how the Fed works

This is from Eventhorizon:

"The method by which the Fed permanently increases the money supply is via Permanent Open Market Operations (POMO). They buy US govt treasury securities and agency debt and credit the seller with newly created money. The newly acquired treasuries are added to the System Open Market Account (SOMA) which is the backing for our money (FRNs, Federal Reserve Notes). This is the monetization of US Govt debt, and my point was that it seems to have accelerated markedly the last couple weeks ($6bn in 2 weeks vs $2bn in 3 months)

'To keep the Fed Funds rate as close to target as possible the Fed temporarily adds (pumps) or subtracts (drains) money via Temporary Open Market Operations (TOMO). They use Repurchase Agreements (Repos or RPs) - the Fed buys treasury securites in exchange for cash and the counter-party agrees to repurchase them at a small premium (the implied interest rate) on a pre-agreed date (anything from 1 to 60 days later, but mostly 1 day, 1 week or 2 weeks). They carry out an operation of some kind pretty much every day, and it is done by dutch auction. The Fed does not publish the outstanding RP balance, so you have to figure it out by following along the daily transactions. Guttenberg’s point was they did a big pump today, while mine was to contrast this to the steady drain we have seen most of the year to date.
Finally the Treasury Department set up a program about a year or so ago whereby they put any spare cash balances they have to work via their own RP program called the Term Investment Option (TIO) program. Some consider this an additional source of liquidity or pumping. Personally I don’t see it that way, it acts like a sweep account attached to the government’s checking account, so it doesn’t add to the money supply. Whatever the truth, the TIO program accelerated this month, though it’s not that surprising given that its April.

'Hopefully that helps to make my post more intelligible. Bottom line is in April there seems to have been a noticeable change in activity, but as Russ points out it may or may not be significant. "

working thesis

Here's my working thesis for the next few months:

The long-term phenomenon of our time is the Yen carry trade. This has provided global liquidity for the past five years.

Inflation and a weak dollar fuel the stock market.

Right now, the main concern is that the Fed may raise rates and strengthen the dollar, but that will probably not dent the trade deficit. The question is where will foreign money go if they cut back on Treasuries?

Nothing except a global recession will stop the market. I see at least a good 3-6 months of nice gains.

Liquidity

Here my new liquidity thesis, with a little help from Gregor (see last post).

The liquidity bubble started with lower rates in 2002. It's now continuing with the resurgence of the carry trade. Liquidity is coming from the Bank of Japan, not the Fed. It doesn't really come from the BoJ, but from whoever buys Japanese bonds at 0.5%. Who would buy that? Well, I'll have to leave that question for another day, but I'll speculate that it's Japanese citizens who see 0.5% as a safe play against Japan's 20 years of deflation.

What happens in the future? If the Fed lowers, the carry trade just shifts to the Pound and the Euro, and the Dollar tanks. (Remember Soros' rule that inflation and a weak dollar are good for the stock market). If the Fed raises, then that will just pull more liquidity out of the carry trade. Besides, real 10-yr. rates are only 2.1% over inflation. That can't last.

The world is long dollars, short Yen.

The housing downturn should be contained, and the ripples outward should diminish rapidly. In fact, if it doesn't damage liquidity, it will just attract more people to look away from real estate and towards the stock market..

Actions: sell QID. look for growth aka Apple. Adobe? Financials? GS? Commodities?

If this is right...

then I need to change direction. I need to analyze this some more later, but I think this guy explains where liquidity comes from, and why it's not going away.

More on this later...

In the past two days, we've had $128 billion in buybacks and buyouts, and the market is down 15 points. This could be the sign of a peak. At the beginning of the year, the bulls were raving about the $2 trillion (with leverage) that private equity was ready to throw into the markets. However, that's only $8 billion per day. At this rate, soon there will be nothing left to prop up the market. Remember, bubbles require more and more assets to sustain growth.

More on this later...

Random thoughts

I need to keep my beliefs in front of me.

Namely, that the housing downturn will mirror the housing boom. I don't want to be one of the people who were calling for an imminent end to the housing bubble in early 2003 (2.5 years before the top). That's where I think we are in the cycle on the way down.
Here's a list of "reflexivity," affecting fundamentals in housing:

1. Regulations are tightening credit. The tighter credit gets, the lower prices will go.
2. Banks are stopping subprime lending altogether. Ditto.
3. Banks are reducing or eliminating their exposure to "liar's loans".
4. Banks are lending smaller amounts, and requiring larger down-payments.
5. Builders have 8 months of inventory and 50% more than normal "speculative" building than normal. More pressure on prices.
6. Foreclosures are at an all-time record. Increase in supply.
7. We have an under-the-radar population of 20 million illegal aliens (5-7 million workers?) who don't show up in the employment numbers. Undocumented workers outnumber legal workers at least 3 to 1. How many jobs are already lost? Remittances to Mexico are down 25% from last year's high. Maybe unemployment is really 10%, not 4.4%. Sales tax receipts in bubble states are down 20%.
8. Falling prices encourage people to wait, no matter how good the economy is.

Protectionism

Chucky Schumer says that he has the votes to push protectionist tariffs over a veto. Protectionism will be a huge mistake. First of all, any meaningful tariffs will raise prices significantly. This will contribute to inflation. Tariffs will also weaken the dollar, also contributing to inflation. Higher inflation, then, will be the first effect. The second effect will be a lower demand for Treasuries. China, with 40% of their economy based on exports, will be hit hard. Any unexpected shocks to the global economy will raise risk premiums across the board. Combine decreased demand for Treasuries, inflation, and financial shocks, and you have a recipe for massively higher interest rates.

I think this scenario could play out over the next couple of years. It bears watching, because it is the kind of thing that will be completely overlooked by the mainstream. The first idea that comes to mind is buy gold.

Power

I've been thinking about the source of the United States' economic power. The question could be asked 'Who is more dependent on the other, the U.S. or China?' One might say China because they are taking manufacturing jobs away from the U. S. However, I would ask what manufacturing jobs are worth if there's no demand for the product. We are paying China to flood our market with ever cheaper goods, and build ever more factories. In other words, they are competing amongst themselves for our money. Without our money, their factories are liabilities, not assets. They cannot support their own factories. We could, but choose not too, because we'd rather not cannibalize ourselves to compete with endless cheap labor. This is the first pillar of American power, namely, that we make foreign countries dependent upon us. If you're still not buying my argument with China, think about ancient history. From the 60's through the 90's to the present day, we've had a huge trade deficit with Japan, in which Japan built itself into an industrial power. Yet, no one would ever say that Japan's economy is better than ours. This is exactly what has been happening with China, ever since trade restrictions were loosened in the late 80's (not exactly sure about the date). Drawing from history again, China will suffer the same deflationary collapse that Japan did if they don't allow their currency to appreciate. Look at Europe: as dumb as the socialist French seem sometimes, and as arrogant as the British can be, they are intelligent enough to let their currencies float according to the market.

The second pillar of U.S. economic power is the setting of world prices. Every important commodity is priced in dollars. When imports come in too quickly, we devalue the dollar (remember going off the gold standard?). This is what is happening today with China: the best way to smooth out the trade imbalance (to preserve stability) is to devalue the dollar. When other nations are not dependent enough on dollar inflows, then the government strengthens the dollar. This is what happened under President Reagan, and Fed Chief Paul Volkner, during the 80's.
Here is another advantage of setting world prices: poor countries like Iran have to subsidize oil prices in their own country.

Employment reports

1.

For every legal worker in the construction business, there are 3-6 illegals. That's why the employment numbers have held up so well. In February, construction lost 56,000 jobs. Multiply by 3 to 6 and you have 168K to 336K, dwarfing job creation. So, while the employment reports won't show it, it's still happening, and it will affect the economy.

How can we play this?

If millions of Mexican citizens lose well-paying construction jobs, they will send fewer dollars back. I read a recent report that said that 10% of Mexico's citizens live in the United States. You can bet on it that they make more than the average in Mexico. 10 million/4 per family = 2.5 million workers. It's probably more than that because many come here without family and send money back home.

What about a short on the Peso? Might be okay, but $50 billion home out of GDP of $700 billion is not enough. Plus, the dollar is dropping, and Mexico exports a lot of oil. I'll have to think of another way.

2.

Ethanol production:

• inflation -- higher food prices
• possibly higher interest rates
• more fertilizer
• more tractors
• more trucking
• more railroad traffic
• more rail tanker cars

Which pond is small enough to overflow when the ethanol rock falls in? Most of them have already gone through the roof; corn, for instance. Again, I'll have to keep thinking...

3.

Where is inflation coming from? - the falling dollar. Look at imports. Everything from China keeps getting cheaper and cheaper. Raw materials keep going higher and higher.

housung update

D.R. Horton said that home orders for the quarter fell 59% in california and 39% nationally. Ouch!

mortgage rot spreading...

American Home Mortgage (AMH) took a beating, today, down 15%. Here's the relevant information from Marketwatch:

"During March, conditions in the secondary-mortgage and mortgage-securities markets changed sharply," said Michael Strauss, American Home's chief executive, in a statement. "While the market may recover ... our working assumption must be that current market conditions will persist." (Marketwatch)

"The company announced that it's stopped offering certain types of Alt-A loans." (Marketwatch)

So, now it's official: the subprime mess has spread to the Alt-A segment of the market. Last year, only 60% of mortgages issued were prime. Subprime lending has contracted 25-30% already this year. If Alt-A does the same, that's 20% of the market that has been removed from the pool of home buyers. Demand for homes will continue to decrease, and the supply of homes will increase.

Chinese monetary policy

The People's Bank of China raised reserve requirements for the sixth time this year. They are trying to moderate economic growth to slow inflation. However, they don't want to let the Yuan appreciate. Thus, their current tack is to reduce liquidity.

Now, why don't they want the Yuan to appreciate? That would definitely slow down their economy and remove liquidity by making Chinese goods more expensive in the rest of the world. I think they see several problems with that. 1. Fewer exports means lower employment. 2. A higher Yuan means that China loses billions on their U.S. dollar denominated holdings. 3. A low Yuan also encourages investors to keep their money at home instead of sending it abroad.

The problem with this is that by keeping the Yuan low and trying to mop up liquidity with other methods, the People's Bank of China is trying to have their cake and eat it too. On the one hand, they print money to keep the Yuan low, and on the other hand, they raise reserve requirements to reduce liquidity. I believe that slowing economic growth and inflation is impossible as long as the PBOC has a low Yuan as its first priority. Right now, their policies are self-contradictory. This cannot end well.