On Friday, the 30-share Dow Jones industrial average fell 14 points, or 0.1%, to close at 10,318.16.  The broader S&P 500 index closed 0.3% lower at 1091.38 and the tech-heavy Nasdaq finished the day at 2146.04, off 0.5%.  On the week, the Dow average managed to hang on to gains, registering a paltry 0.5% advance.  The S&P 500 and the Nasdaq fell 0.2% and 1%, respectively.  On the New York Stock Exchange, 1.1 billion shares exchanged hands, with declining issues ahead of those that advanced in price by a three-to-two margin.

Last week’s disappointing reports on housing and weak forecasts from technology companies had antsy investors swooping up safe haven investments like Treasury bonds and dollar.  The demand for safe havens also spiked after European Central Bank President Jean-Claude Trichet remarked that the bank is planning to unwind some of its stimulus measures.  A higher dollar pushed crude prices lower and pressured stocks.

Nevertheless, at the center of the activity on the Wall Street is the ascending price of such physical assets as gold, which touched its fresh highs of $1146.80 on Friday, and a declining dollar.  The metal, although lacking fundamental valuation measures, has surged 29.7% so far this year.  Since India's central bank bought 200 tons from the IMF, the metal has jumped 11.5% on its dollar-alternative, safe-haven, inflation-resistant appeal.

Meanwhile, the decline in the US dollar has raised valuation expectations for the major industrial companies, with offshore sales expected to boost revenues.  Nevertheless, this week’s highlight remains today’s after-market-close earnings from Hewlett-Packard (NYSE:HPQ).  Last week the company preannounced strong quarterly numbers, anticipating record sales results of $30.36 billion, and earnings of $1.13, and also lifted its 2010 guidance.

Last week, the 1% decline in the technology shares came after weaker-than-expected guidance from two software companies, Autodesk (NASDAQ:ADSK) and Salesforce.com (NYSE:CRM), was compounded by disappointing numbers from Dell (NASDAQ:DELL).  Technology companies felt the heat after Dell (NASDAQ:DELL) reported quarterly earnings that were well below analysts’ expectations.  The company said sales of its computers to big businesses remain weak.  Shares in the company plunged 10% to $14.29.  So far in November, the NASDAQ has advanced 5%, and is up 36.1% year-to-date. 

The 0.2% pullback in S&P500 was caused by declines in oil and gas (-1.4%) and tech (-1.3%) sector shares that offset gains in health care issues (+1.5%) and basic materials (+1.2%).

The earnings calendar has slowed, but companies still due to report include: Campbell Soup (NYSE:CPB) on Monday; American Eagle (NYSE:AEO), Barnes and Noble (NYSE:BKS), Dollar Tree (NASDAQ:DLTR) on Tuesday, with Deere (NYSE:DE), J Crew (NYSE:JCG) and Tiffany (NYSE:TIF) on Wednesday.

The table at the right summarizes the percent change between January 6 and November 11 in the cash prices of 19 commodities reported in the Wall Street Journal (downloaded via Webstract). The average commodity in this list has appreciated 37% since the start of the year.

A recent paper by Ke Tang and Wei Xiong documents an increasing tendency for commodity prices to move together over the last few years. A decade ago, what happened to oil prices was largely unrelated to movements in most other commodity prices. The graphs below show how the correlations between oil prices and the prices of four representative commodities have increased significantly over time.

Correlation (using a rolling sample beginning one year before indicated date) between returns on oil and specified commodity. Source: Tang and Xiong (2009).

One explanation I often see in the popular press is that movements in commodity prices are driven by changes in the value of the dollar relative to other currencies. However, the magnitude of movements in commodity prices greatly exceeds the size of changes in the exchange rate. For example, the table above shows that since the start of this year oil prices have increased five times as much as the dollar price of a euro; see also Steve Gordon's graphs. While the depreciation of the dollar is part of the story, most of the explanation must be found elsewhere.

Another important factor is resurging real economic growth outside the United States, which produces pressures for both the dollar to depreciate and the real price of commodities to appreciate. According to this theory, the increasing correlations between commodity prices results from the fact that countries like China are so much more important for the world economy today than they were a decade ago.

A third explanation is that investors are making increasing use of commodities as an investment class. Although Treasury Inflation Protected Securities offer a hedge against an increase in the U.S. consumer price index, they don't offer protection for foreign investors against depreciation of the dollar. Insofar as increases in the prices of commodities like oil may depress real economic activity, holding commodities as an investment also offers useful diversification against risks to equities. Particularly when interest rates are low, there is an incentive to hoard physical commodities as an investment vehicle.

The paper by Tang and Xiong proposes that the increased use of commodities as a financial investment accounts for the increasing correlation among commodity price changes over time. In support of that claim, they note the growing popularity of investment strategies based on the Goldman Sachs Commodity Index or the Dow Jones Commodity Index. Tang and Xiong document that correlations among commodities included in the indexes have increased faster than those not included. For example, one of the regressions they estimate relates the return on commodity i to equity returns, bond yields, the value of the dollar, and oil prices, where the coefficients are allowed to grow with time at different rates before and after 2004, and with different trends on these coefficients estimated for commodities included in indexes as for those excluded. The figure below shows their estimated time path for the coefficient on oil prices comparing the indexed and non-indexed groups.

Coefficient relating return on average commodity to return on oil as a function of time for commodities included in the GS or DJ indexes (top curve) and those excluded (bottom curve). Source: Tang and Xiong (2009).

For any of the explanations in this third class, one of the important challenges is to reconcile the story of commodity speculation with supply and demand for the underlying physical commodity. If we propose that speculators have driven the price of the commodity up, the physical quantity demanded should decline as a result. In order to be sustained, a coherent speculation-based theory of commodity price appreciation requires increased physical storage of the commodity.

The solid black curve in the figure below plots the typical U.S. crude oil stocks (excluding those held in the Strategic Petroleum Reserve) for each week of the year, based on the average over 1990-2007. The red line gives the actual values for 2008, which were significantly below the historical average, particularly in the spring of 2008 when oil prices were rising so dramatically. Those below-normal inventories were one reason I focused on what was going on to the fundamentals of supply and demand in trying to understand the behavior of oil markets in the first half of 2008.

Weekly U.S. crude oil ending stocks, excluding SPR, in thousands of barrels, from EIA. Black line: average over 1990-2007. Red: 2008. Green: 2009.

On the other hand, inventories of crude oil this year, shown in green above, have been substantially above normal, meaning that in the absence of that oil going into storage, we would have expected to see lower oil prices than we currently have.

Moreover, much of the current stockpiling may be taking place outside the United States. For example, Yves Smith noted this story from Bloomberg last August:

Copper, nickel and other base metals stockpiled by speculative Chinese investors including pig farmers may be sold when "market sentiment turns," said Scotia Capital Inc.

A price surge and easy bank credit this year encouraged pig farmers, stock brokers and businessmen to buy copper and nickel for speculation, Liu Na, an analyst with Scotia Capital, wrote in a note dated Aug. 17, citing reports from the state-owned China Central Television....

"These stockpiles are in 'weak hands' as speculators have no real use for base metals," Liu wrote. "When the market sentiment turns, they are very likely to turn into quick sellers, especially when the bank's money is involved."

I also found this November 3 story from the Financial Times of interest:

Gold prices continued to rise on Wednesday extending the all-time highs which followed India's central bank bought 200 tonnes of the precious metal, swapping dollars for bullion as the country's finance minister warned the economies of the US and Europe had "collapsed".

India's decision to exchange $6.7bn for gold equivalent to 8 per cent of world annual mine production sent the strongest signal yet that Asian countries were moving away from the US currency.

Policy-makers in the Federal Reserve have traditionally thought of inflation as a broad movement in all wages and prices, which to some extent is under their control, and viewed changes in relative commodity prices as outside their control. I believe that this is not the correct understanding of the current situation. Concerns about inflation, particularly on the part of foreign dollar-holders, are likely to show up first in the relative prices of internationally traded commodities. Insofar as these relative price changes can be destabilizing in themselves, it cannot be wise for U.S. policy-makers to ignore them.

Today, we're fortunate to have Joe Gagnon, senior fellow at the Peterson Institute for International Economics, as a guest contributor.

With short-term risk-free interest rates essentially at zero in the major developed economies, conventional monetary policy is in a liquidity trap. As a number of commentators have observed, printing zero-interest-rate money to buy zero-interest-rate assets has no real economic effect because the assets are near-perfect substitutes for money. But does that mean that central banks have lost their power? Jim Hamilton asserts that central bank purchases of other assets, with positive yields, can always create inflation, though he is silent as to whether they can affect output. Building on Gauti Eggertsson and Michael Woodford, Scott Sumner argues that central banks can boost output and inflation despite zero interest rates by raising the public's expectations of future inflation and thus lowering the real rate of interest. According to Sumner, purchases of a variety of assets are one way central banks can bolster these expectations.

Is there any evidence on the effect of central bank purchases of longer-term or riskier assets?

In recent months, central banks have purchased large quantities of longer-term assets. These purchases appear to have been effective at pushing down longer-term interest rates, which should stimulate economic activity. For example, the Federal Reserve (Fed) has purchased large quantities of longer-term agency-backed securities and Treasury bonds. The following table shows that Fed communications about such purchases had substantial effects on a range of long-term interest rates, including on assets that were not included in the purchase program, such as interest rate swaps and corporate bonds.

Since March 19, the Fed has not made any substantive changes to its planned purchases of longer-term assets. Over this period, the 10-year Treasury yield has risen about 75 basis points and the corporate yield has fallen about 200 basis points, reflecting a relaxation of the extreme financial strains and flight-to-quality that characterized the first few months of this year. Conventional fixed mortgage rates, a key target of the Fed's policy easing, have changed little on balance since late March.

Paul Krugman has argued that potential gains and losses when long-term interest rates move make a policy of purchasing such bonds especially risky, and that fiscal stimulus is a safer bet. However, central banks, including the Fed, have always held risky assets, including long-term bonds, foreign exchange reserves, loans to private banks, and even equities. In many cases, such assets comprise the bulk of the central bank's portfolio.

A good definition of expansionary monetary policy is the printing of money to purchase financial assets. Expansionary fiscal policy is the selling of financial assets to purchase goods and services, to cut taxes, or to increase transfers. On these definitions, both monetary and fiscal policy can be effective when short-term interest rates are zero.

This post written by Joe Gagnon

It is indeed an old adage that while goods things are to be preferred over bad things it is possible to get too much of the former. Looking at recent comments from the governor of the Reserve Bank of Australia it is not difficult to imagine how these, albeit old and worn, pearls of wisdom may well have inspired Mr. Stevens in his effort to tiptoe the thigthrope between signalling the intention to raise rates into an expected economic recovery on the one side and trying to prevent the Aussie shoot of on helium into the sun with wings of wax on the other.

(quote Bloomberg)

Australia’s central bank Governor Glenn Stevens signaled a surge in the nation’s currency to near parity with the U.S. dollar has given him scope to slow the pace of future interest-rate increases.

Stevens, who yesterday became the first central banker in the world to raise borrowing costs twice in 2009, said the 28 percent gain in the currency this year may hurt exports and cool inflation, allowing him to “gradually” raise borrowing costs. Just last month, he warned it may be “imprudent” to keep rates at “emergency levels.” The local currency and bond yields fell as traders slashed bets on another quarter-point boost next month, after Stevens raised the overnight cash rate target to 3.5 percent from 3.25 percent. Investors have been driving the Australian dollar toward parity with the greenback, betting China’s economic growth will boost exports from Australia, the biggest shipper of iron ore used in making steel.

Policy makers “are probably glad for the parity talk as it reduces the amount of work they need to do with monetary policy,” said Matthew Johnson, an interest-rate strategist at UBS AG in Sydney. “A December move is a 50-50 proposition.” Traders are betting there is a 50 percent chance Stevens will increase the key rate by another quarter point on Dec. 1, according to Bloomberg calculations based on interbank futures on the Sydney Futures Exchange at 12:22 p.m. today. Prior to Stevens’s comments, they had a 96 percent bet on such a gain.

Mr. Stevens' comments follows in the heels of the recent push by part of the Aussie towards parity with the US dollar reflected primarily in the fact that the RBA has already raised twice in 2009 (from 3.00 to 3.5%) as well as a growing risk sentiment which is a fundamental prerequistie, in the current market, for observing investors react to (growing) yield differences. In so many words, this is all about carry trade and more specifically about the fact that in a world where the G3 and others are still fiddling with quasi- or outright QE it takes a brave sould to initiate a hiking process since it will mean an immediate reaction in the currency market. This is especially the case when the liquidity anchor effectively constitutes the US and thus; while the US pump priming keeps a floor under risky assets and volatility at low levels it becomes a veritable turkey shoot to gun for those currencies whose central banks are on the hike (see more here).

Following Mr. Stevens' comments, the Aussie did lose a bit of its steam even if many currency punters still see it racing towards parity over the course of the coming year.

For example David Forrester who is currency economist at Barclays Capital expects the Aussie to test the parity level in 2010, a call based on the idea that the RBA will have hiked rates to a full 5.5% by the end of next year. Needless to say, in a world where risky assets continue to fly and risk aversion is kept in check this will provide a juicy interest rate differential vis-a-vis the G3 and thus the carry trade flows (be they actual carry trades or simply spot market piggy backing) will be plentiful. 

The question is of course; can you blame the RBA for wanting to raise rates?

As it turns out, not really and particularly not in light of global central banks' new found focus on asset prices in setting the policy rate. You know, it was all Greenspan's fault and all that jazz. Still, for those worried about a too rapid V-shaped recovery, Australian house prices seem to offer plenty of things to worry about.

From Q3-08 to Q1-09 the house price index (weighted for the 8 biggest cities) fell a modest 5.6%, a drop which has been decisively paired in Q2/Q3-09 with the index rising a cumulative 8%. This picture is repeated if we look at a general gauge for consumer spending in the form of a sector break down of retail sales.

Consequently, the annual as well as monthly flow of retail trade turnover never really went decisively into negative in the context of the financial crisis which has no doubt contributed to the fact that the RBA never really contemplated a move into ZIRP and QE.

What happens next then?

Well as I noted recently, the burden of rebalancing may be tough to carry for those economies who have central banks brave enough to raise interest rates. Ironically of course and if it is really asset prices you are worried about, the risk is naturally that you just end up sucking in liquidity as you which in itself defeats the purpose of the hiking campaign (see Edward's recent piece on Norway for a Scandinavian perspective on this). Naturally, you can retort to Brazil like capital controls, but in a world where capital flows freely and where the global economies are largely interdependent, this is like trying to stop a freight train with a VW Polo. Also, allow me to finish with a small quibble of mine in relation to the sudden urge by part of central bankers to target asset prices. I mean, this is fine and all and for those who know a little bit about monetary policy this is not something completely new. The problem is merely that targeting asset prices may not only be counterproductive in a world where asymmetric liquidity conditions and carry flows are the norm, by targeting asset prices also entail targeting a price which is considerable more volatile than traditional prices (because I assume that forecasting long term asset prices is not as easy as many believe). In this way, a steady gaze at asset prices may also conflict with central banks' general propensity to favor incremental and gradual moves.

Whether this is the case in Australia, only time will tell. Yet, from the lovely fjords of Oslo, to the beaches of Rio, and on to the Great Barrier Reef policy makers may soon learn that you can indeed get too much of a good thing.

After a two-week selloff, fueled in part by concerns that the seven-month old rally had gotten ahead of any economic recovery, stocks got a boost last week following better-than-estimated economic numbers and Alcoa’s (NYSE:AA) surprise quarterly profit.  That helped investors set aside worries and extend the rally.  Meanwhile, White House economic adviser Lawrence Summers reiterated the Obama administration’s commitment to a strong dollar, citing recent comments by U.S. Treasury Secretary Timothy Geithner.

This morning’s stock futures show markets are headed for a higher opening as the busy week of earnings commences. Ahead of the market's open, Dow Jones industrial average futures are up 59 points, or 0.6%, to 9,866.  Standard & Poor's 500 index futures gained 7.30 points, or 0.7%, to 1,075.40, while Nasdaq 100 index futures rose 11 points, or 0.6%, to 1,736.50.

On Friday, the Dow Jones industrial average rose 78 points, or 0.8%, to 9,864.94 -- its highest closing level in a year.  The S&P 500 index gained 6 points, or 0.6%, to 1,071.49 and the Nasdaq climbed 15 points, or 0.7%, to 2,139.28.  On the New York Stock Exchange, advancing issues beat those that declined in price by a three-to-two margin.  For the week, the DJIA rose 4% and the S&P 500 index gained 4.5% - their best performance since July.  The Nasdaq advanced 4.5% during the week.

Last week's rally saw all but one of the S&P500 industry sector recording gains.  Only telecommunications shares failed to advance, and fell 5.9%, following AT&T's (NYSE:T) announcement that it plans to allow internet-based phone calls on phones including Apple's (NASDAQ:AAPL) iPhones.  The gains last week were led by basic materials (+8.4%), oil and gas (+7.6%), financials (+6.3%), industrials (+5.0%), tech (+4.9%), consumer services (+4.5%), consumer goods as well as utilities (+2.9%), and health care (+2.7%).  Financials rose after a Goldman Sachs (NYSE:GS) report recommended large-cap banks. Gains in industrial shares were helped by last week’s fall in dollar and Caterpillar's (NYSE:CAT) announcement that it plans to hike prices globally in 2010.  Retail shares rose after firms reported better-than-expected comparable monthly sales numbers.

This week sees the release of the first big batch of third-quarter earnings.  Companies reporting their numbers include Johnson & Johnson (NYSE:JNJ), Intel (NASDAQ:INTC), JP Morgan (NYSE:JPM), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), Nokia (NYSE:NOK), Google (NASDAQ:GOOG), IBM (NYSE:IBM), Bank of America (NYSE:BAC), and General Electric (NYSE:GE).

Australia's decision dented demand for the U.S. dollar, which, in turn, raised commodities prices.  US energy and materials stocks moved up, oil also rose, and gold reached a record high.  Stock investors cheered the drop in the dollar because it boosts corporate profits by making U.S. goods cheaper for overseas buyers. Companies can also get a bump in profits when they convert sales made in foreign currencies to dollar terms. The dollar has been falling for months so that added to expectations for positive corporate profit reports.

Five stocks rose for each that fell on the NYSE.  Producers of energy and raw materials had the two biggest advances in the S&P among 10 industries, rising about 2.1% and 1.9% respectively.

Financial sector shares (up 1.1%) received another boon, over and above Goldman's (NYSE:GS) upgrade of large-cap banks on Monday, as Bank of America/Merrill (NYSE:BAC) upgraded European banks to "overweight".  Gains in the financial sector included a 2.5% increase in JP Morgan (NYSE:JPM), 3.2% in Morgan Stanley (NYSE:MS) and 2% in Wells Fargo (NYSE:WFC).

Deal activity has also picked up steam, lifting confidence in financial markets.  Banco Santander (NYSE:STD) raised over $8 billion in an IPO of its Brazilian subsidiary.  ExxonMobil (NYSE:XOM) announced its has agreed to pay $4 billion for Kosmos Energy's 23.49% stake in the Jubilee oil field off the coast of Ghana.  Societe Generale said it intends to raise $7.1 billion in new shares to repay the French government, buy the 20% of Credit Nord it doesn't currently own, and improve its Tier 1 ratio.

Gold futures advanced as high as $1,045 an ounce in New York, topping the 18 month record of $1,033.90, on speculation that anticipated accelerating inflation will spur demand for the precious metal as a store of value.

The U.S. dollar index was off 0.31 at 76.33 in late trading, but up from its 76.22 session low after the Saudi Arabian central bank chief denied an Independent newspaper report that the Saudis and other Arab producers planned to price oil on a basket of currencies, instead of the dollar.

Observers believe that the decline of just over 4% on the S&P 500 prior to this week’s stellar stock movement seemed to give investors the entry point they were looking for to build positions on stocks.  "I think that most people believe that stocks are going to generally keep drifting higher for the next few months," said Gary Webb, CEO at Webb Financial Group. "So while nothing fundamental has changed this week, investors are taking opportunities to buy on the lows."

Nobel Prize winning economist Joseph Stiglitz added that US unemployment will keep rising and should be the focus for policy makers.  Gains in the stock market show that investors have been “irrationally exuberant" about a recovery.  

New York Fed President William Dudley said a tepid economic recovery should allow the Fed to keep interest rates at rock-bottom lows for a prolonged period.  Because the U.S. economy faces many headwinds, including an anemic labor market and a fragile banking system, Dudley said, inflation will not become a problem in the foreseeable future. "The recovery will turn out to be moderate by historical standards," Dudley said in a speech at Fordham Law School. He added that "the banking system has still not fully recovered."

Earnings are due today from Costco (NASDAQ:COST), Family Dollar (NYSE:FDO) and Alcoa (NYSE:AA).

First, a little background. The traditional tool of monetary policy is an open market purchase, in which the Fed purchased U.S. Treasury securities that had previously been held by someone in the private sector. The Fed would pay for those securities by crediting deposits in an account that the selling bank had with the Federal Reserve. These reserve deposits of banks represent claims that the bank could use, if it wished, to withdraw green currency from the Federal Reserve. The volume of reserve deposits historically was extremely important in determining the interest rate at which banks would lend the deposits to one another overnight. The traditional understanding of monetary policy was that the Fed would use open market purchases to achieve its desired objectives for the overnight interest rate and the money supply.

If the Fed wished to implement a purely temporary increase in the volume of reserve deposits, historically the tool of choice was a repurchase agreement, in which the Fed would buy a particular security with a promise to return it at a specified future date. The purchase was again implemented by creation of reserve deposits, and when the security was returned, those deposits came back into the Fed.

The Fed began to see a new potential use for these repos after the initial banking difficulties in August 2007. Although repos were traditionally used as a device for temporarily injecting reserves, their structure amounts to a collateralized loan from the Fed to the counterparty. The Fed's objective subsequent to August 2007 was to increase the volume of its lending and support the market for certain securities that it could accept as collateral for repos. Thus the Fed utilized an expansion of repurchase agreements as one of the initial tools for responding to the crisis, simply rolling them over to create a de facto expanded lending facility.

The graph below tracks the various assets held by the Federal Reserve since the beginning of 2007. The height of the graph represents the total asset holdings at the end of each week, with the colors indicating the contribution of each category. Repos are represented by the turquoise band. This traditionally had been small and highly variable, but grew significantly in the early phases of the financial crisis. Later the Fed came to use direct loans through its Term Auction Facility in preference to repos. Since January, the Fed has been directly buying up mortgage backed securities and agency debt in the way it used to purchase Treasury securities.

Figure 1. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to September 23, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

A separate question is what happens to all the reserve deposits created through this process. The Fed has never wanted to see the huge volume of reserves it created end up as currency held by the public, for fear this would be inflationary. It has relied on several devices to keep that from happening. One was use of the Treasury's account with the Fed, another traditional feature of Fed operations that ballooned as it became adapted to new purposes. The Fed asked the Treasury to borrow funds that it simply left in deposit in its account with the Fed. These idle reserves held by the Treasury absorbed some of the vast increase in new reserves created by the Fed.

A more important tool was that the Fed started paying interest on reserves in October 2008, and by November had increased that rate to the target fed funds rate itself. This created a very strong incentive for banks to simply hold reserves idle at the end of each day rather than lend them out on the overnight fed funds market. In effect, by paying interest on reserves, the Fed is borrowing directly from banks and using the proceeds for the various asset expansions detailed above.

The graph below shows the Fed's liabilities at the end of each week. The height of the graph is, by definition, exactly equal to the height of the previous graph at every date. The first graph tracks what assets the Fed acquired with its operations, while the second graph shows where the funds it created ended up. The surge in the Treasury account (in yellow) and excess reserves of member banks (green) explain why the huge expansion in the Fed's balance sheet has not translated so far into a massive increase in the quantity of currency held by the public (blue).

Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to September 23, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

The question under discussion at the moment is the extent to which the Fed could continue to rely on these two devices-- Treasury borrowing on its behalf and banks' willingness to simply hold the ballooning reserves-- to contain the monetary consequences of its expansion. The traditional political gamesmanship over the debt ceiling could well induce the Treasury to want to discontinue its facilitation of the expansion of the Fed's balance sheet, in which case the Fed must either reduce some of its lending or count on banks to hold even more excess reserves. Some in the Fed are assuming that they could always ensure the latter outcome, if needed, by raising the interest rate the Fed pays on reserves. But clearly the Fed has no desire at the moment to raise interest rates, so it's difficult for me to imagine them taking that step any time soon.

Where else could the Fed get the funds? Fed Chairman Ben Bernanke described his contingency thinking last July:

the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Just as the Fed converted the use of repos, which had historically been used on a small scale to temporarily add reserves, into a much larger operation with which it could lend broadly on a long-term basis, it is now contemplating using the reverse repo, which had historically been used on a small scale to temporarily drain reserves, into a much larger operation with which it could borrow broadly on a long-term basis. Thus we saw the following report from Bloomberg last week:

The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions.

Central bank officials are discussing plans to use so-called reverse repurchase agreements to drain some of the $1 trillion they pumped into the economy, said the people, who declined to be identified because the talks are private. That's where the Fed sells securities to its 18 primary dealers for a specific period, temporarily decreasing the amount of money available in the banking system.

There's no sense that policy makers intend to withdraw funds anytime soon, said the people. The central bank's challenge is to decrease the cash without stunting the economy's recovery and before it sparks inflation. Fed Chairman Ben S. Bernanke said in a July Wall Street Journal opinion article that reverse repos are one tool to accomplish that goal without raising interest rates.

"One thing the Fed has to figure out is if they can launch pilot programs without spooking the market and creating the perception that they are about to tighten," said Louis Crandall, chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based research firm that specializes in government finance. "They are discussing things like accounting issues, and updating the governing documents to the volume of reverse repos the dealer community could absorb."

Is this a feasible interim plan for handling the liability side without increasing either the money supply or interest rates? In a mechanical sense I believe the answer is yes. But the nature of inflationary pressures that we should be watching at the moment would arise from a depreciation of the dollar relative to other currencies and increase in the dollar price of internationally traded commodities. A modest move toward a weaker dollar and slightly higher inflation would be welcome. But the concern in my mind is whether a flight from the dollar could become more precipitous and destabilizing. It may not be the most likely scenario, but it is one for which I hope there has been some contingency planning.

And if the Treasury and the Fed think they could prevent that simply by borrowing even more without raising interest rates, they are mistaken.

Although the Fed, in its policy statement, contended that it would continue to employ a wide range of tools to stimulate the economy, investors saw little reason to rejoice, wondering if the stocks were too expensive at current levels.  The Fed reiterated that it will slow its purchase of mortgage-backed securities, signaling its confidence that an economic recovery is indeed underway.  However, there was no talk of exit strategy methods and timetables.  Nevertheless, the FOMC minutes, released at 2:15 ET, maintained the Fed's intentions to keep "exceptionally low levels of the fed funds rates for an extended period."

Fed’s decision to hold interest rates steady helped the greenback maintain its recent momentum but the government’s auction of $40 billion in 5-year notes Wednesday failed to elicit an upbeat response, after Tuesday's sale of $43 billion in 2-year notes witnessed strong demand.

The Dow Jones industrial average fell 81.32 points, or 0.8%, to close at 9,748.55. The broader Standard & Poor’s 500-stock index lost 10.79 points, or 1%, to end at 1,060.87, while the Nasdaq composite index retreated 14.88 points, or 0.7%, to 2,131.42.  On the New York Stock Exchange, 1.32 billion shares exchanged hands and advancing shares outpaced those that declined three to two.

A surprising rise in crude stockpiles and a higher-than-anticipated yield on the Treasury's $40 billion auction of 5-year notes combined to generate a widely-expected but moderate pullback.  Today's markets are expected to take a cue from the existing home sales report along with the G-20 meet before deciding on a future course of action.  Moreover, this morning the US took another swipe at China trade practices, alleging China has improperly subsidized some types of coated paper.

Meanwhile, the weekly EIA report showed a surprising 2.8 million barrel build in crude inventories. The Street was expecting a 2.25 million barrel fall.  The unexpected build hurt basic material and oil and gas shares.  Basic material shares, up 51.2% year-to-date, were the leading decliners on the S&P500, off 2.3%.  Oil and gas shares fell 1.9%.  Exxon (NYSE:XOM) declined 1.2% to $69, while Chevron (NYSE:CVX) retreated 1.7% to $71.37.  Newmont Mining Corp., (NYSE:NEM) the largest U.S. gold producer, lost 3.6% to $43.59.  Freeport-McMoRan (NYSE:FCX) the world’s largest publicly traded copper producer fell 2.8% to $71.09.

On the DJIA twenty-five of its thirty components closed down; on the S&P500 only five stocks finished higher. Financial shares were also hit hard, with declines of 2.0%, as investors grew concerned over prospects for an eventual unwinding of the Fed's cheap money policy. Consumer services traded down 1.4%; health care 1.1%; and industrials 1.0%. Only telecommunications shares managed gains, moving 1.5% higher on the day; year-to-date, however, the group is the only sector to remain in negative territory on the year, with a 2.0% drop.

The 2:15 ET release of the FOMC minutes failed to elicit much of a response. Fed Chairman Bernanke had already spread the word of the recession's end, so the language change suggesting economic activity has now "picked up," and is no longer "leveling out" seemed old news, along with notes that "conditions in financial markets have improved further, and activity in the housing sector has increased."

The 30-share Dow Jones industrial average finished higher by 51 points, or 0.52%, at 9,829.87. The broad Standard & Poor's 500-stock index gained 7 points, or 0.66%, at 1,071.66 and the technology-laden Nasdaq composite index gained 8.26 points, or 0.39%, to 2,146.30.  Treasury prices rallied after the government’s successful auction of $43 billion in two-year notes.

Meanwhile, dollar continued its downward spiral against other major currencies, sending energy and material shares higher.  Gold and crude prices also advanced.  Gold reached $1014 per ounce, up $12.50, and oil, after a 3.3% plunge Monday, went above the $70 level, rising 2.6% to $71.55.  Volume on the NYSE was a modest 1.27 billion shares, with advancing shares ahead of decliners by a seven-to-three margin.

Among the ten S&P500 industry sectors, seven closed higher, led by financial shares (+2.2%), basic materials (+1.9%), industrials (+0.8%).  On the downside, telecommunication shares fell 0.6%, health care stocks eased 0.3%, and utilities edged 0.1% lower.

Twenty of the DJIA's thirty components finished higher yesterday.  On the Dow average, JP Morgan (NYSE:JPM) was the leading gainer, rallying 4.3% to $46.47 after analysts at Bank of America (NYSE:BAC) lifted their third-quarter earnings estimate on the firm to 49 cents per share from 46 cents per share.  Caterpillar (NYSE:CAT) shares jumped 3.6%, following the expected weak dollar benefit to foreign sales.  Bank of America (NYSE:BAC) rose 2.1% after Rochdale Securities’ Richard Bove raised the shares' price target to $25 from $19 due to the firm's recent moves to exit two federal guarantee programs.  However, rumors that CEO Ken Lewis might resign over the Merrill bonus saga kept the stock’s move in check.  Alcoa (NYSE:AA) rose 2.3% after analysts at Goldman Sachs (NYSE:GS) raised price target on the firm, citing projections for higher aluminum prices.

Analyst upgrades also benefited shares of Macy's (NYSE:M) (+5.1%); Citigroup (NYSE:C) lifted its rating on the shares to "buy" from "hold" on higher revenue expectations.  US Steel (NYSE:X) shares increased 4.6% after Bank of America (NYSE:BAC) changed its recommendation on the stock to "neutral" from "underperform," citing expectations the firm should return to profitability in 2010. Clorox (NYSE:CLX) shares gained 2.6% on speculation of a potential Procter & Gamble (NYSE:PG) bid.  AIG (NYSE:AIG) shares fell 5.4% in a late-session sell-off on talks of a possible secondary offering.  Goldman (NYSE:GS) shares rose 1.7% to $185.52, closing at its highest level since July 2008.

Of key interest today would be the much-expected FOMC policy report, due out at 2:15 ET.  Expectations that the Fed will maintain record low interest rate levels of zero to 0.25% are intact. Most expect the Fed language to support an ongoing accommodative stance.  Moreover, President Obama cautioned that unemployment could even get a little worse in coming months. Therefore, the Fed's $1.75 trillion asset purchase program is likely to remain in place to encourage the recovery's traction.

The European Central Bank has made up to €1bn in extra profits from crisis-related emergency lending, but its caution on unconventional policy measures has curbed potential earnings, analysts estimate. Extra liquidity pumped into the eurozone banking system since the collapse of Lehman Brothers last year has probably generated an extra €900m ($1.5bn, £780m) in profits so far, according to calculations by Goldman Sachs.

Some €300m of the total has been generated since June, when the ECB provided €442bn in one-year loans in its biggest liquidity providing operation. The extra profits are on top of the sums that the ECB normally makes on its market operations. Although the interest rate currently charged by the ECB – 1 per cent – was the lowest in its 11-year history, revenues “remain juicy because of the quantity of liquidity that banks keep hoarding”, said Natacha Valla, European economist at Goldman Sachs in Paris.

From last October the ECB has been meeting, in full, eurozone banks’ demand for liquidity. Ms Valla argued, however, that by sticking largely to using policy instruments already in its armoury the ECB had forgone potentially far higher margins.

Profits on the ECB’s programme to buy €60bn in covered bonds – low risk assets issued by banks and backed by public sector loans and mortgages – could be dwarfed by those on schemes launched by other central banks, which have involved higher risk. The Financial Times reported last month that the US Federal Reserve had made a $14bn profit on its crisis loan programmes, with its purchases of commercial paper among its most lucrative operations.

Instead, the ECB has created arbitrage opportunities for eurozone banks, which have used liquidity provided by the central bank to buy large amounts of government bonds, including from some of the smaller eurozone countries and riskier assets. These, in turn, can be used as collateral to raise fresh funds from the ECB. Eurozone banks’ holdings of euro-denominated government bonds have increased by more than €200bn since last year.

Now, I wish that I could present PDFs of both reports here (i.e. the VP and Iberian Equity report), but I can't due to the fact that such reports are usually behind the firewall. However, this first note by FT's Alphaville on the VP report and the second note, just published, on the challenge by Iberian Equities are enough to get a sense of the argument.

I have seen VP's rebuttal and I still square with their side of the fence. Especially, Iberia Equities make the following point in their report;

"Variant claims Spanish banks are not marking their loan books to market. Non-performing loans in Spain (4.6% of the system’s loans by the end of Jun’09) are marked-down according to different provisioning calendars set by the Central Bank. For non-mortgage loans, NPLs are provisioned at the end of year 2. The majority of mortgage loans (40% of loans or two thirds of mortgage loans) have been – until the BoS made changed the interpretation of the rule - also 100% provisioned by year 2. Only a small fraction of
low –risk mortgages (20% of loans) are provisioned according to a long calendar (100% provision by year 6). By international standards, Spain’s provisioning calendars are quite strict especially considering >60% of loans have a mortgage collateral".

To which VP replies;

"Non-performing loans are being passed off as current, vacuumed up and rolled ito cedulas to deposit at the ECB's repo window.  (Incidentally, that is the only way many Spanish banks are finding any semblance of liquidity right now.  Without the ECB, some Spanish banks would have the same liquidity problems that subprime mortgage originators had.  The ECB is a mega warehouse, effectively, for the Spanish banking system.  This is intimately tied in to the question of funding excess consumption in Spain, which we discussed.)"

In my opinion and apart from the glaring neglect, in the Iberian Equity report, on the macroeconomics of the situation this is the most important omission. This is to say, that had it not been possible (which it still is) for Spanish banks to park many of their assets at the ECB as collateral for funding, they would have effectively needed to mark to a non-existing market (i.e. write off the whole thing in one swoop in which case it would have been bye bye Sandy). I mean, this was what happended with Bear Stearns and Lehmann and then only afterwards did the Fed (and the "appointed" buyers) wade in to scoop up these assets which are now sitting and waiting for better times (presumably, I mean, I don't know how quick they are ground down to reflect market fundamentals).

So, as you can see, I am still with VP here but not everyone may agree in which case it is naturally something which should be debated with facts and reason.

Investors see Hungary becoming “significantly” less risky, allowing for further reductions in interest rates, central bank Deputy Governor Ferenc Karvalits said. “Over the past few months, international risk appetite has improved significantly, the risk assessment of the region and Hungary has stabilized, and this allows for further easing of monetary conditions,” Karvalits said in an interview on Kossuth Radio today.

The Magyar Nemzeti Bank lowered its benchmark interest rate by half a percentage point to 8 percent on Aug. 24 as it works to jolt the economy out of its worst recession in 18 years. The bank has shaved 1.5 points off the key rate since July as confidence rises in the first European Union nation to get a bailout. Hungary received 20 billion euros ($28.5 billion) in an emergency loan from the International Monetary Fund, the EU and the World Bank.

The country has a “good chance” to finance its budget deficit from the market and may not need the next installment of the IMF loan, Karvalits said. The forint weakened 0.3 percent against the euro and was trading at 268.82 at 7:48 a.m. in Budapest.

You see, one of the principal reason why Hungary is in such a mess is that as inflation shot up in the months leading up to the crisis Hungary chose to loosen its peg against the Euro. At the time, the rationale seemed wise albeit very bold. In an environment where investors were willing to take risk (i.e. hunting for yield) their objectives could be aligned with that of public authorities in the sense that the former got their yield whereas the latter got the nominal appreciation needed to keep inflation in check.

It did not work quite like that.

As the crisis hastened its grip on global markets and as its locus steadily moved to Eastern Europe the Hungarian Forint plummeted and lay bare the country's vulnerabilities in the context of balance sheet (on the liability) side denominated in Swiss Francs. The result was that Hungary crashed into a recession unable to tweak monetary policy downwards because of a fear that this would scythe the Forint and thus essentially bankrupt scores of households and companies. On the other, the government also had (and has) difficulties raising funds on international capital markets.

Now however things appear to have changed at least for a moment and Hungary's central seem poised to take advantage of the relatively benign market conditions to lower interest rates to support its ailing economy. The underlying idea is simple. If you believe that risk aversion is to stay low, the Forint should not be sensitive towards the lowering of nominal interest rates since after all the carry remains plentiful. In this way, my view is that Hungary's central bank is trying to claw back the control over monetary policy by locking in a lower interest rate for the Forint. The key question which we should be asking ourselves however is of course whether Hungary could actually be forced to raise rates further down the road to defend the Forint. Clearly, bets are being made inside Hungary at the moment that this is not the case.

This is very interesting in a practical as well as a theoretical sense as I have discussed for example in this post about carry trade and global monetary policy. More recently, Edward Hugh mused on the same topic (more or less) invoking the idea of the (eternal) triangle of monetary policy in an open economy context.

In the case of the Central Europe "four", Poland and the Czech Republic opted for maintaining their grip on monetary policy, thus accepting the need for their currency to "freefloat" and move according to the ebbs and flows of market sentiment. As it turns out this decision has served them remarkably well, since the real appreciation in their currencies which accompanied the good times helped take some of the sting out of inflation, while their ability to rapidly reduce interest rates into the downturn has lead to currency depreciation, helping to sustain exports and avoid deflation related issues.

The other two countries (Hungary and Romania), to a greater or lesser degree prioritised currency stability, and as a result had to sacrifice a lot of control over monetary policy, in the process exposing themselves to the risk of much more violent swings in market sentiment when it comes to capital flows. Having been pushed by the logic of their currency decision towards tolerating higher inflation, they have seen the competitiveness of their home industries gradually undermined, and as a consequence found themselves pushed into large current account deficits for just as long the market was prepared to support them, and into sharp domestic contractions once they were no longer disposed so to do.

Edward's account here is important since it alerts us to the fact that it was only at the very end that e.g. Hungary opted for float because it was believed that it would make the inflation problem go away. At that point however, the structural imbalances and essentially damage were already embedded in the system of course. Nevertheless, it is unequivocally the fact that Hungary, at the moment, is attempting to benefit from the relative benign market conditions which means that risk aversion remains relatively subdued.

Elsewhere in Market Land ...

If our little trip to Hungary suggests that risk is on, if only a little bit and potentially in the case of Hungary news elsewhere suggest that the waters are more choppy. Of course, none of this is earth shattering by any means of the word, but since much, if not everything, seems to be revolving around China at the moment it seems worthwhile to dwell at recent news on how China are expected to "tweak" its hitherto lax lending policies to skim the worst of the mounting bubble (quote below from Bloomberg).

China’s banking regulators are “tweaking” lending policies to remove “froth” from the system while growth remains the top priority for policymakers, according to Royal Bank of Scotland Group Plc. The goal is to manage risk exposure among banks and asset quality by checking lending from going into A-shares traded on the mainland and properties, Wendy Liu, Hong Kong-based head of China research at RBS ABN Amro, said in a report dated yesterday.

(...)

The banking regulator sent draft rule changes to banks on Aug. 19 that would require lenders to deduct all existing holdings of subordinated and hybrid debt sold by other lenders from supplementary capital, said the people, who have seen the document and declined to be named as the matter is private. This may cut lending by as much as 700 billion yuan ($102 billion), China International Capital Corp. said Aug. 24.

Of course, the main bias of the Chinese stimulus program and thus the authorities' objective remain one of promoting growth through the expansion of domestic investment and, one would assume, consumption. As RBS ABN Amro's Wendy Liu is quoted of saying; "policymakers have a far greater tolerance for asset-price appreciation over the medium term than before". That sounds about right to me even if I am no sage, at all, on China.

What is interesting in the case of the recent news from China was also the following piece by Bloomberg whose headline (Yen Strengthens as China Policy Concern Spurs Demand for Safety) makes a direct link between policies in China and risk sentiment in the market and thus also the movement of the Yen and the USD (remembering of course the narrative that repatriation of profits may ultimately be the main driver of the Yen at the moment).

The yen rose for a third day against the euro in the longest stretch of gains since July on concern Chinese production curbs would slow economic recovery, fanning demand for the relative safety of Japan’s currency. The currency gained versus major counterparts including the pound on speculation Japan’s exporters are repatriating earnings to take advantage of a new tax law. A government report today may show a faster contraction in the U.S. economy than previously estimated.

“We have talks from China cutting back expanding, trying to sort out the balance sheet and prevent too much reckless lending,” said Peter Frank, a London-based currency strategist at Societe Generale SA. “But domestic factors, like capital repatriation, are driving yen’s strength right now.”

Whether there is a history to be made here is debatable, but one thing is certain. China seems to have decidedly taken center stage in the global market discourse. Finally and essentially as a small footnote, yours truly took notice of the fact that despite the decidedly positive sentiment in the core of Europe at the moment on the back of the Q2 GDP print and upbeat confidence readings in Germany, aggregate retail sales continued their steady decline.

Whether all this signifies that risk is "on" or "off" I will allow the reader to decide for themselves. Personally, I am still bearish, but it is difficult to deny that the relative calm and positive environment that has prevailed since spring seems rather strong. I would expect sentiment to change once we return to "normal" in Q4 once the elections in Germany and Japan have been resolved and, more importantly, once OECD stimulus packages start to wane. Most importantly however, there is the situation in Southern and Eastern Europe still loom as the most likely harbringers of, if you will, black swans in which case risk almost surely would be off.