How the Bank of Yellen Really Operates

by Bill Bonner

Dying Cows Praying for Nicaragua when you live in Tunbridge Wells is the first sign of madness. Evelyn Waugh “Three more cows died,” Jorge, our Argentine ranch manager, reported yesterday. We had reacted as fast as we could. Still, the disease – whatever it is – moved faster. Jorge and his crew of five gauchos worked for three days – including a Sunday and a national holiday – almost without rest. From first light ‘til after dark they rounded up the cattle and ran them through the stocks. It was hard work. But there were no complaints. They all knew it had to be done. All the animals have now been given an injection. Whether that stops the epidemic, or not, we wait to find out … (Photo credit: Nathan Cowlishaw) Rube Charm We are beginning to ruminate on the strange, wide and unappreciated gulf between Nicaragua and Tunbridge Wells… A stock character of show-business (less so now than 50 years ago) was the “hick.” Recently fallen from the turnip truck, he knew his bucolic world. He knew his cows and his bottom 40 … but the larger, outside world was a mystery. Confronted with a public policy issue (for these men were often elected to the House or the Senate), he resorted to folk wisdom and practical experience. “Well, if you give money to lazy people, it won’t make them any less lazy,” he might have opined on a welfare program. Or: “I don’t know why we need to put fancy theatras and basketball courts in public high schools. I went to a one-room school house. And I can guarantee you it didn’t have air-conditioning.” This down-home outlook made the hick a laughingstock to urbane policymakers. And he was often a fool. But it endeared him to the bumpkins who elected him. President Johnson was one of the last major politicians who used this rube charm to good effect. When the occasion called for it he wore his cowboy hat. And he had many colorful expressions to substitute for real thinking. One of his favorites was: “The time to kill a snake is when you have a hoe in your hand.” The expression brought back the reality of country life. When you saw a snake with your own eyes you knew what to do… especially if you had a hoe in your hands. But a hoe is one thing; a Huey helicopter is another. Here on the ranch, we find a dead cow. We make decisions that put the whole farm into motion, costing us a few thousand dollars that we can ill afford. Either we are right. Or we are wrong. But at least we operate on facts, as best we can. And we suffer the consequences as we must. We are six hours from the nearest city. Things happen here that we see, feel… and within the limits of our own senses and sensibilities… understand. (Photo credit: Cecil Stoughton) No Hoe But the markets are a different animal. At our Bonner & Partners Family Office research department, a question has been preoccupying us: Does QE transmit inflation to consumer prices? Much time was spent researching how the banking system works in a fiat money world. More time was spent wondering how and when the velocity of money might increase. Experts disagree on major points. Can banks use their excess reserves to increase lending? Even this simple question throws up so many different viewpoints… and so many footnotes and nuances… that we regard it as beyond meaningful understanding. On what facts does Janet Yellen operate? How connected is she to the real world? Does she understand the connections between QE and consumer price inflation better than we do? Or does she mistake the US Army for a hoe and the Vietcong for a snake, as Lyndon Johnson did? You can judge for yourself. Our old friend John Mauldin is quoted in a film about how the Bank of Yellen operates. As you will see, Yellen has no real facts. She has no hoe. And she wouldn’t know a dead cow if it bit her on the derriere. Since the beginning of time until today, there is no evidence that activist central bankers – like activist politicians – have ever done anything but cause mischief. Yet the entire market is depending on them, as though they knew what they were doing. We repeat our warning: A distorted market is a dangerous one. (Image via Flickr / DonkeyHotey) The above article is from Diary of a Rogue Economist originally written for Bonner & Partners. Bill Bonner founded Agora, Inc in 1978. It has since grown into one of the largest independent newsletter publishing companies in the world. He has also written three New York Times bestselling books, Financial Reckoning Day, Empire of Debt and Mobs, Messiahs and Markets.

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Gold and Gold Stocks – A Comment on the Correction

by Pater Tenebrarum

A Bigger than Expected Downturn The recent downturn in gold and gold stocks has become bigger than we expected. We basically thought that gold might correct to the support area around $1320 and then resume its rally to test the interim high around $1420 to 1430 that was reached last August. Clearly that has turned out to be an overoptimistic assessment. One hint that things may turn out otherwise was probably the fact that gold stocks turned down again very shortly after making a standard upside move from a small triangle/pennant, which is usually a bullish continuation pattern. Often when bullish (or bearish) formations fail, there is a tendency for prices to overshoot in the other direction (see the GDX chart further below). From a fundamental point of view, it was perhaps an unfortunate coincidence that the loss of the 'Ukraine premium' happened so shortly before the latest 'taper scare', whereby the biggest problem about the latter was apparently the fact that Ms. Yellen announced a time plan for the Fed's eventual hiking of interest rates. Of course, such a time plan is nonsense anyway. No-one knows what monetary policy will be more than a year from now, least of all the bureaucrats running the Fed. Let us not forget that their policy is a rule reactive, i.e., they are like someone driving a car forward while gazing intently out of the rear window all the time. As we have pointed out on occasion of the most recent FOMC announcement: bureaucrats are as a rule not the best economic forecasters. If they were actually good at this kind of thing, they would be running a business, not a bureaucracy. In fact, if one looks at the transcriptions of their meetings, which we hoi-polloi for unfathomable reasons only get to see with a 6 year delay, then the one thing that stands out like a sore thumb is how utterly clueless they often seem to be. Mind, this is not something new. If one looks at transcripts from as far back as the 1930s one will find that they were just as clueless then as they are now. It is apparently in the nature of the job. Of course this does give one pause. One wonders why anyone would think it a good idea to give these people price fixing powers allowing them to manipulate one of the most important signals actors in the economy employ for the purposes of calculation and coordination. However, that is neither here nor there – the important point we want to make is only this: gold market participants evidently got cold feet over what seemingly amounted to guidance about the presumed coming tightening of monetary policy. However, this reaction made just as little sense as announcing the rate hike time plan did. Market participants should know how meaningless such statements are. However, it still is the best explanation for what triggered the recent move in the gold price. Basically the news served as an excuse to take profits, and then the move acquired a bit of a life of its own, as numerous stops were triggered on the way down. By now, gold has retraced almost exactly 50% of the preceding rally: Gold, daily – landing at the 50% retracement level (for now). Oversold, but it could of course get more so – click to enlarge. Not to belabor the obvious too much, previous downturns of similar speed and extent have tended to go quite a bit further (sometimes after intermittent bounces). If this one doesn't, it will represent a change in character. One can of course rule nothing out – including, as some observers believe, that a drop to a new low will occur as a kind of 'final shake-out', but this is just guesswork at this juncture. Interestingly, on Thursday, a divergence between gold and gold stocks developed. While the metal dropped by $14 on the day (from one COMEX close to the next), GDX and the gold stock indexes actually ended the day in positive territory. The gold juniors ETF GDXJ rose even by a not too shabby 3.5%. Below is a chart showing the intraday action in GLD and GDX over the past 5 trading days, followed by a chart zooming in on Thursday's action. GLD, 5 minute candles over the past 5 trading days. GDX is the black line above. The blue dotted lines show the level of Wednesday's close – click to enlarge. GDX and GLD, line charts zooming on Thursday's trading. In the final hour of trading the divergence began to take shape – click to enlarge. Will this divergence prove meaningful? We don't know yet of course, but it might well. Gold stocks have interestingly also precisely hit a Fibonacci retracement level on Thursday. Gold Stocks Hit 61.8% Retracement There is nothing magical about Fibonnaci retracements of course, but sometimes it is uncanny how they seem to come into play. For instance, while gold itself hit the 50% level almost on the dot, the gold stocks managed to touch the 61.8% retracement level on the dot on the same day. Just below that level is another lateral support line defined by two previous lows. Needless to say, any decline beyond these levels will likely lead to a test of the previous lows at a minimum, so it seems rather important that they hold: The HUI, daily – a reversal after hitting the 61.8% retracement level – click to enlarge. Incidentally this action has also filled a chart gap that was created on occasion of the rally out of the congestion zone of late January/early February. So the gaps do all still get filled after all. GDX has bounced off the 61.8% retracement level of the rally from the December low as well. The GDX chart is below – we have annotated the failed rally out of the triangle discussed above. The recent pullback has of course  also pushed the RSI below the 50 level, which is a slight negative. GDX – also bouncing off the 61.8% retracement level. The quick reversal of the rally out of the triangle has proved to be a warning sign – click to enlarge. Sentiment Data We keep an eye on unusual options activity every day.  Gold stocks rarely show up in the list of stocks with notable options volume, but when one of them does, we have found it often means a short term trend change is imminent (in fact, it seems that it is a straightforward contrary indicator: heavy put volume is seen shortly before rallies, heavy call volume shortly before declines). Note that it is usually only a single stock that displays noteworthy action, in rare cases there may be two. On Thursday, there was enough buying of GFI puts for the activity to become noticeable. Interestingly, the stock almost immediately began to rally thereafter (and with it, the rest of the sector). Other sentiment data show that the recent slight improvement in bullish sentiment has neither gone very far, nor could it be maintained at what were historically modest levels to begin with. In other words, skepticism remains high. Potentially this could lend quite a bit of support should the rally resume (it is not the skepticism as such that provides the support, it is the prospective unwinding of negative sentiment). First a look at the Rydex precious metals fund. Both its asset value and net cumulative cash flows have turned down again, but a little cash actually flowed in yesterday: Rydex precious metals fund. The cumulative net cash flow bounces on Thursday after declining over the past two weeks or so. (interestingly if bounced from what looks like a 'support trend line'!) - click to enlarge. Next a look at sentimentrader's 'public opinion' chart of gold, which is an average of the most important sentiment surveys – the current level of 45 is not exactly reflecting a surfeit of bullish excitement: Gold, public opinion – at 45% bulls, this indicator is at a level that was considered low during the bull market. Compared to more recent readings it is sort of mid-range – click to enlarge. And finally, a chart showing the discount to NAV of the closed-end bullion fund GTU. The fund has traded at a discount for quite some time, reflecting persistent bearishness. It remains at a discount, but the recent slight tendency toward improvement hasn't been eradicated entirely yet: GTU's discount to NAV has increased again, but not to the extreme levels seen in October to December (the November low was a record) – click to enlarge. In short, there is still no great enthusiasm for gold or gold stocks and sentiment has actually never really gotten off the mat in the first place. Obviously, for a bull market to take hold, sentiment must at some point begin to improve along with price action, so this is only a latent positive. Conclusion: There is a certain chance that reaching important Fibonacci retracement levels combined with a positive divergence between gold and gold stocks on Thursday may suffice to end at least the current phase of the correction. It is actually not unusual for initial rally attempts to fall prey to a sharp correction, but there is no way of reliably distinguishing a routine pullback from a new leg down in an ongoing bear market. Considering the many positive divergences that were recorded at last year's lows, one should probably still give the sector the benefit of the doubt at this point. Presumably the near term action will be driven by upcoming economic data again – both ISM and payrolls data are coming next week, and they have regularly impelled moves in gold. They have tended to be bad news for gold more often then not over the past two years, as better data automatically tend to be associated with fears about tightening by the Fed. We should also mention here that the overall fundamental backdrop for gold remains at best mixed at the moment – it is certainly not overly bearish, but also not overly bullish. However, that is not necessarily inconsistent with the  early stage of a new cyclical bull market. It will be important though that this backdrop begins to shift to a more clearly bullish one as time passes.

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Brazil: From Riches to Rags?

By Patrick Carvalho

This year’s FIFA World Cup and the 2016 Olympics seem to be a coronation of Brazil’s undeniable and startling success. But with the Brazilian presidential elections looming later this year, a surge in street protests and growing economic unrest, will Latin America’s largest nation cope under the international spotlight? Brazil’s economic and social advancements in the last 20 years are indisputable. Since its last external debt default in 1987 and hyperinflation in 1993, the Latin American giant has successfully implemented a macroeconomic plan (the 1994 Plano Real) that set the country in a new direction: steady poverty reduction and a rising middle class; single-digit annual inflation rates; net external creditor position since 2007; over US$350 billion in foreign reserves; declining bottom-line public debt; investment grade credit rating status; and the list goes on. The establishment of the macroeconomic stability tripod, namely flexible exchange rates, independent central bank inflation targeting and restrained fiscal balances, delivered success for Brazil in the decade to 2006. Since then, the reality has become more complicated. Sometimes good news ends up shadowing the system’s weaknesses: high crime rates; weak infrastructure, an oversized, convoluted tax system; poor educational levels; outdated labour laws; numbing red tape; and endemic corruption. Above all, worse than these ever-present challenges has been the unfortunate change in the nation’s economic direction in 2006. Shortly before the global financial crisis, a political scandal – with a combustive mixture of sex, money and abuse of power – resulted in the ousting of President Lula’s first treasurer Antonio Palocci. The Malocci Era During his term as treasurer between 2003 and 2006, Palocci, a physician-turned-politician-turned-treasurer, closely followed the economic program initiated by his predecessor (and political opponent), Pedro Malan. In the “Malocci era” a coherent plan of regulatory-driven reform was implemented, paving the way for the economic and social advancements highlighted above. Despite the thriving economy, the ousting of Palocci forced a change in economic management direction under the current treasurer Guido Mantega. Mantega and Palocci represented opposing forces inside President Lula’s administration. Whereas Palocci had advocated that well-regulated market forces are the main driver for economic success, Mantega encompasses the belief that central economic fiddling is the best way to manage the economy. The King Is Dead, Long Live The King! Under the leadership of Mantega, economic dirigisme gained prominence and was energised under the government of current President Dilma Roussef (Lula’s hand-picked successor). Accordingly, Brazil has lamentably trailed back to economic micro-(mis)management and cronyism. Now back on the policy menu: the curbing of Brazil’s central bank independence; energy price freezes; stifling local content requirements for the oil industry; discretionary picking-winner strategies; centralisation of subsidised public credit loans; and import tariff hikes. In addition, no significant structural reforms have been approved since then. Despite the poor economic management, Brazil’s presidential elections due later this year are expected to confirm the same pool of policies that are undermining the country’s prospects, even though signs of the economy’s distress are imminent. This is another tragic example of short term populist policies that are disastrous in the medium and long run. [R]evolution Around The Corner? Since July last year a wave of street upheavals protesting various inequalities have spread throughout Brazil. Unfortunately, the phenomenon is divided by too many voices and conflicting requests. Like the 2011 Occupy protests in several Western cities, vague leadership and the lack of clear demands compromise the effectiveness of the protests. Worse: the very same public, which rightly protests against Brazil’s combination of Scandinavian tax burden levels and sub-Saharan public service delivery, does not support a clear agenda of progressive reforms. In the end, neither revolution, nor evolution, is expected to materialise out of the protests. So, what can we expect from the FIFA World Cup this year and the Olympics in two years? Lots of Carnival-like parties, sparse protest incidents and incredible sport performances. Not much else, regrettably.

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The Next Global Financial Crisis

By: Clif_Droke

Investors dodged another bullet recently as geopolitical instability temporarily subsided after Russia's annexation of Crimea. Although U.S. equities have experienced an internal correction since then, most of the damage has been relegated to over-extended tech stocks that were in need of a pullback. A reflection of the recent lifting of selling pressure on Russian equities can be seen in the daily chart for the Market Vectors Russia ETF (RSX), a proxy for Russia's stock market. RSX has rallied 10 percent off its year-to-date low and is now above the 15-day moving average to signal at least a temporary break of the immediate-term downtrend. Wall Street's concern with China's slowing economy has also diminished from earlier this month and is reflected in the 4 percent rally of the Shanghai Composite Index recently. With China, Russia and the emerging markets on the backburner, equity investors should enjoy a temporary respite of worries until at least later this spring. While U.S. stocks are under mild selling pressure right now, the fact that the S&P 500 Index (SPX) is hovering close to its highs despite the correction in growth stocks suggests that the bulls haven't yet given up their control over the market. A "spring fling" to new highs can't be ruled out before the final descent of the long-term deflationary cycle makes its presence known. Maybe not in the next couple of months, but certainly by the summer we should see signs of increasing market volatility and accelerating selling pressure, especially as we head closer to the final bottom of the 60-year deflationary cycle this fall. If China and/or other emerging market countries are experiencing turmoil at that time, it will only serve to exacerbate the volatility. Speaking of China, it's worth noting that Goldman Sachs Group has warned that financing arrangements in China using commodities to obtain credit may unwind in the next 12 to 24 months. The unwinding would likely be driven by increased volatility in the yuan currency, according to Goldman. The unwinding would be bearish "given relatively limited physical liquidity to absorb the shock," Goldman's chief commodities analyst Jeffrey Currie wrote. Already we've seen preliminary signs of what the next global market crisis could look like. The problems have originated in China and Russia with other countries (e.g. Brazil, Chile, Turkey) playing supporting roles. This is very similar to what happened in 1998 with the financial crisis that rolled across the globe beginning with Asia and extending to South America, Russia and finally hitting the U.S. like a tsunami. Few market analysts in 1998 (a super boom year) believed the "Asian contagion" would infect U.S. markets, but they were dead wrong. It happened very quickly in '98 with most of the damage occurring in July through September - the final "hard down" phase of the 4-year and 8-year cycles. Not coincidentally, 2014 is also a bottom year for the 4/8-year cycles as well as several others. Also worth noting is the latest action in the bond market. In the Feb. 28 commentary entitled "The deadly undercurrent of deflation," we discussed buy signal for bonds confirmed by the Coppock Curve indicator for the iShares 20+ Year Treasury Bond ETF (TLT). The Coppock Curve is one of the single best indicators for issuing buy signals on bonds (though it is less helpful for determining tops). The Coppock Curve is derived by adding the 14-month and 11-month rate of changes for bond prices and smoothing the result with a 10-month weighted moving average. As I wrote in the Feb. 28 commentary: "The recent Coppock Curve buy signal for bonds, assuming it pans out, means that Treasury yields will be declining while bond prices rise. Declining yields are very much consistent with the Kress cycle scenario for 2014, which suggests that disinflationary if not outright deflationary pressures will increase until the long-term cycles bottom later this year." While I don't expect selling pressure to be very strong against equities until after May, the fact that TLT broke out above an 8-month trading range ceiling this week is an indication that investors are becoming more concerned about deflation and its effects on global market volatility. Contrary to Wall Street's expectations, global market volatility is still a prime consideration for stocks in the intermediate-term. China's slowing economy may come to exert a significant drag on global equities as the year progresses, and Russia will remain the proverbial powder keg until the Ukraine situation has been fully resolved. Until then, investors are advised to fasten their seatbelts as there will likely be increasing turbulence this summer. Again, this summer the 4-year, 8-year, 10-year, 12-year, etc. cycles through the 60-year cycle will also be cascading into their final bottoms around late September/early October. It would be surprising indeed if the financial market somehow emerged unscathed by this crescendo, especially given the fragile state of the global economy. Kress Cycles Cycle analysis is essential to successful long-term financial planning. While stock selection begins with fundamental analysis and technical analysis is crucial for short-term market timing, cycles provide the context for the market’s intermediate- and longer-term trends. While cycles are important, having the right set of cycles is absolutely critical to an investor’s success. They can make all the difference between a winning year and a losing one. One of the best cycle methods for capturing stock market turning points is the set of weekly and yearly rhythms known as the Kress cycles. This series of weekly cycles has been used with excellent long-term results for over 20 years after having been perfected by the late Samuel J. Kress. In my latest book “Kress Cycles,” the third and final installment in the series, I explain the weekly cycles which are paramount to understanding Kress cycle methodology. Never before have the weekly cycles been revealed which Mr. Kress himself used to great effect in trading the SPX and OEX. If you have ever wanted to learn the Kress cycles in their entirety, now is your chance. The book is now available for sale at:

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The Gas Fracking Treadmill: No Technology Miracle Here—Just Economics, Stupid!

by Wolf Richter

This winter, polar vortices blew across the land and hit the price of natural gas and sent it into dizzying spikes and plunges, aggravating head fakes, and whiplash-inducing turnarounds, and some traders timed it just right and made a buck. Now the winter is petering out, and we’re left with a very peculiar situation. Years of “shale gas revolution” that had turned into a crazy over-hyped no-holds-barred land-grab and fracking boom veered into overproduction that whacked the price, causing untold industry mayhem, billions in write-offs, and the collapse of a business model – drilling profitably for dry natural gas. But nothing can be priced below the cost of production forever. The Energy Information Administration reported today that for the week ending March 21, natural gas in underground storage dropped by 57 billion cubic feet to 896 Bcf, down 50.8% from the five year average for that week, and down 44.6% from the five-year minimum. Or 12 days supply. While NG production is fairly steady throughout the year, consumption jumps during heating season and also perks up in the summer when power generators are trying to supply enough juice for maxed-out air conditioners. After the heating season ends, inventories begin to build, hopefully to a level that will be enough to get us through the winter – hopefully, because this year, the equation seems iffy. Look what happened: The last time we saw a March with storage levels below 1,000 Bcf was in 2003. But last year, consumption was 16.7% higher than in 2003. Something has to give. It isn’t just the weather. In some parts of the country, we can use the weather to explain the low storage levels and price spikes this winter. But in the West, which includes my beloved State of California where the weather has been gorgeous most of the winter, storage levels dropped 44% below the five year average! It got so bad that the Independent System Operator issued a Flex Alert on February 6 for voluntary power conservation; Southern California Gas Company had issued “Emergency Curtailments” to several gas-fired power plants. Old inefficient coal powerplants are being retired around the country because they would be too costly to upgrade and operate under the new emission rules. Some nuclear power plants, including the leaky San Onofre plant in Southern California have been retired. A multi-year drought has gripped the West Coast, and hydropower generation has been curtailed. Gas-fired power generation has to fill in the gaps. Then there’s the new industrial miracle: with natural gas being far cheaper in the US than in the rest of the world, global companies with energy-intensive processes and chemical processes that use natural gas as feed stock have been building plants in the US to gain a competitive advantage through lower cost. Meanwhile, drillers, those that wanted to survive, switched from drilling in shale formations that are high in dry gas to those that are high in natural-gas liquids and oil, which sell for much higher prices and turn wells profitable. That strategy reduced dry gas to a byproduct. But fracking is a treadmill. Production falls off a cliff soon after a well starts producing, and new wells must be drilled constantly just to keep production even. The more wells are drilled, the more wells must be drilled just to keep production level. But at low prices, fracking is a money suck. Billion have disappeared into the ground. So drillers got off the treadmill. Rig count for NG wells dropped to 326 as of last Friday, down from 1,450 during the crazy days of 2007, down from 652 two years ago, down 418 last year. It was the lowest rig count since 1995. OK, new drilling technologies, efficiencies, etc. etc. make up for part of it, but look at the results. Production is declining in some shale formations and has flattened out in others. Overall, production in the US last year rose only 1.0% to 24,887 trillion cubic feet, while consumption rose 2.1% to 26,627 trillion cubic feet. This imbalance is likely to get worse this year; it has had a good start so far. The largest, most productive shale formation, the Marcellus, is the big exception. Production jumped 40% from January to November last year. The glorious shale gas revolution has become a one-trick pony. During its heady days, thousands of wells had been drilled in the Marcellus, but there were few pipelines to take the gas to market, and perhaps 1,300 wells remained shut in. Last year, takeaway capacity caught up, and the gas started flowing to New York City and elsewhere – hence the sudden spike in “production.” Meanwhile, drilling activity plunged. As of March 21, there were 78 active drilling rigs in the Marcellus, down from 89 rigs a year ago and from 141 rigs during the peak of the Marcellus drilling bubble in October 2011. Now that the gas is flowing, the steep decline rates are catching up with reduced drilling activity. Since December, production has barely budged. And unless a miracle happens, such as a sudden drilling boom, we may have a peculiar situation this coming winter: a shortage. Not that the US will run out; there are plenty of producing countries chomping at the bit to sell us LNG. We’d be competing with Japan and Korea, and they paid up to $18 per million Btu, instead of our current $4.50/mmBtu. Yet price is the solution. A substantially higher price will motivate drillers, and production will eventually catch up with demand. The current price – though up 134% from two years ago – isn’t nearly high enough. And the longer the price hangs out in this range, the more interesting the situation is going to be. This may turn into a seatbelt mandatory ride. Now even the new boss of Shell Oil, already steeped in an Alaska offshore debacle, admitted that fracking in the US, after Shall’s huge investment, is a money-losing business.

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Duration Risk: Why “Tapering” Is a Mirage and the Fed May Be Loosening Instead | Cris Sheridan | FINANCIAL SENSE

by Cris Sheridan

John Butler made an interesting comment in his recent interview with the Financial Sense Newshour. He said, when you look at the Fed’s balance sheet, one can argue that the Fed really isn’t pulling back on its stimulus to the markets at all. In fact, Butler explained, it may actually be loosening instead: “The Fed may be tapering its purchases in nominal dollar amounts but in terms of the amount of interest rate risk it is assuming vis-à-vis the private commercial banking system, actually the Fed is continuing to assume additional interest rate risk at an elevated rate. And so from a bank balance sheet or liquidity management perspective, Fed policy is no tighter today than it was last year. And I can’t stress this point enough: It’s just as loose today as it was pre-taper…and arguably looser depending on how you define interest rate risk.” In case you don’t understand the above, what Butler is saying is that while the Fed is buying less and less debt each month in dollar terms, it is simultaneously buying a larger amount of long-dated bonds, which has the overall effect of keeping conditions loose. Here’s a recent chart from the St. Louis Fed showing how they’ve ramped up their purchase of long-dated Treasuries (ten years or more) over the last few years, while pulling back on shorter maturities: Source: St. Louis Federal Reserve With the above in mind, Butler stated that tapering “is something of a mirage…as long as the Fed continues to absorb more and more long-dated bonds, the banks will have an incentive to increase lending and leverage, notwithstanding the ‘taper’.” Via email, Butler explained in more detail why this is so: Ever since the ‘taper’ talk began I have been making the point that by only looking at the face amounts of debt purchased by the Fed we do not get the full picture. Indeed, recall when the Fed made a big deal about long-maturity purchases in the first place? Well, they were doing so to emphasize that they still had massive firepower to stimulate credit by buying long-dated bonds. ‘Duration’ is a fancy word for ‘maturity’ which incorporates the specific coupon and principal repayment schedule of a given bond or portfolio of bonds. More subtle is the concept of ‘convexity’ risk, which is only significant in longer 10y+ maturity bonds as it increases non-linearly with maturity. Consider what banks are: they are financial intermediaries that borrow short to lend long. This means they are exposed not only to the level of interest rates, but to the term structure. The Fed has the power, through debt purchases, to affect both. In short maturities, however, there is little ‘duration’ or ‘convexity’, so the nominal amount of debt the Fed purchases is a proxy for the amount of interest rate risk it assumes from the banks. The less risk, the more long-term lending the banks can make, and the greater the implied, potential ‘money multiplier’ they can generate. In long maturities (beyond 10 years), the Fed takes far more ‘duration’ and ‘convexity risk’ off the banks, yet the banks receive the new money and can lend it out nevertheless. So the risk/reward for banks can shift dramatically when the Fed purchases 10y+ bonds instead of, say, 1y bonds, and the flexibility here can easily compensate or even overcompensate for the ‘taper’ currently underway. And the data show the Fed is continuing to increase its purchases of 10y+ bonds, the ones that really take the bulk of interest rate risk off the banks. So based on this, you can argue fairly that the ‘taper’ is something of a mirage. Bank risk and liquidity managers know this and they think in ‘duration’ and ‘convexity’ terms. As long as the Fed is continues to absorb more and more 10y+ supply, the banks will have an incentive to increase lending and leverage, notwithstanding the ‘taper’. I’m a bit surprised more has not been written about this. There was an article in the FT two years or so back making this point but now there is an odd silence. Has any US bank published on this? If not, why not? Do they not want to? Does the Fed not want them to? If the Congress or others learned that the ‘taper’ really isn’t a ‘taper’ at all, would there be repercussions? I don’t know, but if the ‘taper’ was a PR campaign [see story] rather than a true change in policy all along then this would make more sense. In the FT article, Brian Sack, executive vice president of the Federal Reserve Bank of New York, explained how the Fed views this very process of increasing the duration risk of its portfolio as an important aspect of stimulus: If economic developments lead the FOMC to seek additional policy accommodation, it has several policy options open to it… One option is to expand the balance sheet further through additional asset purchases, with the just-completed purchase program presenting one possible approach. Another option involves shifting the composition of the SOMA [System Open Market Account] portfolio rather than expanding its size. As noted earlier, a sizable portion of the additional risk that the SOMA portfolio has assumed to date came from a lengthening of its maturity, suggesting that the composition of the portfolio can be used as an important variable for affecting the degree of policy stimulus. Later in the interview, Butler noted that the reason the market probably hasn’t reacted that much to the “taper” so far is precisely for this reason: “[Those] who have a direct line to the Fed, who are involved in the whole primary dealer liquidity distribution network for Treasury securities and swaps and everything else, these people are well aware that conditions have not materially tightened and their institutions can act accordingly when they receive those internal reports from people actually in the know. Say one thing, do another. That’s kind of the way the Fed is operating. And that may help to explain why the U.S. equity market has still been able to shrug off a lot of what’s been taking equity markets down elsewhere in the world.”

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