How the Fed Screwed the Pooch


This is how the casino works for the casino bosses. From the WSJ:

All eyes are on this week’s FOMC meeting—will the ‘tapering’ of bond-buying finally kick in? Then what? … We are in an age where the eight male and four female members of the FOMC are responsible for whether securities markets float or sink.


Jamie Dimon got the world’s attention June 6 when he told an audience in China that securities market behavior in the months ahead is likely to be “scary and volatile.”

On the blog, “Seeking Alpha,” market analyst Joseph Stuber theorized that the J.P. Morgan Chase CEO was sending out a message on behalf of the Federal Reserve that it is mulling an early wind-down of its latest round of quantitative easing and that things might get rocky. Whether or not the Fed was sending a signal, markets have been skittish in advance of the Federal Open Market Committee meeting that ends on Wednesday. Will the Fed really begin “tapering” its $85 billion monthly purchase of Treasury and federal-agency bonds? A lot of people are waiting to hear.

We are in an age where the eight male and four female members of the FOMC are responsible for whether securities markets float or sink. Traders around the world who in better times considered a range of variables now focus on a single one, Federal Reserve policy.

“It’s a different world when central banks are managing interest rates,” said Mr. Dimon in China. And this world can indeed become “scary.”

Unsurprisingly, bond markets have been dampened by the guessing about the Fed’s policy intentions. Buyers were unenthusiastic at last week’s Treasury auction of 10-year Treasury notes. The market price of 10-year Treasurys has fallen despite the massive Fed purchases.

More troubling is the behavior of the stock market. Traders last week blamed uncertainty about the FOMC for the sharp ups and downs on the New York Stock Exchange. The Dow Jones Industrial Average dropped 105.9 points for the week. Volatility resumed on Monday, with a 183-point spread between the high and low point of the Dow, as it recovered from last week’s loss.

In the bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other to maximize yield. But in the new world of government rigging, they often head in the same direction. That’s not good for investors. [Note: We’ve CREATED this world with bad economic policies.]

Stocks have had a big ride under the Fed’s near-zero interest rate policy as investors have accepted greater risks for better returns than those available on bonds. But there may be another reason for the stock run-up. The Fed’s huge bond purchases may impact stocks directly. Hence, the 15,000 Dow may be a bubble that will deflate if the Fed starts “tapering.”

To understand the possible connection, follow the money. Because the Fed makes its Treasury bond purchases from the “primary dealer” banks, the proceeds boost the banks’ deposits at the Fed far in excess of the reserves legally required. Since the QE4 buying program began last December, excess reserves have burgeoned by more than a half-trillion dollars to just short of $2 trillion. To encourage the banks to hold this money so that it won’t enter the credit markets and destroy the value of the dollar, the Fed pays the banks a quarter of a percentage point interest on their deposits.

But it may not be that easy to contain $2 trillion in inflationary cash—and some analysts believe that excess reserves are a direct factor in the run-up in stocks. Their arguments are abstruse, involving such possibilities as “hypothecation” of those deposits, that is, using them as collateral to raise money in the “shadow banking” market for investment in stocks.

Banks have constant dealings in the shadow market with nonbank entities like money-market and hedge funds and other big money pools. It’s not a big stretch to imagine them using excess reserve deposits as collateral to raise money.

A modicum of support for such theories comes obliquely from New York Fed President William Dudley, a member of the FOMC. In a February speech, he raised concerns about the failure of the massive Dodd-Frank financial reform legislation to adequately regulate shadow banking. Mr. Dudley complained that Dodd-Frank actually raised the risks to the financial system by barring Fed intervention if a shadow bank is in danger of failure. He was referring to the huge business that money-market funds do in raising collateral for “tri-party repos,” where third parties manage the temporary sale and repurchase of securities that banks use to raise short-term cash.

The Fed president apparently was concerned about a “run” on one of the parties if the collateral goes sour. He wasn’t talking about hypothecating excess reserves, but who’s to say that tri-party repos are the limit of Fed concerns about shadow banking.

Aside from direct Fed influence, there is another reason to be concerned about a stock-market bubble—leverage. Margin debt at the New York Stock Exchange reached a record high of $384 billion in April, which means that the stock market is getting heavy support from borrowed money. [Thanks Mr. Fed!]

With a decline in bond values despite the Fed’s buying spree, and the possibility that Fed policy has also inflated stocks, the FOMC faces some tough issues this week. Surely, it can’t go on forever adding more trillions to its balance sheet and the excess reserves of the banks. But what happens when it stops? How scary will it be?

That’s an enormous puzzle for the 12 ordinary mortals on the committee to try to solve. The superhuman task derives from the grandiose belief by Chairman Ben Bernanke and his White House supporters that the Fed is capable of superhuman feats, like running the global economy.