Journalists Jumping To Conclusions Can Get Contusions
Courtesy of Lee Adler of the Wall Street Examiner
Pedro da Costa, maybe the smartest and best reporter covering the Fed, and who seems like a good guy, has a blog post out suggesting that the $50 billion ECB dollar lending operation today will cause the Fed's balance sheet to expand. He's piggy backing on Mike Derby's column in the Wall Street Journal, most of which is behind a paywall, so I don't have the full story on that. I think that the conclusions are unwarranted, or at least premature, until we see the Fed's H41 statement for this week or next, depending on when the funding settles. If not same day, the effect would not show up until next week's H41.
Da Costa's piece implies that one result of the loan will be a jump in the Fed's custody accounts of foreign central bank holdings of Treasuries and Agencies and that that would somehow imply an increase in the size of the Fed's balance sheet. First, even assuming all of the $50 billion came via swaps with the Fed, custody holdings are custody holdings. They are assets of foreign central banks (FCB). They are not part of the Fed's asset base. There is no direct connection between the swaps and the custody holdings. I have no clue why he thinks that the ECB lending dollars to its constituent banks would cause an increase in FCB holdings of Treasuries and Agencies. If the ECB is investing those dollars in loans to banks, then they can't be buying Treasuries with them. The point he makes there, makes no sense in that respect.
In fact, sale of those custody holdings would be one means by which the ECB could have raised the $50 billion in USD to fund these loans. That would have NO IMPACT on the Fed's balance sheet. It would not involve the Fed supplying one red cent.
Even if we assume that the Fed does fund the swaps, there are a number of ways that can be done and simultaneously sterilized. Even beyond sterilizing the impact, there are ways it may be accomplished which would actually shrink the balance sheet! ("A sterilized intervention means an intervention that doesn’t affect the monetary base — swapping dollar t-bills for euro T-bills, or T-bills for mortgage-backed securities." - Krugman.)
In fact, the Fed's balance sheet has been shrinking since June as MBS holdings have been paid down, and the replacement MBS purchases have apparently all been 60 day forwards. As a result, the Fed's assets have shrunk by about $50 billion since July, and, all other things being equal, would not begin to rebuild to the $2.654 trillion SOMA target until the purchase program is complete this coming June, and the settlements continue through August. The point here is that the Fed has shown no inclination to grow its balance sheet. There's been a lot of hot air about it, but they haven't pulled the trigger.
I reported to Professional Edition subscribers last month the big withdrawal from the bank reserves deposits at the Fed that went into Other Deposits. I tried, but failed, to interest any mainstream reporters, including your friend and mine, Mike Derby of the Wall Street Journal, and Greg Robb of Marketwatch, in this massive transfer. There have now been several massive deposits and withdrawals between bank reserves and Other deposits on the Fed's balance sheet in the past several months. The net amount remaining in Other was $52.8 billion last Wednesday. That's a sea change from the nominal amounts typically held in Other deposits.
"Other," as defined by the Fed, includes "foreign official organizations," along with GSE direct deposit accounts at the Fed, and the account of the US Exchange Stabilization Fund (ESF), aka the Plunge Protection Team, which operates out of the U.S. Treasury.
Since we are making assumptions, let's assume that the $52 billion are mostly funds of "foreign official organizations." If these are ECB funds and the ECB withdraws them to fund these dollar loans, this would force the Fed to either borrow the dollars itself, which would seem to be a non starter under current market circumstances, or sell SOMA Treasury holdings outright, thereby SHRINKING rather than expanding the Fed's balance sheet. The Fed could not on the one hand see its liabilities reduced and its assets increased. It cannot "reprint" a withdrawal of money that was already in existence and on deposit. The immutable law of double entry accounting would not allow it. The Fed would have to sell assets to fund the withdrawal, i.e. the reduction of the existing deposit liability under this scenario.
Now I have no clue what WILL happen, but neither does Mike Derby, unless he just got off the phone with the Fed's media leak line. Maybe he's right, maybe not. If they are right, then the commodity speculators will swing into action. But if they are wrong, and the loans are funded via means such as described above, the implications would be bearish for stocks and commodities. Because I like Pedro, I want to warn him that we should wait until the data is in before we jump to conclusions and maybe end up with reportorial contusions.
Note:
I was confused about the paying down of MBS and how that affects the Fed's balance sheet, and so asked Lee to explain further. Here's what he wrote back. ~ Ilene
Lee: The Fed's MBS holdings are gradually paid down when mortgage borrowers pay off their mortgages, either because they sell their houses (or they go into foreclosure and the lender sells it and writes off a portion) or when they refinance their mortgages and a new lender takes out the original lender.
In order to prevent its balance sheet from shrinking the Fed has undertaken various securities purchase programs. Since QE2 ended in June, the Fed's objective was to hold the balance sheet steady at $2.654 trillion. Each month it attempted to estimate in advance the rate at which its MBS holdings would be paid down and it scheduled purchases of Treasury securities to replace the MBS paydowns, making up any shortfall or adjusting for any overage the following month.
When the Fed began Operation Twist in early October, it changed its MBS replacement program. Instead of purchasing Treasuries from the Primary Dealers, it opted to purchase MBS from them, in the hopes of more directly boosting the housing market. However, instead of immediate settlement of the purchases as was the case with the Treasury purchases, the MBS purchases were 60 day forward contracts. As a result from late September on, MBS were being paid down and disappearing from the Fed's balance sheet, but no new purchases had settled. No new MBS purchases were settled until the last week of November. The first settlement (approx $5 billion) will be reflected on the H41 to be released Thursday evening. But MBS will continue to be paid down as the Fed's purchases begin to settle each week. The MBS purchase program is due to end in June. The settlements will continue until August. All other things being equal, the Fed's balance sheet would remain below its target of $2.654 trillion until next August.
This is all a technicality, but the fact remains that the Fed is tight, and that even if they did actually print the $50 billion in swaps, it would only bring the balance sheet up to the target level.
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