Funding securities purchases with reserves

by SoberLook

We've received numerous e-mails regarding the comment (here) that the Fed (or any other central bank for that matter) finances securities purchases with reserves. It's unfortunate that the internet is full of misinformation, propagated by both bloggers and the mass media. The Fed's operations are not a mystery - it's just basic accounting. And the fundamentals of accounting tell us that if you increase your assets by purchasing something, your liabilities increase as well. The balance sheet "has to balance".
When the Fed buys a security, any of the following could be taking place:
1. The Fed sells another security in the same amount (such as in Operation Twist).
2. The Fed can lend that security via repo. In this situation the increase in assets (security purchase) corresponds to increase in liability (the Fed borrows cash against the bond).
3. The Fed can accept time deposits (now it owes money on the deposit - thus increases its liability).
4. The Fed can in effect use the proceeds from the repayment of various emergency facilities to cover the purchase. This was the case during part of QE1 (see discussion from 2009).
5. The Fed can increase bank reserves (by simply crediting the seller's reserve account). Remember that reserves are liabilities on the Fed's balance sheet.
These are all different ways the Fed can finance securities purchases. Only number 5 represents outright quantitative easing. Unless 1-4 are involved, reserves are used to fund balance sheet expansion.

There are some silly notions about what banks can and can not do with their reserve balances. Keep in mind that cash is fungible. A bank can buy securities or loans from another bank and get rid of its excess reserves - thus converting reserves into other assets. Of course then the seller bank will be stuck with these excess reserves. Only the Fed can change the total reserve balance in the banking system as a whole by buying and selling securities or by borrowing and lending money.

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Great Graphic: The McDonald's Empire

by Marc to Market

This Great Graphic was posted on the FT Beyond Brics blog and comes from Wikipedia.   It shows the countries in which McDonald's operates.   The occasion for the map is the company's announcement of plans to open a restaurant in Vietnam next year.  This will be its 199th country. 

By the end of this year, McDonald's projects it will have over 2,000 outlets in China, which would move the PRC into third place behind the US (18k+), and Japan (3.5k+).   France, the UK, Canada and Brazil each have between 1,200 and 1,500 McDonald's restaurants.  

The FT article notes that although it is rare, McDonald's has pulled out of a few countries, like Bolivia, Jamaica and Iceland.  And some of the locations, like in Cuba and Iraq, really serve the US military rather than the general public.  In those examples, the hamburger follows the flag, but there are a number of other hot spots where McDonald's is not tied to the military, such as Pakistan. 

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There’s a Madman at the Wheel… Someone Stop Him Before We Crash

by Graham Summers

Stocks are rallying because Ben Bernanke speaks at Congress on Wednesday. Stocks historically rally into Bernanke speeches.

The markets are at new all time highs. But it is now clear that Bernanke has absolutely no clue what he’s doing.

Just two months ago, Bernanke hinted at tapering QE. Note, he didn’t actually taper anything he just hinted at it.

This talk of tightening lasted all of two months. And remember, throughout this period of hinted the Fed was spending $85 BILLION per month via QE 3 and QE 4.

Imagine if you were in the car with a driver who was going 85 MPH down a road with a speed limit of 35 MPH (this isn’t a bad metaphor as there is absolutely no evidence that QE creates jobs or GDP growth so there is no reason for the Fed to be doing it in the first place).

The guy is obviously out of control. The dangers of driving this fast are myriad (crashing, running someone over, etc.) while the benefits (you might get where you want to go a little faster assuming you don’t crash) are minimal.

Now imagine that the driver turned to you and said, “I’m thinking about slowing down.” Seems like a great idea doesn’t it? But then a mere two minutes later he says “ we need to continue at 85 MPH for the foreseeable future.”

At this point any sane person would scream, “STOP.” The driver is clearly a madman and shouldn’t be let anywhere near the driver’s seat. Moreover, he’s totally lost all credibility and isn’t to be trusted.

That’s our Fed Chairman.

As I’ve noted before… QE, which doesn’t create jobs or GDP growth, does create inflation. The cost of everything is soaring in the US. Since 2002, the cost of just about every item you buy at the grocery store is up in a big way. Check out this list compiled at The Blaze:

• Eggs: 73%
• Coffee: 90%
• Peanut Butter: 40%
• Milk: 26%
• A Loaf Of White Bread: 39%
• Spaghetti And Macaroni: 44%
• Orange Juice: 46%
• Red Delicious Apples: 43%
• Beer: 25%
• Wine: 60%
• Electricity: 42%
• Margarine: 143%
• Tomatoes: 22%
• Turkey: 56%
• Ground Beef: 61%
• Chocolate Chip Cookies: 39%

The damage doesn’t stop there. The cost of everything from healthcare to college tuition is soaring. Heck, even the new Twinkies are smaller, but cost the same (a “hidden” price increase).

Make no mistake, inflation is entering the US financial system in a big way.

Inflation is good for stocks at the beginning. But then it eats into profits very quickly. At that time, things get really ugly for the markets.

Speaking of which… corporate profits are falling sharply, as is GDP, while stocks continue to rally hard.

Sounds a bit like 2007-2008 doesn’t it?

Stocks may hit new highs, but this rally has all the hallmarks of a blow off top, coming at the final stage of a bubble. Indeed, stocks have not been this overextended in over 20 years… that includes the 2007 peak. Soon after we reached that point… we then plunged into one of the worst market Crashes of all time.

By today’s metrics, this would mean the S&P 500 falling to 1,300 then eventually plummeting to new lows.

This is not doom and gloom. This is a fact. The Fed has created an even bigger bubble than the 2007 one.

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Treasuries touch one-week low on bets Bernanke damps taper talk

By Susanne Walker

Federal Reserve Chairman Ben Bernanke (Source: Bloomberg)

Treasury 10-year note (CBOT:ZNU13) yields touched a more than one-week low amid speculation Federal Reserve Chairman Ben S. Bernanke will seek to damp investor expectations of a reduction in stimulus when he speaks to Congress tomorrow.

Treasuries erased an earlier gain after the cost of living in the U.S. rose in June by the most in four months as gasoline prices increased. Pacific Investment Management Co.’s Bill Gross added to holdings of U.S. government debt in his flagship fund in June while betting incorrectly on gains in inflation-indexed securities in the first half of 2013.

“The market is anticipating a dovish, defensive presentation -- and if it doesn’t get enough of that, they may see it as hawkish,” Larry Milstein, managing director in New York of government-debt trading at R.W. Pressprich & Co., said of Bernanke’s two days of testimony in Washington. “Inflation is a non-issue and last week he seemed to be more concerned about deflation than inflation. He’s going to lean to the dovish side. The market is already pricing that in.”

The benchmark 10-year yield was little changed at 2.54% as of 10:03 a.m. New York time, according to Bloomberg Bond Trader data. It reached 2.51%, lowest since July 5. The price of the 1.75% security maturing in May 2023 traded at 93 5/32.

TIPS Returns

As of yesterday, investors in U.S. government securities linked to consumer-price gains have lost 7.7% this year, headed for the first annual decline since 2008, Bank of America Merrill Lynch index figures showed. Conventional Treasuries fell 2.7% over the same period.

The difference in yield between 10-year notes and similar- maturity Treasury Inflation Protected Securities, a measure of trader expectations for inflation over the life of the debt called the break-even rate, was at 2.09 percentage points, set for the highest close since June 11. That compares with an average of 2.37 percentage points in the past year.

The Fed’s price indicator for the period from 2018 to 2023, known as the five-year five-year forward break-even rate, fell to a two-week low of 2.41% as of July 11.

The consumer-price index increased 0.5% after a 0.1% gain the prior month, a Labor Department report showed today in Washington. The median forecast in a Bloomberg survey called for a 0.3% rise. Overall consumer prices increased 1.8% in the 12 months ended in June, more than projected and after a 1.4% year-over-year gain the prior month. The core measure, which excludes food and fuel, climbed 0.2% from May.

Highly Accommodative’

The report “looks fairly strong -- it bodes well for the inflation side of the story,” said Aaron Kohli, an interest- rate strategist in New York at BNP Paribas SA, one of 21 primary dealers obligated to trade with the Federal Reserve. “Break- evens are a good buy at this point.”

Bernanke said on July 10 that the U.S. needs “highly accommodative monetary policy for the foreseeable future,” after last month saying the central bank may begin to slow its $85 billion in monthly bond purchases this year and end them in 2014 if economic growth meets policy makers’ goals.

Industrial production rose in June by the most in four months, with output at factories, mines and utilities climbing 0.3% after being little changed in May, a Fed report showed today in Washington. The gain matched the median forecast of 86 economists surveyed by Bloomberg. Manufacturing, which makes up 75% of total output, increased more than projected.

The U.S. central bank is scheduled to buy as much as $1.75 billion of government securities due from February 2036 to May 2043, according to the New York Fed’s website.

Foreign Holdings

Foreign sales of U.S. long-term securities rose in May as private investors overseas sold a record amount of Treasuries, a government report showed.

The net long-term portfolio investment outflow for the month was $27.2 billion after a revised decline of $21.8 billion the prior month, the Treasury Department said in a statement today in Washington. U.S. residents bought a net $27.2 billion in foreign long-term securities, while investors abroad were net sellers of $29 billion of Treasury bonds and notes, the report showed.

China’s holdings of Treasuries rose $25.2 billion to a record $1.316 trillion, according to the Treasury. Japan, the second-largest holder, lowered its holdings to $1.11 trillion.

Pimco’s Views

Pimco’s Gross raised the proportion of U.S. government debt in the $268 billion Total Return Fund to 38% from 37% in May, according to data on the company’s website. Newport Beach, California-based Pimco doesn’t comment directly on monthly changes in holdings or specific types of securities within a market sector such as the percentage of Treasury Inflation Protected Securities in the U.S. grouping.

Gross had been buying TIPS on a bet that money printing by the world’s central banks would push up consumer prices, making Treasuries the largest portion of the fund. When yields began to rise in May on expectations the Fed would slow its bond-buying program, inflation expectations didn’t, amplifying the losses on inflation-hedged U.S. debt.

The Total Return Fund, the world’s largest mutual fund, fell 4.7% in May and June, prompting $9.9 billion in withdrawals last month, the most on record.

The Treasury is contacting primary dealers as it seeks ways to support the TIPS market. The advice is being sought after direct bidders, non-primary-dealer investors that place their bids directly with the Treasury, bought 0.4% of debt offered in a sale of 30-year TIPS in June. That was the least since 2010, versus 14% in February and an average of 17.7% at the past nine auctions.

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Hardening Brazil’s Soft Power

by Celso Amorim

BRASILIA – It is, perhaps, a truism for Brazil’s citizens that their country is and always will be a peaceful one. After all, Brazil has lived with its ten neighbors without conflict for almost 150 years, having settled its borders through negotiation. It last went to war in 1942, after direct aggression by Nazi U-boats in the South Atlantic. It has forsworn nuclear weapons, having signed a comprehensive nuclear-safeguards agreement with Argentina and the International Atomic Energy Agency. Through the Common Market of the South (Mercosur) and the Union of South American Nations (Unasur), Brazil is helping to integrate the region politically, economically, socially, and culturally.

Illustration by Paul Lachine

But is soft power enough for one of the world’s major emerging countries?

To be sure, Brazil’s peaceful foreign policy has served it well. Brazil has used its stature to advance peace and cooperation in South America and beyond. Its constructive stance derives from a worldview that accords pride of place to the values of democracy, social justice, economic development, and environmental protection.

Brazil’s unique approach to promoting these ideals is an important source of its soft power, reflected in the broad international support that placed Brazilians atop international institutions like the Food and Agriculture Organization and the World Trade Organization.

Yet no country can rely on soft power alone to defend its interests. Indeed, in an unpredictable world, where old threats are compounded by new challenges, policymakers cannot disregard hard power. By deterring threats to national sovereignty, military power supports peace; and, in Brazil’s case, it underpins our country’s constructive role in the pursuit of global stability.

That role is more necessary than ever. Over the past two decades, unilateral actions in disregard of the UN Security Council’s primary responsibility in matters of war and peace have led to greater uncertainty and instability. Likewise, little progress toward nuclear disarmament has been made, in disregard of the Nuclear Non-Proliferation Treaty.

Brazil’s abundance of energy, food, water, and biodiversity increases its stake in a security environment characterized by rising competition for access to, or control of, natural resources. In order to meet the challenges of this complex reality, Brazil’s peaceful foreign policy must be supported by a robust defense policy.

Brazil’s National Defense Strategy, updated in 2012, states that the modernization of the Armed Forces is intrinsically linked to national development. Thus, it emphasizes the need to strengthen the domestic defense industry. In accordance with the Strategy, Brazil is enhancing its conventional deterrence capabilities, including by building a nuclear-propelled submarine as part of a naval program commensurate with its responsibilities in the South Atlantic.

Brazil coordinates closely on defense matters with its neighbors, both bilaterally and through Unasur’s South American Defense Council, which aims to promote confidence-building, transparency, a joint regional defense industry, and, most important, a common defense identity. One potential mechanism for advancing these objectives is a South American Defense College, now under consideration.

South America is becoming a region where war is unthinkable – what the political scientist Karl Deutsch once called a “security community.” Having visited every South American country in my tenure as Defense Minister, I am convinced that, the most effective deterrent on the continent is cooperation.

At the same time, Brazil is pursuing increased bilateral defense cooperation with African partners. With our neighbors on both shores of the South Atlantic, Brazil is working closely to strengthen the Zone of Peace and Cooperation of the South Atlantic (ZPCSA), which aims to keep the ocean free from rivalries foreign to it and from nuclear weapons.

Brazil is also reaching out to other emerging countries, such as its fellow BRICS (Brazil, Russia, India, China, and South Africa) and members of the IBSA Dialogue Forum (India, Brazil, and South Africa). For example, Brazil conducts IBSAMAR, a regular trilateral naval exercise, with South Africa and India. More broadly, we are exploring ways to cooperate in the joint development of defense technologies.

Through such endeavors, Brazil hopes to contribute to a more balanced international order, one less subject to hegemonies of any kind, without losing sight of the importance of mutually beneficial partnerships with developed countries.

Even as Brazil hardens its soft power, it remains deeply committed to the path of dialogue, conflict prevention, and the negotiated settlement of disputes. The presence of Brazilian peacekeepers in countries like Haiti and Lebanon underscores Brazil’s contribution to maintaining peace and security worldwide. In the twenty-first century, a truly stable global order will depend on a legitimate and effective UN Security Council, one that reflects the plurality of the emerging multipolar world.

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Transatlantic Trade Goes Global

by Michael J. Boskin

STANFORD – Negotiations have now commenced between the United States and the European Union on the Transatlantic Trade and Investment Partnership (TTIP), potentially the largest regional free-trade agreement in history. If successful, it would cover more than 40% of global GDP and account for large shares of world trade and foreign direct investment. The US and EU have set an ambitious goal of completing negotiations by the end of 2014. Historically, however, most trade agreements have taken much longer to complete.

Illustration by Dean Rohrer

The scale of the TTIP is enormous. With Croatia’s accession at the beginning of July, the EU now consists of 28 member states, each of which has its own particular set of special interests pressing for trade promotion or protection, based on comparative advantage, history, and raw domestic political power.

Moreover, the desired scope of the agreement is vast, complicating the process further. The TTIP would eliminate all trade tariffs and reduce non-tariff barriers, including in agriculture; expand market access in services trade; bring about closer regulatory harmonization; strengthen intellectual-property protection; restrict subsidies to state-owned enterprises; and more. This all but guarantees difficult talks ahead; indeed, France has already demanded and received a “cultural exception” for film and TV.

Expanding trade boosts income, on average, in all the countries involved. Economists estimate that global free trade, enabled by many successful rounds of multilateral talks (most recently the Uruguay Round, culminating in the establishment of the World Trade Organization), has boosted worldwide income substantially.

Regional free-trade agreements (FTAs), such as the TTIP, do so as well, but some of the gains may come at the expense of other trade partners. Within each country, despite net gains, there are also some losers. The best way to deal with the economic, political, and humanitarian concerns raised by trade agreements is via transition rules, temporary income support, and retraining, as opposed to maintaining protectionist barriers.

The gains from such pacts stem from a variety of factors, the most important of which is comparative advantage: countries specialize in producing the goods and services that they are relatively most efficient at producing, and trade these goods and services for others. Economies of scale and other factors are also important.

As the scope of trade liberalization shrinks, so do the benefits – more than proportionally.  Estimates of the annual gains from a fully realized TTIP are $160 billion for the EU and $128 billion for the US. British Prime Minister David Cameron predicts two million new jobs. And a non-inflationary boost to growth in a weak global economy would be particularly timely.

But the devil is in the details. Tariffs are generally modest already, so gains from their further reduction would be modest as well. It is vital to remove non-tariff barriers, such as localized rules and restrictions not based on scientifically legitimate safety or health concerns, despite political pressure to maintain or tighten them. Limiting the scope of trade and investment covered by the TTIP would likewise reduce the benefits.

Trade negotiations become either broad and deep or narrow and limited. NAFTA, for example, followed the former route, greatly boosting trade among the US, Canada, and Mexico. Its copycat, SAFTA (the South Asian Free Trade Agreement), moved slowly to reduce tariffs and the list of excluded items, so India signed separate bilateral FTAs with Bangladesh and Sri Lanka.

The TTIP is being divided into 15 specific working groups. While the negotiations are new, the issues separating the two sides are long-standing and widely known. One of the most difficult is the EU’s limitation of imports of genetically modified foods, which presents a major problem for US agriculture. Another is financial regulation, with US banks preferring EU rules to the more stringent framework emerging at home (such as the much higher capital standards for large banks recently proposed by America’s financial regulators).

Several other serious disagreements also stand in the way of a comprehensive deal. For example, US pharmaceutical companies have stronger intellectual-property protection at home than in the EU. Entertainment will become increasingly contentious with online distribution of films. And the anachronistic 1920 Jones Act requires cargo carried between US ports to be shipped only on American ships (recall the confusion about the possibility of foreign ships coming to help during the BP Gulf oil spill). Safety regulations and restrictions on foreign control of companies in sensitive industries are further points of contention.

The TTIP is not just about the US and the EU. Mexico already has an FTA with the EU, and Canada is negotiating one. At some point, NAFTA and TTIP will need to be harmonized.

Meanwhile, the world’s other countries – still accounting for more than half of world GDP and the bulk of global trade and FDI – are wondering how the TTIP would affect each of them. One possibility, suggested by my ex-colleague, former US Trade Representative Carla Hills, is that a successful TTIP would be a major impetus for rekindling the moribund Doha Round of global free-trade talks. The Uruguay Round received a similar boost soon after NAFTA was signed.

Everyone everywhere has an interest in how the TTIP talks develop and in what ultimately results from them. To take a simple example, more reasonable EU rules on genetically modified agricultural imports from North America, if translated with appropriately careful monitoring to Africa, could be a tremendous boon to African agriculture. Failure to make any inroads on this score in the TTIP negotiations would almost certainly block genetically modified food in Africa.

Analogous issues arise in sector after sector, and in one regulation after another. We can hope, but in no way guarantee, that the details agreed at the end of the TTIP negotiations justify the enthusiasm at their start.

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