Something Evil This Way Comes - Real Soon Now!

The Federal Reserve and the Monkey Wrench Gang

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You may now stop singing and dancing and playing around. The party is about to be over and I'll be glad to be a party pooper and tell you why.

The Federal Reserve is about to pull the plug on money pumping. The signs of this non-action (when one stops doing something, it's a non-action, right?) have been laid out in plain text tablets from on high and even plainer actions everywhere this week and last.

Straws in the Wind

Bill Gross, an extremely smart fellow and boss of PIMCO, the largest bond fund in the world has cast two votes against U.S. Treasury debt. First, a few weeks ago, in his weekly newsletter, he plainly stated that PIMCO was not going to hang around with a "wait and see" attitude as far as QEII ending, maybe QEIII, maybe not. So he sold every last Treasury Bond he had in his voluminous inventory. Boom... Just like that.

This week, we got the second vote against U.S. Treasury debt. Looking critically at PIMCO's positions, we now find that that the position in U.S. Treasury debt is over -3%. PIMCO is short 3%+ of assets in Treasury debt. There can be no doubt that Mr. Gross is putting his money right smack where his mouth is. I, for one, feel Mr. Gross is at a considerably higher pay grade than yours truly and would not care to bet against him.

Another straw blowing around is the fact that interest on U.S.Treasury debt is beginning to crawl higher - not rapidly - but 30 Year T-Bonds have moved from 4.48% to 4.64% since April first and 10 Year T-Bonds have moved from 3.46% to 3.59% in the same time frame. Fact of the matter is that the entire long bond yield rates from 5 years out has risen about the same percentage amount and that change is about 3.6% over two weeks or 93.6% at an annual rate if things don't change.

For those who are not bond investors, I feel I need to interject a tiny bit of background here. Bond value (i.e. sales price) varies inversely with bond yield. If you buy a 10 year, $1,000 face value T-Bond at an interest rate of 2%, in addition to earning negative return on it (inflation eats the purchasing power of the bond faster than the interest adds to the return) you also run a possibility of capital gain or loss depending on open market bid/sell prices on the bond. If interest rates drop to 1%, the value (and price on the market) of the bond doubles to $2,000 so that at the end of ten years, the interest paid will be the same. By the same token, if interest rates increase to 4 percent, the face value of the bond is cut in half to $500 so that, at the end of ten years, the interest paid on the bond remains the same. ($200 in either case). When the bonds are sold on the open market, this back and forth movement goes on throughout the life of the bond. (I exclude TIPS here for simplicity - for TIPS, see http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm.)

The point of the story is that rising interest rates are absolute poison to the fixed income interest dependent markets (Treasury bonds, corporate bonds, mortgage securities - any debt instrument that has a issue face value, a fixed maturity date and a fixed opening interest rate). Also, all variable interest rate loans (ALT-A, adjustable rate mortgages, et al) as interest rates increase, so will payments increase on the loan to insure the new interest rate is reflected in payments.

Now that we've got that wee background out of the way, we'll take a look at a silver stake that was just driven through the Heart of the FOMC at the Federal Reserve and just bloody guarantees that Bill Gross is absolutely correct in his bet that interest rates are going up "real soon now".

The Federal Reserve Changes Accounting Rules So It Can't Go Broke!

Way back on January 6, 2011, (Hat tip to John Hussman for bringing this to light), in a mostly forgettable Federal Reserve Weekly Report, very quietly and in small print that escaped the notice of the media and just about everyone else, was inserted a note to the effect that the Fed had changed its own accounting rules which, frankly, looks illegal as Hell to me. Will whom ever oversees the Federal Reserve please stand up?

More background:

The Fed, as a bank, must hold asset reserves to back up the credit it issues, just like a real bank, right? Well not so fast. If a bank has a leverage level of 1:1, then it would have to have its' entire loan portfolio default before it would be in trouble, a very unlikely thing. A bank that is leveraged 10:1 would come out fine until 10% of it's loan portfolio defaulted and then it would go bust because its' reserve capital drops to zero. This is why there is a loan window at the Federal Reserve that will loan banks money when they need it, should they run into trouble with reserve requirements and need a helping hand. This is all well and good for the banks as it stabilizes the system and smooths out the flow of funds. But there is a limit, by law, as to the limits of leverage a bank can have. Apparently the TBTF banks have no limit on either the reserve requirement or leverage because if they "technically" go broke, the Federal Reserve merely purchases the bad mortgages, loans, whatever at full face value, tucks it into the Federal Reserve's vault - valued at full face value even if they are truly valued at zero - gives the banks fresh money in exchange and just like magic - all's well. For a little while.

Now these rotten assets that caused the TBTF banks to "technically" fail and be bailed out are subject to the same mathematical rules to which every other debt instrument is subject. If interest rates go up, the face value of the debt goes down. If interest rates go up, the value of the "phantom" assets the Fed holds goes down as well (regards of the real value).

But we have a problem. Several problems in fact. Problem #1 is that the Federal Reserve, if it were an ordinary bank would be shut down in a heartbeat by regulators because it's already busted. The fed's leverage approaches 50:1, it's vaults are stuffed with rotten garbage that isn't worth burning, valued at full value in the old extend and pretend game. Now, if it takes 50% of assets to default to put a bank with a leverage of 2:1 out of business, how much loss of value can the Federal Reserve handle before it's totally busted?

Since the Federal Reserve is currently at a 50:1 leverage (honest!), it's 2%. If 2% of the Federal Reserve asset base disappears, the Fed is well and truly bankrupt on paper. (I know the Fed is bankrupt now, but we're talking "broke" so the whole world has it rubbed in their faces!).

How the Federal Reserve Fixed Its Own Problem In Advance and Insures It Will Never Go Broke!

So, back on January 6, 2011, the Feds changed the rules (same as TEPCO changing the rules to allow more radioactivity perfectly ok and rendering it harmless at the stroke of a pen) so that should any assets held by the Fed take a hit from higher interest rates, the value lost, instead of being deducted from the value of the asset base itself, it recorded carefully and in my opinion, illegally in a new account called, "Liabilities of the U.S.Treasury".

I include here a segment of an article from the CNBC web site (posted on 21 January and never again mentioned by the MSM) on which you may come to your own conclusions.

"The change essentially allows the Fed to denote losses by the various regional reserve banks that make up the Fed system as a liability to the Treasury rather than a hit to its capital. It would then simply direct future profits from Fed operations toward that liability. This enhances transparency (!!!) by providing clearer, more frequent, snapshots of the central bank's finances, analysts say. The bonus: the number can now turn negative without affecting the central bank's underlying financial condition.

"Any future losses the Fed may incur will now show up as a negative liability as opposed to a reduction in Fed capital, thereby making a negative capital situation technically impossible," said Brian Smedley, a rates strategist at Bank of America-Merrill Lynch and a former New York Fed staffer.

"The timing of the change is not coincidental, as politicians and market participants alike have expressed concerns since the announcement (of a second round of asset buys) about the possibility of Fed 'insolvency' in a scenario where interest rates rise significantly," Smedley and his colleague Priya Misra wrote in a research note." (various emphasis mine)

Source: http://www.cnbc.com/id/41198789

Now what I really want to know is how does the Federal Reserve get to change its' own accounting rules with no oversight, no permission, no notification of Congress - NO NOTHING.

It makes me feel so much more secure to know that "technically", the Federal Reserve can no longer go broke regardless of how interest rates rise or how much money they loan the Treasury or foreign banks or how much money they flood the world with! They are now literally living in a fantasy world of make believe where they must assume everyone else in the entire world is totally adrift mentally and incapable of seeing the plain truth. The Federal Reserve has gone berserk, insane and completely unable and unwilling to use rational thought for any level of activity.

Summary (or put all the BS in one box)

The actions of the Federal Reserve and Bill Gross of PIMCO plus all the propaganda put out by the Presidents of several Regional Federal Reserve Banks add up to one thing.

At least temporarily (i.e. until total panic and discontent rule inside the beltway), further QE is toast. What exactly comes next is anyones' guess but this is not all of the story. It goes deeper and scarier as you examine just how thin a line has been drawn between depression and hyper-inflation + depression the Federal Reserve has managed to doodle into the picture.

Once again, I will borrow from an excellent analysis of John Hussman who draws some startling conclusions. If interest rates increase a mere 0.25%, it would require one of two things; draw down the money supply by an immediate $600 billion (i.e all of QEII) or accept a 40% increase in inflation. To allow interest to rise to a mere 2%, all the QE to date would have to be withdrawn from the money supply or they would have to accept a 70% inflation in price levels. It normally takes 6-8 months from a change in the money supply to reflect itself in the inflationary front. Hence, the run up in food, gas, commodities, etc. we see around us today are from QE1 and QEII will make itself felt real soon now.

(source here: http://www.financialsense.com/contributors/john-hussman/looking-ahead)

All in all, there is no doubt that the Federal Reserve is on the path to higher interest rates which will kick the markets end over end. Stocks markets will take a hit (including PMs), the bond bull will die a kicking screaming death and volatility and instability in all things from industrials to financials to commodities will be the order of the day.

I am standing aside for a time, except for my core holdings in precious metal and commodities and a very modest chunk of a permanent portfolio fund. I maintain holdings in short term CDs of several foreign countries currencies but keep them all on a very short string.

I would recommend you adopt an extreme defensive posture in your investments and short term planning. I'd maintain this outlook until the dust settles, the volatility drops back into the atmosphere and we get a feeling whether or not the Federal Government has the cojones to wring out the excessive funds they stuffed into the banks pockets at the expense of taxpayers. If they do, fine, it'll hurt, GDP will wither, unemployment will climb sharply, there will be defaults and bleeding in the streets here an there. If they do not and reverse stance and go to QEIII, QEIV, etc, etc then we just drag that dry powder out of storage and back we go into PMs and commodities and anything end everything except the dollar and things dollar denominated.

For now, be very conservative and very careful. There are Evil Things on the Prowl and it may take a while to make them go away - if they do at all.

END


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