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The Fed Maintains its Flexibility

(July 31, 2009)

Dear Subscribers and Readers,

As we discussed in our July 10th and July 19th commentaries, the surprise announcement on July 9th by the Bank of England to bring its quantitative easing policy to a close means that – with the ECB, the Bank of Japan, and the People's Bank of China no longer flooding their markets with liquidity – it is now solely up to the Federal Reserve to “pick up the slack.”  As covered in our recent commentaries, the Bank of England has consistently purchased between 6 to 7 billion pounds (US$9.8 to US$11.5 billion) in Gilts, commercial paper, and corporate bonds on a weekly basis – effectively monetizing these debts and creating money “out of thin air” in the process.  In our July 19th commentary (“Europe Stuck in a Quagmire”), we mentioned that the Bank of England should effectively halt its purchases in just two weeks.  Sure enough – for the week ending July 30th, as shown in the following chart, the Bank of England just purchased 3.9 billion pounds of securities (mainly Gilts) – its lowest weekly level since its first week of purchases in early March.  More importantly, the amount of its cumulative purchases has hit its 125 billion pound (US$206.4 billion) limit, which effectively halts the Bank of England's quantitative easing program:

Central Bank Reserves Supplied Via Asset Purchases by the Bank of England (in Sterling millions) - The amount of asset purchases by the Bank of England plunged to 3.9 billion pounds last week - its lowest level since its first week of purchases in early March. In addition, the BoE's QE policy has finally hit its 125 billion pound limit.

The Bank of England will make its next monetary policy decision on August 6th.  Consensus suggests that the BoE will formally announce an end to its QE program, especially given the latest rise (the third consecutive monthly rise) in UK housing prices.  From both a political and the current economic standpoint, it is difficult for the BoE to justify raising its limit to 150 billion pounds.  However, without the option to ramp up its QE policy, the UK risks the possibility of liquidity event – and will be even more dependent on the Federal Reserve as the latter is the only major central bank with both an easing bias and the flexibility to use its balance sheet to ease global liquidity (the People's Bank of China also has this flexibility, but its impact on global liquidity is limited as China's capital accounts are still closed).  As I have maintained over the last couple of months, the BoE should have allowed itself a further 25 billion pound “cushion” to insulate the UK economy from any unexpected tightening in global liquidity.

Thankfully, for the bulls, the Federal Reserve has maintained its easing bias.  While the Federal Reserve did slow down its debt monetization program from late May to early July, we mentioned at the time that there was no doubt that it will come back if oil declined below $60 a barrel or if the Dow Industrials Average declines below 8,000.  Three weeks ago, the price of crude oil settled below $60 a barrel while the Dow Industrials was on the verge of declining below the 8,000 level.  The Federal Reserve responded by ramping up its debt monetization purchases – purchasing US$36.9 billion in Treasuries and agency securities during the week ending July 15th, an additional US$60.4 billion for the week ending July 22nd, and $17.9 billion for the week ending July 29th, as illustrated in the following chart:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - After slowing down its purchase of Treasuries and agency securities during late June and early July, the Fed's purchases for the last few weeks have been relatively robust - clocking in at US$36.9 billion, $60.4 billion, and $17.9 billion respectively. Make no mistake: The Fed has maintained its accommodative stance despite the stock market rally over the last few weeks...

More importantly, the Fed (as discussed in the latest FOMC statement) the option to purchase an additional $700 billion in MBS and $100 billion in agency debt by the end of this year, subject to liquidity and market needs.  Combined with the Fed's actions over the last three weeks, this suggests that the so-called “Bernanke put” is still alive and well.

Obviously, there are still many potential areas of systemic risk, as we have discussed in the last few months.  The European banking system remains vulnerable, as discussed in our July 19th commentary.  While the region could mitigate its bad debts by a combination of “earnings its way out” and recapitalizing its balance sheets, it will continue to act as a drag on global GDP growth for the foreseeable future.  If Eastern Europe suffers a sudden devaluation (this would result in widespread loan defaults in Eastern Europe), then the European banking system may not recapitalize its balance sheets in time.  In such a scenario, this could mean outright nationalization – accompanied by a dramatic decline in global liquidity and monetary velocity.

Closer to home, the systemic risks posed by troubles in the commercial real estate market will continue to be problematic for the next 12 to 24 months.  The focus is no longer on the 19th largest banks in the nation, however, as these banks could easily “earn their way out” of losses in the commercial real estate market, especially since the national banking market has gotten less competitive over the last 12 months.  Rather, the focus will be on regional banks, as regional banks have double the exposure to commercial real estate (relative to large banks), while only having 60% of the earnings power, as shown in the following exhibit, courtesy of Goldman Sachs:

NPA growth was concentrated in commercial, commercial real estate and construction in 2Q - linked quarter change in NPAs by product
* Click on image to view larger image

Interestingly, NPA (non-performing assets) growth in credit cards actually declined during the second quarter, while only rising 1% for home equity loans.  Of course, this could be a head fake – but there's no doubt that NPAs in commercial mortgage and construction loans are still on an uptrend.  This author continues to expect a number of regional banks to either fail or to merge over the next 12 to 24 months. Whether this poses a risk to the banking system is not clear at this stage, as the FDIC is working actively behind the scenes to lure private equity funds into the sector.  Failing this, the FDIC (and the government) will need to move in and backstop the system, as a nationwide failure of regional banks will no doubt result in a dramatic decline in liquidity growth and monetary velocity.

Signing off,

Henry To, CFA

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