The basic power of the Fed derives from its ability to create money, which it can use to buy assets or extend loans. We can summarize the Fed's actions in terms of either the asset side of its balance sheet (the assets and loans it holds), or the liabilities side (the money or other obligations it has created). Let's start with the asset side. Up until January of 2008, by far the most important assets held by the Fed were short-term Treasury bills. As last year wore on, the Fed significantly expanded its loans in the form of currency swaps with foreign central banks, direct lending to U.S. banks through term auction credit, and the Commercial Paper Lending Facility. Altogether such measures more than doubled the various asset holdings of the Fed by the end of the year, despite the fact that the Fed sold off 40% of its original T-bills.

Figure 1. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to July 15, 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.

In 2009, the Fed has been winding down some of these programs, with significant declines in swaps, CPLF, and TAC, replaced by big increases in items such as mortgage-backed securities and agency debt. The changes over the last few months should not by any stretch be described as a return to "plain vanilla" central banking. The risk on MBS and agencies is greater than that for T-bills, and the asset level today remains 130% above its value at the start of 2007.

Where did the Fed obtain the funds with which it acquired all these new assets? To say that it did so by "printing money" would be inaccurate. The Fed doesn't lend a half trillion in term auction credit by handing out big bundles of green paper with Ben Franklin's picture on them. Instead, it creates an entry in an account that the recipient bank has with the Fed known as the bank's Federal Reserve deposits. The bank could, if it wanted, use those credits to ask the Fed for those Ben Franklin souvenirs. Instead the bank presumably used the new deposits to pay for some obligations or make some loans, either of which it would instruct the Fed to implement by transferring those reserves to some other bank. That bank in turn could use the reserves to ask for C-notes, or pass them on to somebody else through its own loans or any other expenditures.

And the buck stops-- where? In normal times, the process of banks putting any excess reserves to use would continue until there's enough expansion of banking and economic activity that ultimate recipients did want to turn those reserves into green currency. And once that happens, it would not be a misleading summary of the bottom line to say that the Fed eventually paid for its original asset purchase by "printing money".

But in the fall of 2008, the Fed did not want that to happen. It wanted to extend a trillion in new loans, but it did not want to see currency held by the public go up by a trillion dollars, out of fear the latter would be very inflationary. The Fed's thinking was that we didn't need a traditional inflationary expansion of credit, but instead needed to allocate credit to particular functions without having conventional measures of the money supply swell.

The graph below describes how the Fed did that, looking now at the liabilities side of the Fed's balance sheet. The height of Figure 2 at any date is identical, by definition, to the height of Figure 1, but whereas Figure 1 was looking at what the Fed did with its funds, Figure 2 summarizes how the Fed obtained those funds. In other words, Figure 2 looks at where the reserve deposits the Fed created ended up, and explains why the dramatic actions of Figure 1 haven't yet shown up as currency held by the public.

Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to July 15, 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.

One big factor has been the accounts that the U.S. Treasury holds with the Fed. Essentially, the Fed asked the Treasury to borrow some money through public auctions, which it did. Banks paid for these new T-bills by instructing the Fed to transfer to the Treasury the Federal Reserve deposits that they'd received from the Fed as a result of the programs in Figure 1. The Treasury then just left the funds sitting there in its accounts with the Fed. In effect, the Fed obtained the funds for some of its actions on the asset side not by "printing money" but instead by having the Treasury borrow funds on its behalf on the liabilities side.

However, an even bigger volume of the deposits that the Fed created are still just sitting on the banks' books. The way the fed funds market functioned in 2007, that would never have happened. Why close your bank's books for the day with funds just sitting there in an account with the Fed, earning no interest, when you could loan them out overnight instead? A big bank would never do such a thing in 2007. But they're happy to do so in 2009, in part because the overnight lending opportunities are not particularly attractive at the moment, and in part because the Fed now pays interest on those reserves. From the bank's point of view, funds left on deposit with the Fed at the end of the day aren't idle at all, under the new system adopted in the fall of 2008.

One of the points that Bernanke makes in his op-ed is that the Fed could continue to use this device, if need be, to prevent essentially any volume of its asset side activity from showing up as an increase in currency held by the public, simply by raising the interest rate the Fed offers to pay on reserves to whatever level is necessary to persuade banks to continue to hold these funds idle overnight. In effect, the Fed is through this device borrowing directly from the public to fund its asset-side activities rather than by "printing money".

Should that allay any inflationary concerns people may have about the doubling in the size of the Fed's balance sheet? In a narrow mechanical sense, perhaps. It is true that the new assets have not yet shown up as an increase in the money supply, and it is true that the Fed has the power to prevent them from doing so in the future. But my concerns about inflation are not that the Fed would lose the ability to target a particular level for the money supply, and certainly are not concerns about the next six months, where I still see deflation as a bigger worry than inflation. Instead, my concern is that the current fiscal trajectory is fundamentally inconsistent with the Federal Reserve choosing to keep inflation under control. Both devices, ballooning of the Treasury's account with the Fed and enabling the Fed in effect to borrow directly on its own, are indeed as much fiscal measures as they are monetary. But to someone worried about the increasing co-mingling of monetary and fiscal policy, that blurring of the lines is not a reassuring development.

My specific worry is that we will eventually face a crisis of confidence in the Treasury and the dollar itself. It is true, as Bernanke suggests, that raising the interest rate paid on reserves in such a setting would be a policy tool that could be used in response. But it would be an unattractive measure to the point of perhaps being impossible to use in practice, for the same reason other countries have dreaded raising interest rates in the face of collapsing real economic activity and a flight from their currency.

I fear that the United States government is mistakenly assuming that it can borrow essentially unlimited sums without undermining confidence in the dollar itself. The real question of a successful exit strategy, in my opinion, is how do we extricate ourselves from the joint fiscal commitments currently assumed by the Treasury, the Fed, the FDIC, the Medicare and Social Security trust funds, and various and sundry implicit and explicit federal guarantees?

The answer, in my opinion, is not to be found in the Treasury doing even more borrowing on behalf of the Fed or the Fed doing even more borrowing on behalf of itself.

Not that you should listen to me, or anyone else who's entertaining the idea of trying to time this—or ANY market. (Exhibit A is my ill-advised November 2008 buy of XLF, the Select Sector SPDRs Financials ETF). The market COULD easily be back on track and headed to 15,000. But I'd say that consensus still has this as a bit of a false bull run, with us circling back around at some point to test the lows.

So given that everything else in my financial life lines up nicely with an equity bull market, the gold hedge doesn't seem like such a bad call, particularly vis-a-vis the dollar, which may be looking more and more like the Zimbabwean dollar the way Obama, Geithner and the good-times spending crew are going to have us printing money. That Zimbabwean dollar, by the way, is trading at $4.5 BILLION to a U.S. dollar. And that's the buffed-up official rate.

You've got some different options on gold-there's the behemoth ($31 billion plus) SPDRs Gold Trust (NYSE Arca: GLD) and iShares Gold Comex Gold Trust (NYSE Arca: IAU), which has about $1.8 billion. If you like the share-play angle (the one I'd always used exclusively until the bullion funds became an option), you've got Van Eck's Market Vectors Gold Miners ETF (NYSE Arca: GDX) on the ETF side, with $2.38 billion in assets of its own. Ironically, the reason people like GDX is that it sometimes shows more volatility than the price of bullion itself (which may feel counterintuitive with the way gold-mining companies hedge the price of gold. But that's the stock market for you, I guess).

To give you an idea, GLD is currently trading at $85.27 a share (more or less on par with 1/10-of-an-ounce of gold, minus the tiny amount of gold that has been sold off over the years to pay the 40 bps fee). It has a 52-week range of $68.81 to $98.99. GDX, on the other hand, is currently trading at $33.20 and has a 52-week range of $15.85 to $51.84. So at a glance, if you want more of a boomerang effect, consider going GDX. If you want the shiny yellow stuff with your name on it in a vault, consider going for the gold bullion ETFs. Wait a bit and there will be at least one other U.S.-listed option as well, from London-based ETF Securities.

We'll Miss You, Greg Newton

The small world of ETF punditry has suffered a mighty blow with the passing of Greg Newton (of a heart attack last week). The ebullient Aussie was all piss and vinegar, and his blogs were as witty and insightful as they were irreverent. Naked Shorts is still up and as biting and funny as ever for those of you who wish to take a gander and spend some time remembering Greg.

We were close with him here at IndexUniverse.com, where Greg was a sometime-contributor and always kept things interesting for us. Back in his days at MARHedge, he brokered the deal that had us purchase the ETFR publication. He seemed happier, and a little wilder when he went off to do Naked Shorts—which was just as he wanted it.

We'll miss you Greg. I'm sure you're already stirring up some trouble wherever you are.

1. We, the Leaders of the Group of Twenty, met in London on 2 April 2009.

2. We face the greatest challenge to the world economy in modern times; a crisis which has deepened since we last met, which affects the lives of women, men, and children in every country, and which all countries must join together to resolve. A global crisis requires a global solution.

Things stink all over due to this mess, and it has gotten worse lately.

3. We start from the belief that prosperity is indivisible; that growth, to be sustained, has to be shared; and that our global plan for recovery must have at its heart the needs and jobs of hard-working families, not just in developed countries but in emerging markets and the poorest countries of the world too; and must reflect the interests, not just of today's population, but of future generations too. We believe that the only sure foundation for sustainable globalization and rising prosperity for all is an open world economy based on market principles, effective regulation, and strong global institutions.

It would be nice if everybody could grow and get richer.  Lets not forget about the poor countries that have been hurt even more than the rich countries by this crisis, even though it was not their fault.  However, we will not fundamentally alter the overall global economic system.

4. We have today therefore pledged to do whatever is necessary to:

• restore confidence, growth, and jobs;
• repair the financial system to restore lending;
• strengthen financial regulation to rebuild trust;
• fund and reform our international financial institutions to overcome this crisis and prevent future ones; promote global trade and investment and reject protectionism, to underpin prosperity; and
• build an inclusive, green, and sustainable recovery.

By acting together to fulfill these pledges we will bring the world economy out of recession and prevent a crisis like this from recurring in the future.

Nice set of goals.  However, what is meant by do "what ever is necessary" to repair the financial system.  Calls for stronger regulation of markets are good and very much needed.  The international financial institutions they are referring to here are the World Bank, the IMF and their regional counterparts.

5. The agreements we have reached today, to treble resources available to the IMF to $750 billion, to support a new SDR allocation of $250 billion, to support at least $100 billion of additional lending by the MDBs, to ensure $250 billion of support for trade finance, and to use the additional resources from agreed IMF gold sales for concessional finance for the poorest countries, constitute an additional $1.1 trillion programme of support to restore credit, growth and jobs in the world economy. Together with the measures we have each taken nationally, this constitutes a global plan for recovery on an unprecedented scale.

This is a major increase in support for the IMF and is a very useful step.  It actually means that the calls to help out the poor countries that are suffering from this are not just platitudes, but that the major countries of the world are actually prepared to help.

Restoring growth and jobs

6. We are undertaking an unprecedented and concerted fiscal expansion, which will save or create millions of jobs which would otherwise have been destroyed, and that will, by the end of next year, amount to $5 trillion, raise output by 4 per cent, and accelerate the transition to a green economy. We are committed to deliver the scale of sustained fiscal effort necessary to restore growth.

I will note that the vast bulk of that $5 trillion is coming from a handful of countries, most notably the U.S. and China, with honorable mentions to Japan and the U.K. Continental Europe is effectively trying to free ride off the increased aggregate demand from the countries that are actively stimulating their economies. I would however read this clause as an endorsement of the Obama Strategy.

7. Our central banks have also taken exceptional action. Interest rates have been cut aggressively in most countries, and our central banks have pledged to maintain expansionary policies for as long as needed and to use the full range of monetary policy instruments, including unconventional instruments, consistent with price stability.

A pat on the back for the central bankers.  This is an explicit endorsement of the use of Quantitative Easing (central banks buying long term government bonds and effectively printing money) which is being implemented by the Fed and the Bank of England.  I would also see this as a call for the European Central Bank (ECB) help out a bit more.

8. Our actions to restore growth cannot be effective until we restore domestic lending and international capital flows. We have provided significant and comprehensive support to our banking systems to provide liquidity, recapitalize financial institutions, and address decisively the problem of impaired assets. We are committed to take all necessary actions to restore the normal flow of credit through the financial system and ensure the soundness of systemically important institutions, implementing our policies in line with the agreed G20 framework for restoring lending and repairing the financial sector.

We have thrown lots of money at the banks to keep the system afloat and are prepared to continue throwing money at the banks.

9. Taken together, these actions will constitute the largest fiscal and monetary stimulus and the most comprehensive support programme for the financial sector in modern times. Acting together strengthens the impact and the exceptional policy actions announced so far must be implemented without delay. Today, we have further agreed over $1 trillion of additional resources for the world economy through our international financial institutions and trade finance.

Yes, it has been a lot of money we have thrown at the banks.  So far we have been helping out private commercial banks.  However given the scale of this problem we also need to significantly increase the resources of the IMF and World Bank (mostly IMF).

10. Last month the IMF estimated that world growth in real terms would resume and rise to over 2 percent by the end of 2010. We are confident that the actions we have agreed today, and our unshakeable commitment to work together to restore growth and jobs, while preserving long-term fiscal sustainability, will accelerate the return to trend growth. We commit today to taking whatever action is necessary to secure that outcome, and we call on the IMF to assess regularly the actions taken and the global actions required.

The sun will come out tomorrow.  We think this plan will work, but perhaps the IMF can give some progress reports from time to time.

11. We are resolved to ensure long-term fiscal sustainability and price stability and will put in place credible exit strategies from the measures that need to be taken now to support the financial sector and restore global demand. We are convinced that by implementing our agreed policies we will limit the longer-term costs to our economies, thereby reducing the scale of the fiscal consolidation necessary over the longer term.

We are sure we can pull back from the fiscal stimulus before it bankrupts us and from the monetary stimulus before hyperinflation breaks out.  You don't get to be a head of state by lacking in confidence, and this was a meeting of 20 heads of state or government.

12. We will conduct all our economic policies cooperatively and responsibly with regard to the impact on other countries and will refrain from competitive devaluation of our currencies and promote a stable and well-functioning international monetary system. We will support, now and in the future, to candid, even-handed, and independent IMF surveillance of our economies and financial sectors, of the impact of our policies on others, and of risks facing the global economy.

If the independent surveillance of the economy by the IMF applies to the U.S. then this is big news.  More likely there are no teeth to this.  If the U.S were any other country, the IMF would have long ago pressed us to nationalize the banks, clean them up and sell them off.

Strengthening financial supervision and regulation

13. Major failures in the financial sector and in financial regulation and supervision were fundamental causes of the crisis. Confidence will not be restored until we rebuild trust in our financial system. We will take action to build a stronger, more globally consistent, supervisory and regulatory framework for the future financial sector, which will support sustainable global growth and serve the needs of business and citizens.

Deregulation was a VERY bad idea when it comes to financial institutions.  With the world now interconnected more than ever before, regulations need to be strengthened and made more consistent across boarders.

14. We each agree to ensure our domestic regulatory systems are strong. But we also agree to establish the much greater consistency and systematic cooperation between countries, and the framework of internationally agreed high standards, that a global financial system requires. Strengthened regulation and supervision must promote propriety, integrity and transparency; guard against risk across the financial system; dampen rather than amplify the financial and economic cycle; reduce reliance on inappropriately risky sources of financing; and discourage excessive risk-taking. Regulators and supervisors must protect consumers and investors, support market discipline, avoid adverse impacts on other countries, reduce the scope for regulatory arbitrage, support competition and dynamism, and keep pace with innovation in the marketplace.

Everyone has to regulate, no trying to lure financial activity to your country by promising to look the other way when institutions take on excessive risk in the hunt for short term profits.

15. To this end we are implementing the Action Plan agreed at our last meeting, as set out in the attached progress report. We have today also issued a Declaration, Strengthening the Financial System.

In particular we agree:

• to establish a new Financial Stability Board (FSB) with a strengthened mandate, as a successor to the Financial Stability Forum (FSF), including all G20 countries, FSF members, Spain, and the European Commission;
  that the FSB should collaborate with the IMF to provide early warning of macroeconomic and financial risks and the actions needed to address them;
  to reshape our regulatory systems so that our authorities are able to identify and take account of macro-prudential risks;
• to extend regulation and oversight to all systemically important financial institutions, instruments and markets. This will include, for the first time, systemically important hedge funds;
• to endorse and implement the FSF's tough new principles on pay and compensation and to support sustainable compensation schemes and the corporate social responsibility of all firms;
• to take action, once recovery is assured, to improve the quality, quantity, and international consistency of capital in the banking system. In future, regulation must prevent excessive leverage and require buffers of resources to be built up in good times;
• to take action against non-cooperative jurisdictions, including tax havens. We stand ready to deploy sanctions to protect our public finances and financial systems. The era of banking secrecy is over. We note that the OECD has today published a list of countries assessed by the Global Forum against the international standard for exchange of tax information;
• to call on the accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards; and
  to extend regulatory oversight and registration to Credit Rating Agencies to ensure they meet the international code of good practice, particularly to prevent unacceptable conflicts of interest.

That is a long list of reforms and areas for tighter supervision.  Mostly it amounts to more international cooperation on regulation, in a more formal and institutionalized way.  The call for regulation and oversight of the Credit Rating agencies (i.e. Moody's and S&P) is long overdue, as their lack of action and incompetence was a major factor in this whole mess occurring.  All big financial institutions, including hedge funds need to be regulated.

16. We instruct our Finance Ministers to complete the implementation of these decisions in line with the timetable set out in the Action Plan. We have asked the FSB and the IMF to monitor progress, working with the Financial Action Taskforce and other relevant bodies, and to provide a report to the next meeting of our Finance Ministers in Scotland in November.

We hope we can get our act together by November.

That is about half of the statement, I will have a follow up post on the rest of it.  In general the basic thrust of the statement is that it endorses aggressive government actions, both on the fiscal and monetary front to address the crisis.  It calls for much stronger regulation.  Perhaps the most significant news is a very large commitment to strengthening the resources of the IMF to help some of the emerging economy's deal with the fallout of this mess that they did not create.

Treasury Secretary Timothy Geithner began his remarks to the Senate Banking Committee this morning as follows:

To get credit flowing again, to restore confidence in our markets, and restore the faith of the American people, we have proposed a fundamental reshaping of the government's program to repair the financial system.

It all begins with transparency. We propose to establish a new framework of oversight and governance of all aspects of our Financial Stability Plan. The American people will be able to see where their tax dollars are going and the return on their government's investment. They will be able to see whether the conditions placed on banks and institutions are being met and enforced. They will be able to see whether boards of directors are being responsible with taxpayer dollars and how they're compensating their executives. And they will be able to see how these actions are impacting the overall flow of lending and the cost of borrowing.

To which I responded, Amen! And Amen! And I continued reading:

These new requirements, which will be available on a new website FinancialStability.gov, will give the American people the transparency they deserve.

So I surfed to that site, where I read:

This site is coming soon.

Hmmm. Going back to Geithner's statement:

Second, we are going to bring together the government agencies with authority over our nation's major banks and initiate a more consistent, realistic, and forward looking assessment about the risk on balance sheets. We're calling it a financial "stress test." We want banks' balance sheets cleaner, and stronger. And we are going to help this process by providing a new program of capital support for those institutions that need it.

OK, so what do we do if we discover that an institution's balance sheet is, like, stressed?

Institutions that need additional capital will be able to access a new funding mechanism that uses money from the Treasury as a bridge to private capital. The capital will come with conditions to help ensure that every dollar of assistance is used to generate a level of lending greater than what would have been possible in the absence of government support.

Oh, dear. We obviously don't have clear details of the plan, only the concept, but it sounds to me like the wrong concept. As I've argued before, there basically are five parties who might be asked to absorb the losses on existing assets, namely, stockholders, creditors, managers, employees, and the taxpayers. My favored concept is, we use player 5 to get as much leverage as possible out of the first 4. It appears that the Treasury's concept is instead a continuation of Plan A, namely, hope that if we hold on tight and keep the ship from sinking long enough, everything will turn out OK.

And maybe it will. But if I were in Geithner's position, what I would be asking for immediately is legislative authority, where needed, to crack heads and make the tough decisions necessary to turn the financial system over to good banks rather than the walking dead.

But let's hand the microphone back to the Treasury Secretary:

Third, together with the Fed, the FDIC, and the private sector, we propose the establishment of a Public-Private Investment Fund. This program will provide government capital and government financing to help leverage private capital and get private markets working again. This fund will be targeted to the legacy loans and assets that are now burdening many financial institutions.

I'm even less clear as to exactly how that's going to work. Perhaps the statement released separately by the Federal Reserve fills in some details:

The Federal Reserve Board on Tuesday announced that it is prepared to undertake a substantial expansion of the Term Asset-Backed Securities Loan Facility (TALF). The expansion could increase the size of the TALF to as much as $1 trillion and could broaden the eligible collateral to encompass other types of newly issued AAA-rated asset-backed securities, such as commercial mortgage-backed securities, private-label residential mortgage-backed securities, and other asset-backed securities. An expansion of the TALF would be supported by the provision by the Treasury of additional funds from the Troubled Asset Relief Program.

Here's what I don't like about this. The Treasury is acting as though there's a sixth party who can step into the funding gap here in the form of the Federal Reserve. Once again, that will be OK if Plan A works out, that is, if things go well enough that the Fed's losses on any assets acquired and loans extended are limited to the TARP funds already authorized. But if not, we're back to the same calculation-- the Treasury must borrow (if foreigners remain willing) and taxpayers must ultimately pay the bill. Either that, or the Fed just covers the bill by printing money for the whole thing.

There's a very real danger in going as far down the road of Fed-Treasury cooperation as we already have. The Administration starts to think of the Federal Reserve as another cookie jar it can draw on to cover all these pesky bills which, if Plan A fails, we'll find are impossible to pay by any means other than monetization and a huge inflation.

And fear of that, if it catches fire, would be a far more destabilizing event than a controlled receivership for a few more big financial institutions.

S&P500 stock index on Feb 10. Source: Yahoo Finance

Technorati Tags: macroeconomics, economics, bailouts, Treasury Financial Stability Plan, credit crunch

"Big Joe" Clark has his wish list for 2009. And it includes some exchange-traded funds that even Santa Claus might find useful as stocking stuffers.

At the top are corporate bonds. In the coming year, the Anderson, Ind.-based advisor is expecting investment-grade corporates and high yield debt markets to perform like stocks do in more-normal times.

As a result, Clark is buying more of the iShares iBoxx Investment Grade Corporate Bond Index (NYSE: LQD) in client portfolios. It's a fund he held during the latter half of 2008.

At the same time, Clark is initiating new positions in the iShares iBoxx High Yield Corporate Bond Index (NYSE: HYG).

"Both are moving up in terms of prices," he said. "That means their yields are dropping some. But they're still yielding much better than Treasuries and very attractively priced."

The longer-term government bond market is at all-time lows in terms of yields, adds Clark. For example, the iShares Barclays 20+ Year Treasury Bond Index (NYSE: TLT) was paying interest of around 3.41% heading into Friday.

Rallying Bonds 

"Corporate bonds were sold off as an absolute sense of fear overtook the market. The economy is going to face continuing challenges in the coming year. But default rates aren't going to go over a cliff," said Clark.

So ETFs like LQD and HYG remain undervalued, despite a 20% rally in prices since the end of November, he says. "There are still legs on the corporate bond rally," said Clark. "The [yield] spread between Treasuries and investment-grade corporates has to go lower. Treasuries just can't go much lower."

Even though HYG falls into the junk bond category, he believes corporate balance sheets remain relatively healthy. And he points out that many companies issuing junk bonds are flush with cash on their books.

"When credit markets are this out of whack, yields are so low that companies can take debt off their books and refinance those bills at the lowest recorded rates in history," said Clark. "The reality is that opportunity exists to improve corporate balance sheets as long as Treasuries remain at relatively low rates."

Stock ETFs are another matter, he says. "These are very volatile times. The opportunity to get crunched still looms very large over the market moving into 2009," said Clark.

But he's optimistic about foreign ETFs. Clark has moved into the iShares FTSE/Xinhua China 25 Index (NYSE: FXI).

"It found some technical footing a few weeks ago. That makes us feel a little better about this ETF," said Clark.

His firm originally got out of FXI in November 2007 on concerns that China had overspent preparing for the 2008 Summer Olympics. "A number of bad things took place in that country in 2008, from earthquakes to a declining economy," said Clark.

But in early December, FXI broke above its 50-day moving average. That's a key short-term technical price indicator.

"While we're seeing commodity prices still getting hit across the board, China has the cash reserves to take advantage of the situation," said Clark. "They've been able to buy everything they need in terms of raw materials—and horde a little—at fantastic prices."

And China also is a big holder of U.S. Treasuries, he points out. "So they've been able to benefit from the huge rally in Treasury prices," Clark said. "Taken along with its strong cash reserves, China is just in a tremendous competitive position as a player in global markets."

He isn't quite ready to jump into Telecom sector plays yet. But Clark says on his radar are the iShares Dow Jones U.S. Telecom Index (NYSE: IYZ) and the Vanguard Telecom Services ETF (NYSE: VOX).

"When bond yields come down, Telecom has done well in the past," said Clark. "Telecommunications is a highly leveraged industry. So falling corporate bond yields should benefit those ETFs."

From Luxury To Staple 

The overall economy in the U.S. will be challenged in 2009, he adds. "People just aren't going to give up their ability to use cell phones. The ability to communicate on the go has turned from a luxury to a need. We think Telecom is going to resemble a Consumer Staple as the corporate bond yields come down," Clark said.

He also views Europe as taking longer to rebound than the U.S. "Italy's debt just climbed to 104% of GDP, which is spooky. At the same time, the U.S. is at 72.5%, even after all of the troubles we've had over here," said Clark.

With diverse economic profiles, he believes operating under a single currency also won't help Europe's attempts to quickly rebound. "The euro was clearly on a downturn, but a few weeks ago that trend reversed," said Clark. "But the cat's out of the bag about the U.S. printing money. So at some point, the U.S. dollar should go back down and the euro should start going back up."

But currency ETFs and portfolios heavy with European companies aren't on his list of favorites for 2009. Trying to time currency moves and figure out how quickly European stocks rebound are going to be difficult decisions to make over the next several quarters, says Clark.

And while a credit crisis in the U.S. is showing signs of abating, he cautions that markets remain in an extreme case of flux heading into a new year.

"You can start to see the sunrise, but it's clearly not bright outside yet," said Clark.

This from The Daily Reckoning Australia

Now to the big subject of the day: Inflation. You’d think evidence of even bigger deficits in the U.S. is clearly inflationary. But not everyone thinks so. The new prophet of doom, Dr. Nouriel Roubini, says at least four factors are setting up what he calls “Stag Deflation” (as opposed to the stagflation of the 1970s, where you had no growth and rising prices).

Roubini’s four…

The essence of the Fed's balance sheet used to be quite simple. The Fed's primary operations would consist of either buying outstanding Treasury securities or issuing loans to banks through its discount window. It paid for these transactions by creating credits in accounts that banks hold with the Federal Reserve, known as reserve deposits. Banks can turn those reserves into green cash any time they desire, so the process is sometimes loosely summarized as saying that the Fed pays for the Treasury bills it buys or loans it extends by "printing money". Before the excitement began, the Fed's assets consisted primarily of the Treasury securities it had acquired over time (about $800 billion as of August 2007) plus its discount loans (an insignificant number at that time). Its liabilities consisted primarily of cash held by the public (about $800 billion a year ago) plus the reserve deposits held by banks (which again used to be a very small number).

Bernanke's overriding goal since then has been to extend a huge volume of short-term loans to financial institutions. If he'd done that in the usual way, just creating new reserve deposits with each new loan, the supply of cash would have ballooned, bringing worries of inflation. The Fed didn't want to do that, and in fact there was no shortage of funds available for overnight interbank lending. The fed funds rate, an average overnight lending rate between banks, is already quite low, and further reductions seem unlikely to accomplish much. But longer term interbank lending rates remain quite high relative to the overnight rate.

Bernanke's first approach to this challenge was to "sterilize" the new loans from the Fed, basically selling off the Fed's Treasury holdings at the same time that it extended the new loans. When a counterparty buys the Treasury security from the Fed, the Fed debits the bank's account with the Fed, and these debits net out the credits that would be created as a consequence of the Fed's new loans. Reserves go up with the loans, down with the sale of Treasuries, so the net result is an increase in loans from the Fed but no change in reserve deposits. These new Federal Reserve assets came in many colors and flavors, including the Term Auction Facility, the Primary Dealer Credit Facility, currency swaps (which I presume is the biggest single item in the burgeoning "other F.R. assets" category), and the seriously non-acronymizable Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility.

But $800 billion-- the total stock of Treasuries that Bernanke originally had available for this purpose when he started down this path over a year ago-- only goes so far these days, particularly when you remember that a quarter trillion of those securities are now being used in the Term Securities Lending Facility, which the Fed records as an off-balance-sheet transaction. To enable it to extend more than $800 billion in loans without "printing more money," the Fed asked the Treasury to implement a Supplementary Financing Program in which the Treasury would sell securities directly to the public but simply keep the funds in an account with the Fed. The payments by the public for these securities then initiate a flow of reserves out of private banks, the same as if the Fed itself had sold Treasuries to the public out of its own holdings, so the SFP enables the Fed to sterilize a greater volume of loans than it could if it had to rely solely on its original holdings of Treasury securities. The Treasury supplementary account as of last week has provided the Fed with an additional $559 billion to play with. It appears from the latest balance sheet that the Fed has now asked the Treasury to do the same sort of thing with the Treasury's "general account" with the Fed. Historically, that account was just used to facilitate daily Treasury transactions, and was usually held to about $5 billion. Last week, it's up to $56 billion.

It's clear that the Fed is now also using yet another tool to balloon its balance sheet, namely, deliberately encouraging banks to sit on their excess reserve deposits. When these started to shoot up at the end of September, I initially attributed this to frictions in the interbank lending market. But with the announcement on October 6 that the Fed would begin to pay interest on those deposits, and the further announcement on October 22 that the Fed is now raising that interest rate to within 35 basis points of the target for the fed funds rate itself, it is clear that the Fed has now settled on a deliberate policy of encouraging banks to just sit on the reserves it creates, giving it another device with which to expand its balance sheet without increasing the quantity of cash held by the public. That's provided another quarter trillion for the alphabet soup of new facilities.

I had a call from a reporter this week asking me to explain why the Fed raised the interest rate paid on reserves. I think she was expecting a 30-second sound bite, but instead we went back and forth for about 15 minutes and I'm not sure even then that I succeeded in getting the basic idea across. At that point she asked me, "Do you see it as an encouraging development that the Fed has taken this step to address the credit crunch?" My immediate answer was no. It's not an encouraging development because it means that the heroic efforts that the Fed has taken previously weren't enough. The Fed's first $100 billion didn't do it. The Fed's first $1 trillion didn't do it. Having the Treasury take over the $5 trillion in debts and guarantees of Fannie and Freddie didn't do it. The Treasury's $3/4 trillion rescue/bailout package didn't do it. And another quarter trillion will?

If the spread between overnight and 3-month interbank lending rates indeed results from pure illiquidity of the latter market, it seems to me it shouldn't have required too much grease to get that market lubricated. But if, as argued by John Taylor and John Williams, the spread instead represents compensation for counterparty risk, it doesn't matter how much term lending the Fed does. Its actions would only move that spread to the extent they reduce the counterparty risk itself. The primary consequence of the actions would not be to change the spreads but instead would just shift the risk onto the Federal Reserve's balance sheet.

There was another juicy morsel in the latest H.4.1. The latest report acknowledges that the Fed has taken some losses on some of these unconventional assets. The Fed last week wrote off $2.7 billion in losses on the loans to "Maiden Lane LLC," an entity created through the Bear Stearns package. The assets of Maiden Lane consisted of claims on certain troubled securities, and the liabilities consisted of a loan from the Federal Reserve. The Fed now admits that Maiden Lane won't be repaying all of the loan, so it had to reduce its claimed assets by $2.7 billion. This also required a corresponding imputed $2.7 B reduction in the "other" category on the liabilities side of the Fed's balance sheet, presumably in large part coming from debits to the "surplus" and "other capital accounts" entries in the Statement of Condition of the Federal Reserve Bank of New York, though I haven't traced through the details of exactly how that was implemented.

Regardless of the accounting, here's how those losses will show up in practice. When the Treasury auctioned the T-bills for the increase in its supplementary and general accounts with the Fed, and when the Fed sold off its existing holdings of Treasuries, the Treasury started making interest payments to the public. The Fed is also receiving interest on the loans it made, and returns that interest to the Treasury. As long as the loans are performing, it is a wash to the Treasury. But if some of the Fed's loans go bad, it means the Treasury is on the hook for the extra interest costs with no offsetting receipts. In other words, any losses by the Federal Reserve are equivalent to a fiscal expenditure financed by Treasury borrowing.

The notes to the H.4.1. seem to imply that the Fed's intention is to update its assessment of the "fair value" of its Maiden Lane holdings as of the end of each quarter, which would mean no new markdowns until January.

But that doesn't mean that the remaining $1,839 B in Fed assets will all continue to bring in their hoped-for receipts for the Treasury between now and then.

Technorati Tags: macroeconomics, economics, Federal Reserve, interest rates, term auction facility, TSLF, TAF, term securities lending facility, credit crunch

The yen fell over the weekend as investors began moving funds back into the higher yielding currencies of Brazil, Mexico, New Zealand…

As we’ve talked about in these pages before, Fed Chairman Ben Bernanke is a devoted student of the Great Depression. You could almost say that a study of the Great Depression - its causes, its quirks, and finding the means to ensure it never happens again - makes up the sum total of Bernanke’s lifework.

In 2002, Bernanke gave a speech titled, “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” (You can read the full text here.)

This is where the, uh, taxing part comes in (underscore emphasis mine):

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Do you know what gentle Ben is really saying here? He is saying he can tax the dollars right out of your wallet if he chooses to. And if he has to, he will... and there isn’t a thing you or I can do about it (other than convert those dollars into something else before they get devalued).

Simply put, inflation is a form of hidden tax. Whenever the U.S. government prints dollars from thin air, it lessens the value of the dollars in your bank account.

This is no different than taking money from your bank account... except the process is much more stealthy. When the government practices taxation by inflation, many of us don’t even know we’ve been taxed. The value has been drained from the dollars, even if the dollars are still there.

If you’re still fuzzy on the concept of inflation as a hidden tax, ask yourself this: Why does the government bother with collecting taxes at all? In theory, Uncle Sam could just print up dollars for everything he needs.

If there were, say, $10 trillion in circulation, the government could just print up $10 trillion more for itself.... dropping the value of all existing dollars by 50%, but hey, so what.

If we did it this way, there wouldn’t have to be an IRS. We could abolish April 15th, stop worrying about tax lawyers... When Uncle Sam needs something, he just writes himself a check. So why not do it?

There are at least two reasons why direct “taxation by inflation” - a system where the government prints what it needs - does not happen.

For one, lobbyists and their masters love a complicated tax code. It allows them to exploit loopholes and siphon dough from the system in all kinds of ways.

But, more importantly, taxation via printing press would be too obvious. If we did it that way, most everyone would understand the concept of inflation as a hidden tax. There would be no room left for stealth. A lot more people would pay a lot more attention to those printing presses chugging away in the dead of night.

And that’s really one of the ironies of this whole bailout mess.

Now that the Fed and Treasury have been rebuffed in their efforts to go through the front door, they’re just going to concentrate even harder on saving the system via the back door... and that means big-time taxation without representation (i.e., taxation via the printing press).

No Votes on This One

There won’t be any votes on this. The printing has already begun, as The New York Times spelled out on Monday:

Without the broad bailout plan they invented and lobbied hard for, the two agencies are once again forced to careen from one desperate path to another, and to dig deep into their toolkits to rescue the global financial system. Even before the House stunned the world on Monday by rejecting the Bush administration’s bailout bill, the Fed was already resorting to the oldest action in its book: printing money.

In the past two weeks alone, the Fed has borrowed and lent a whopping $710 billion - more than the cost of the proposed bailout - in an effort to keep the system afloat. Some of that went to an “emergency lending program” for various banks; some of it went to “swap lines” with foreign central banks to help shore up European and Asian money markets; and some of it went to flailing institutions like AIG.

And the ironic thing is, the Fed is just getting started. If a follow-up bailout plan doesn’t pass - and many of those chanting “No! No!” are hoping it won’t - then Bernanke will just gear up the printing presses to an even further degree.

Source: Get Ready for Taxation Without Representation

It’s not only Wall Street that is being bailed out by the US taxpayer. They’re going to have to find another $25bn to save Detroit too.

This is another nail in the dollar’s coffin. And it will be fantastic for gold.

The House of Representatives is in the final stages of agreeing a $25bn package of low-cost loans to carmakers. It’s virtually a done deal.
This loan is separate from $700bn bailout for the banking sector, which is still being debated in Congress. The bailout plan is growing bigger by the day.

This is another industry that has brought about its own demise. It failed to invest in fuel efficient cars – and now people can’t afford to drive their gas guzzlers. Corporate America screws up. US taxpayers pick up the pieces. It spells doom for the dollar.

The recent revival in the dollar’s fortunes appears to be over. Once the fall starts, it’s going to gather significant momentum.

In an interview with Bloomberg yesterday, Barrick Gold founder and Chairman Peter Munk said he now expects a move away from the dollar and into gold. I agree.

He was talking about what he called “major, major” holders of dollars. By this he means foreign governments and sovereign wealth funds.

Gold has added around 20% since the collapse of Lehman Brothers (NYSE:LEHMQ). As governments holding dollars all over the world see the scale of structural problems in the US economy, they will seek to diversify. They are likely to become strong buyers of gold.

It is now more likely that the Fed will have to cut interest rates at its October meeting. US interest rate futures show that traders now see an 80% chance that the Fed will cut rates. On 23 September, futures contracts were implying a 58% chance of a rate cut.

The banking bailout plan will erode the appeal of US Treasuries for foreigners. Government figures show that investors outside the US own 56% of the $4.8 trillion in marketable Treasuries outstanding, up from 42% of the $3.4 trillion five years ago.

The countries holding the most US debt are Japan, China, the UK and all the oil exporting nations.

Both China and Japan hold more than $500bn of US debt. With the Fed printing money to bailout out Wall Street and Detroit, US bond holders will be nervous.

Expect a rush of capital out of US Treasuries and a rotation into gold. To discover more ways to profit from natural resources click here.

Source: The Dollar is Being Destroyed – Buy Gold