOs
As opposed to regular CDOs (which contain actual bonds), synthetic
CDOs provide income to investors by selling credit-default swaps on
hundreds bonds from companies and governments.
To juice returns, these synthetic CDOs disproportionally insured the
riskiest AAA rated debt, such as Lehman’s bonds. Synthetic CDOs are
estimated to have sold insurance on between $1.25 trillion to $6
trillion worth of bonds.

Constant-Proportion Debt Obligations
CPDOs are specialized funds which work exactly like synthetic CDOs but
with one major difference: they used leverage to boost returns. These
CPDO funds typically borrowed about $15 for every dollar invested with
them. They also contain safety triggers that force the liquidation of
their investments if losses reach a predetermined level, and most CPDO
funds have begun to hit these triggers. For example, Three CPDO funds
launched in 2006 by Dutch bank ABN Amro Holding NV have already been
forced to liquidate as credit insurance costs spiked and their credit
ratings were downgraded.

Credit Derivative Product Companies
CDPPs are another group of specialized funds which work exactly like
synthetic CDOs and CPDO funds, except for one key difference: they
used an insane amount of leverage, as much as $80 for every dollar
invested. CDPP funds together with subprime CDOs squared are finalists
for the title of “most idiotic financial instrument ever created”.


Since these leveraged investment vehicles sold an enormous amount of
insurance, the premiums for CDS insurance dropped sharply, making
corporate debt seem safer and lowering interest rates. In effect, the
process of building up the 53 trillion CDS market created an era of
artificially low risk premiums on all forms of debt. Unfortunately,
the pendulum is now swinging in the other direction, and the pain has
just begun.

As investors attempt to get out of synthetic CDOs and CPDO/CDPP funds
try to deleverage, they push up the cost of default insurance. In
turn, that raises the risk premium on all forms of debt since most
investors use the cost of default insurance as a guide when deciding
at what interest rate they will buy bonds. Many banks are also tying
corporate loan rates to credit-default swaps, raising borrowing costs
and exposing companies to an overleveraged derivative market which is
largely responsible for crippling the financial system.

The graph below shows how the cost of insuring the debt of EU nations
is being driven up.


The rising cost of insuring debt is impacting treasuries too. The cost
to hedge against losses on $10 million of Treasuries is now about
$100,000 annually for 10 years, up from $1,000 in the first half of
2007. These rising insurance costs have helped push up treasury yields
in the last few months. Worse still, the rising costs of insuring
against government defaults will undermine faith in dollar. After all,
the CDS market is telling us that 10-year treasury notes have become
100 times riskier in the last two years.


5) Unwinding the Gold carry trade

The massive expansion in the US money supply will undoubtedly drive
gold prices several times higher and force the unwinding of the gold
carry trade. To see the threat which unwinding the gold carry trade
poses, it is necessary to understand how US and UK financial
institutions got themselves stuck in an enormous short position in
gold from which they have no hope of ever escaping. For that purpose,
I have outlined below the five steps Wall Street seems to repeat
endlessly on its path to ruin.


Step 1: Wall Street embraces a false paradigm

“Housing prices never fall”

-----

“gold is a relic” or “gold is in a permanent downtrend”

Step 2: Wall Street makes billions embracing this false paradigm…

US/UK Financial institutions made billion in fees from making mortgage
loans and securitizing them.

-----

US/UK Financial institutions made billions via gold carry trade. Here
is an ultra quick explanation how it works from zealllc.com

So, if you can find a cheap enough cost of capital, a safe enough
destination, and you have the credit to borrow large amounts of money,
you too could make enormous profits in carry trades. The notorious
gold carry trade is based on the exact same idea. Elite money-center
bullion banks were given sweetheart opportunities to borrow central
bank physical gold at 1%, sell it in the open market, and immediately
invest the proceeds in higher yielding “safe” investments and reap
vast profits.

As Moneyweek further explains:

It seemed like a no-brainer. The central banks got to squeeze a yield
from their gold. The borrowers got to sell the gold on, and use the
proceeds to fund more exciting investments like 10-year US Treasuries
yielding 4% per year or so. Yes, these 'carry trade' returns were
tiny. But the cost of borrowing gold was tinier still.

Step 3: …and creates a catastrophic mess in the process

Enormous housing bubble
Subprime CDOs squared
Off balance sheet SIVs
Etc…

-----

Commercial banks and speculators are left inescapably short gold.
These ridiculous short positions are best captured by John Hathaway in
his 1999 article, The Golden Pyramid.

The recipe for a shortage has been carefully followed. A few finishing
touches may be required before a market epiphany. There is no known
reconciliation between paper and physical positions, and none will be
attempted until after the squeeze. The weakness of credit analysis and
supervisory oversight, as well as the many ambiguities in the linkage
between paper gold and physical can flourish only if there is supreme
confidence in gold's permanent downtrend. The trust and confidence
essential to balance the gold derivatives pyramid depends on three
critical errors: that mine reserves = physical gold; that gold
receivables = gold on hand; and that financial markets will enjoy
smooth sailing indefinitely. Trust is nothing more than a state of
mind. When this levitation is finally exposed and its illusions
shattered, it is ludicrous to think the imbalances can be corrected by
a small rise in the price and within a comfortable time frame. Expect
the resolution to be swift, furious, and uncomfortable for those
caught short.

Step 4: Something goes horribly wrong

Subprime borrowers start defaulting
Housing prices plummet

-----

Gold prices shoot up after the 1999 Washington Agreement on Gold (EU
central banks agreed to limits on gold sales/leasing).

This gold bear trap is best described by Reginald H. Howe in his
report about central banks at the abyss.

The first Washington Agreement on Gold, announced in September 1999 at
the close of the annual meetings of the International Monetary Fund
and World Bank in Washington, D.C., placed limits for the next five
years on the official gold sales of the signatories as well as on
their gold lending and use of futures and options. Put together at the
instigation of major Euro Area central banks in response to the
decline in gold prices caused by the series of U.K. gold auctions
announced in May of the same year, WAG I caused gold prices to shoot
sharply higher.

Within days, as gold shorts rushed to cover, the price jumped from
around $265 to almost $330/oz. and gold lease rates spiked to over 9%.
The rally caught the major bullion banks completely wrong-footed,
resulting in the panic later described by Edward A.J. George, then
Governor of the Bank of England (Complaint, 55):

We looked into the abyss if the gold price rose further. A further
rise would have taken down one or several trading houses, which might
have taken down all the rest in their wake. Therefore at any price, at
any cost, the central banks had to quell the gold price, manage it. It
was very difficult to get the gold price under control but we have now
succeeded. The U.S. Fed was very active in getting the gold price
down. So was the U.K.

Despite managing to “get the gold price under control”, US/UK bullion
banks (JPMorgan, HSBC, etc…) have been stuck on the short side of gold
ever since.

Step 5: The US fed and UK do everything in their power to “save the
financial system”

Royal Bank of Scotland bailout
Bear Stearns bailout
Freddie/Fannie bailout
AIG bailout
US/UK Quantitative easing
Etc…

-----

Leasing out all US/UK gold to bullion banks
Gold swaps with foreign central banks (then leasing out the gold)
Convincing allies to sell gold
Writing naked call options on gold
Britain’s 1999 gold sales
Pre-emptive gold sales
Allowing JPMorgan’s and HSBC’s manipulation of COMEX futures
Etc…

Make no mistake, gold prices have suppressed, but calling this process
a “conspiracy” would be inaccurate. Gold suppression by the US and UK
is better characterized as a desperate cover-up. Furthermore, while a
side affect of the gold carry trade and gold suppression was to drive
down interest rates, that was never their intended effect. A desire to
hold interest rates would not have been enough to push the fed or the
Bank of England to manipulate gold prices. It was only the threat of
the total collapse of US/UK financial system which prompted the
suppression of gold. The unwinding of the gold carry trade would have
(and will) dragged down the some of the biggest US/UK banks under
(JPMorgan, HSBC, etc…) and that was what had to be prevented at any
cost.

Stay away from any form of paper gold: GLD (HSBC is custodian), gold
pools and unallocated gold accounts, gold futures, etc… Paper gold
investments are guaranteed to default before this crisis ends.

Besides leaving the financial system inescapably short gold, the gold
carry trade also drove down yields on treasuries and other US debt, as
commercial banks invested the proceeds from the sale of borrowed
central bank gold and other naked short positions. Unwinding the gold
carry trade involves the purchase of physical gold, but also the sale
of the investments linked to the gold short positions. As the fed
begins 15-fold expansion of the monetary base (which logically should
eventually send gold prices up at least ten times where they are now),
the unwinding and fallout of the gold carry trade seems imminent.

6) The return of the 580 billion dollars circulating abroad

Over the last thirty years, the steady outflow of 580 billion dollars
has helped drive down interest rates. For example, If 10 billion
dollars leaked out of the US and began circulating abroad, the fed
would print 10 billion and buy treasuries in order to replenish the
domestic money supply. So the 580 billion dollars held abroad resulted
in the purchase of roughly 580 billion treasury bonds by the fed,
thereby increasing demand for US debt.

While the accumulation of oversea dollars has been beneficial in the
past, today the large pools of dollars circulating in foreign hands
pose a threat. With many dollar alternatives becoming available, US
oversea currency looks increasingly likely to start flowing back home.
The main currencies with the potential to displace dollars are:

A) The Chinese yuan which is becoming an international currency
B) The Khaleeji, a new currency being launched by Gulf states which
will be possibly backed by gold.
C) The Euro with its partial gold backing
D) Gold

Furthermore, now that the fed has begun creating money at an
accelerating rate, the extensive foreign holdings of US currency might
exacerbate the effects of inflation fears. As foreign dollar holders’
confidence in the dollar is eroded, they will trade their dollars for
alternate stores of value (yuan, euro, gold, etc…), potentially
sending a flood of currency back to the US. If the Fed failed to
reduce the supply of currency to counteract dollars being unloaded
from abroad, the inflationary consequences would be made worse as the
mass reversal of currency flows from foreigners to the US becomes
overwhelming.

7) Interest rate derivates nightmare

The threat posed by interest rate derivates is perhaps the greatest
out of all the ones outlined so far. It is also the one hardest to
understand. The first thing to note about interest rate swaps is the
size of the market, as explained by the Wikipedia:

The Bank for International Settlements reports that interest rate
swaps are the largest component of the global OTC derivative market.
The notional amount outstanding as of December 2006 in OTC interest
rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from
December 2005. These contracts account for 55.4% of the entire $415
trillion OTC derivative market. As of Dec 2007 the number rose to
309,6 trillion according to the same source.

The growth in interest rate swaps creates demand for bonds because
many of these interest derivatives require the purchase of bonds as a
hedge. Rob Kirby on 321gold.com explains this in his article, the real
ponzi scheme - "unreal interest rates".

Interest Rate Swaps create demand for bonds because bond trades are
implicitly embedded in these transactions. Without end user demand for
the product - trading for "trading sake" creates ARTIFICIAL demand for
bonds. This manipulates rates lower than they otherwise would be.

Interest rate swaps were originally developed to [1] allow parties to
exchange streams of interest payments for another party's stream of
cash flows; [2] manage fixed or floating assets and liabilities and
[3] to speculate - replicating unfunded bond exposures to profit from
changes in interest rates. Growth in the first two of these activities
are dependent on their being increased end-user-demand for these
products - graph 1 above indicated that this is not the case:

In the case of J.P. Morgan in particular [forgetting about the lesser
obscenities at Citi and B of A]; their interest rate swap book is so
big that there are not enough U.S. Government bonds being issued or in
existence for them to adequately hedge their positions.

This means that the obscene, explosive growth in interest rate
derivatives was all about overwhelming the long end of the interest
rate complex to ensure that every and any U.S. Government bond ever
issued had a buyer on attractive terms for the issuer. Concurrent with
the neutering of usury, the price of gold was also "capped" largely
through Fed appointed banks "shorting gold futures" as well as
brokering gold leases [sales in drag] sourcing vaulted Sovereign
Central Bank gold bullion. The gold price had to be rigged
concurrently because historically, according to observations outlined
in Gibson's Paradox - lowering interest rates leads to a higher gold
price. Gold price strength is historically synonymous with U.S. Dollar
weakness which leads to higher financing costs or the possibility of
capital flight.

Same as with the gold carry trade, while the explosive growth in
interest rate derivatives did reduce interest rates by creating demand
for bonds, I am not sure about the conspiracy element. From everything
I have seen and read during the credit crisis, the wizards of Wall
Street (ie: the creators of the subprime CDO squared and other
horrors) and the Federal Reserve seem more like children playing with
dynamite rather than masterminds capable of pulling off vast
conspiracies.

The greater threat posed by interest rate swaps

Besides creating artificial demand for bonds, the interest rate swap
market poses a systematic risk exceeding that of the credit-default
swap market because of its enormous size and the fact that each
interest rate swap contract offers the potential for unlimited losses.
The graph below should help show this danger.

Interest rate swaps were originally developed to [1] allow parties to
exchange streams of interest payments for another party's stream of
cash flows; [2] manage fixed or floating assets and liabilities and
[3] to speculate - replicating unfunded bond exposures to profit from
changes in interest rates. Growth in the first two of these activities
are dependent on their being increased end-user-demand for these
products - graph 1 above indicated that this is not the case:

In the case of J.P. Morgan in particular [forgetting about the lesser
obscenities at Citi and B of A]; their interest rate swap book is so
big that there are not enough U.S. Government bonds being issued or in
existence for them to adequately hedge their positions.

This means that the obscene, explosive growth in interest rate
derivatives was all about overwhelming the long end of the interest
rate complex to ensure that every and any U.S. Government bond ever
issued had a buyer on attractive terms for the issuer. Concurrent with
the neutering of usury, the price of gold was also "capped" largely
through Fed appointed banks "shorting gold futures" as well as
brokering gold leases [sales in drag] sourcing vaulted Sovereign
Central Bank gold bullion. The gold price had to be rigged
concurrently because historically, according to observations outlined
in Gibson's Paradox - lowering interest rates leads to a higher gold
price. Gold price strength is historically synonymous with U.S. Dollar
weakness which leads to higher financing costs or the possibility of
capital flight.

Same as with the gold carry trade, while the explosive growth in
interest rate derivatives did reduce interest rates by creating demand
for bonds, I am not sure about the conspiracy element. From everything
I have seen and read during the credit crisis, the wizards of Wall
Street (ie: the creators of the subprime CDO squared and other
horrors) and the Federal Reserve seem more like children playing with
dynamite rather than masterminds capable of pulling off vast
conspiracies.

The greater threat posed by interest rate swaps

Besides creating artificial demand for bonds, the interest rate swap
market poses a systematic risk exceeding that of the credit-default
swap market because of its enormous size and the fact that each
interest rate swap contract offers the potential for unlimited losses.
The graph below should help show this danger.

The sheer size the fed’s monetary expansion and the dollar’s fall will
soon increase both inflation and inflation expectations. This in turn
will put upwards pressure on treasury yields.

Conclusion

During the last three decades, long-term interests rates have fallen
steadily in US, as demonstrated by the chart below

Logically speaking, the chart above makes no sense. The fundamentals
underlying the US economy have grown steadily worse over the last
thirty years. For example, in 2006, the US’s current account deficit
nearly hit 9 percent of our gdp, and economists usually consider 4
percent to be unsustainable. There are also the US’s chronic budget
deficits and the massive projected social security shortfalls. Even
more incomprehensible, over the last six months the yield on long-term
treasuries has fallen in the face of a disintegrating economy and
massive expansion in the supply of treasuries. This is NOT how the
world works: as the financial health of borrowers decrease, their
interest rates are supposed to go up. The only rational explanation is
that some combination of forces has been unnaturally driving rates
lower. These forces, (outlined above) which have been driving interest
rates down, are today threats and issues which need to be resolved
before the financial crisis can end:

The US budget deficit
The crisis in entitlement spending
The trade deficit and large holdings of treasury reserves
The credit-default swap market
The gold carry trade
The 580 billion dollar circulating overseas
The 8 trillion dollar assets accumulated by European banks
The interest rate swaps market
The Keynesian thinking dominating US economic and fiscal policy

.



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