Category: 1 – Liquidity Trader- Money Trends

Back in September I wrote to you about why I was giving up on the banking system indicators. I’ve reposted that rant in an addendum to this report. Essentially it boils down to this. Every time there’s a critical problem in the banking system due to banker malfeasance, the Fed steps in to paper it over and reward the criminals.

That’s why we focus on the Fed more than anything else.

The banking indicators were useful once upon a time. The Fed has rendered them irrelevant. But I promised to keep an eye on them, so herein is a review. It makes me sick and should make you sick too, but we’re not here to fight the Fed. We’re here to make money by understanding and playing according to the Fed’s rules. The Fed’s first order of business is always to protect its banker clients. And it does that very well indeed.

Once again trouble is brewing, and the Fed will need to come up big again to prevent it from blowing up the banking sector. If history is any guide, the Fed will be there. It may be to the detriment of those who don’t own capital, but they don’t matter. The Fed doesn’t care about them, and refuses to take responsibility for the intractable problems that has caused our society.

Consequently, being a bear for the right reasons does not pay. To make money in these markets you must play on the side of the criminals that run the show, the Fed and its client banks.

These banking indicators help us to understand just what they’re doing, and where the landmines might be that one day could blow this whole game to smithereens.

This brings us to a recurring theme. The first sign of potential systemic blowup would be an upside breakout in the 10 year Treasury yield. It would mean that the Fed had lost control, and that the system was careening toward an abyss from which there might be no Fed response big enough to escape.

We’ll take a look at that, but also some other problems in the banking system balance sheet that the banks and the Fed are pretending don’t exist. Well, they exist and they’re bubbling up just below the surface, to burst forth one of these days in the not too distant future.

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The Fed’s policy remains stable at about $170 billion per month in QE, give or take a few billion depending on the level of MBS replacements. The balance sheet is growing on trend.  The stock market is tracking with it, as usual.

This will lead to a huge problem when the economy begins to react to enlarged stimulus.

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Here’s the problem. When rates are falling, there are more sales, and especially more refi. So the prepayments go up, and the Fed sees a greater reduction in its MBS holdings. Those reductions had been running at the rate of $65-70 billion per month through last month, based on the prepayment rate in the market in prior months. The Fed then bought that much from the dealers in the following months.

As always, those settlements were held in the third week of the month. The Fed would settle a total of $100-110 billion in prior forward MBS purchases that week, and the dealers would suddenly be flush with cash.

Good thing too. Because the 15th of the month is when the Treasury issues a pantload of new notes and bonds. The amount of Fed MBS purchases typically provided enough cash to the dealers for them to cover nearly all of the Treasury issuance. They could either buy it outright, or provide the repo financing to customers so that they could buy it. Then there was even some left over for them to play markup games with their equities inventories.

But mortgage rates have been rising since August. Prepayments are falling as a result. Home sales are holding up, but refis are cratering. As a result, the nearly final figure for the Fed’s MBS settlement in mid December is only $69 billion. That’s $30-40 billion less than in recent months.

At the same time, the TBAC says that the Treasury will issue $98 billion in new notes and bonds on December 15. The day before, the Fed’s MBS purchases will only total $52 billion.

That’s a problem. But there’s an even bigger problem next week. And an even bigger problem after that when the US Government passes new stimulus. Here’s why, and what to do about it.

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Yesterday we looked at the overview of the CLI and the issue of new and secondary stock offerings. The CLI is still bullish. And the supply of new stock issues has not been sufficient to absorb enough of the demand to stop the advance of stock prices, although it has probably contributed to slowing the rise. Likewise, new corporate debt issuance, while massive, hasn’t been sufficient to pull enough of the demand for securities to cause a reversal of the rise in stock prices.

In this Part 2 of the report, I cover the remaining interesting and important indicators that comprise the CLI. Each has its own story to tell, but they all lead to the same conclusion. Still bullish, and, unbelievably, one key component says that the stock market is oversold.

I find it difficult to wrap my head around that. But I won’t argue with it. If there’s one thing I’ve learned in 53 years of watching markets virtually every day, it’s not to argue with impartial indicators. They don’t care what I think should happen. They just show what is happening.

So here we are. The Fed is creating enormous amounts of excess liquidity, “liquidity” being a fancy word for “money.” I use the words interchangeably.

The Fed is creating that excess by pumping money directly into the markets via its POMO operations—buying bonds from Primary Dealers and paying for them by crediting the dealers’ accounts at the Fed with newly imagined money. That leads to secondary effects of increasing money in the system via credit growth, particularly increasing margin credit that results from rising securities prices.

This works, and will continue to work, for as long as the players have enough confidence in the game to keep buying. This keep pushing prices higher, increasing the value of collateral. That, in turn, allows for and promotes ever more credit creation. It’s the quintessential nature of bubble finance. Circular, and more. Always more.

There are those who say that this isn’t sustainable. There are also those who say that an expanding universe isn’t sustainable, that it will collapse in on itself.

In a few trillion years.

I’m agnostic about whether this must finally end in collapse within the foreseeable future. I assume that it will, but I sure as hell don’t know when. So I’ll just operate in the here and now, and respect the trend. We’ll always be alert for signs of change, but at the same time, never forgetting Rules Number One and Number Two.

Don’t fight the Fed.

The trend is your friend.

Meanwhile, as Yogi said, you can observe a lot by watching. I’m confident that by always being vigilant, and open to anything, we’ll be ready just in time to take advantage of, or at least protect ourselves from, whatever is to come.

Now to the indicators.

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