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Bernanke

OF TREASURY AUCTIONS, ROCKS AND HARD PLACES

by TheFalcon on August 12, 2009

The Federal Reserve is clearly resorting to unconventional and perhaps desperate measures to sustain the illusion that buying US Treasury debt and thereby lending to the US government remains the cool thing to do.  Unfortunately for them, their skills at pulling off this type of illusion seem to be slipping.  Or perhaps, their desperation is such that they have no time for elaborate subterfuge.  You be the judge.

In its unprecedented quest to cover the U.S. government’s record setting projected budget shortfall of $1.85 trillion for the current fiscal year, the Treasury held its biggest debt auction ever at the end of July, in an attempt to raise $115 billion.  Needless to say (but I’ll say it anyway), it was imperative for the money raising efforts of the U.S. government that these auctions go well.

They didn’t, at least not initially.  During the first two days, the sale of debt with 2 and 5 year maturities failed to attract much demand and this ugly news was broadcast far and wide by the financial media.  This must have been fairly alarming to Fed and Treasury officials although it was very likely anticipated.  After all, the Fed announced its intentions in March to use freshly printed dollars to buy up to $300 billion in newly issued treasury debt over a 6 month period in anticipation of poor turnout at these affairs.  Well its this kind of policy that makes no one want to come to your party in the first place.   The proof of this was not long in coming, as on the same day of this announcement, March 18th, the US dollar had its 3rd steepest down day ever (-2.9%) representing its biggest drop since 1985.  The Chinese, the biggest lender to the US by far, have become increasingly vocal in expressing their displeasure over this policy leaning ever since.

Back to the crumbling auctions held at the end of July.   Suddenly, on the third day something magical happened.  On Thursday the auction for treasuries with 7 year maturities was held, and oh my, what a difference 24 hours made.  A WSJ article, entitled “Treasurys Rally On Solid Demand In 7-Year Auction”, tells the story.

Apparently, “Treasury prices jumped Thursday afternoon after a successful seven-year auction soothed investors and dealers burned by two disappointing Treasury note sales earlier in the week.”

Let me understand this.  Investors were not interested in short term exposure to ballooning US government debt but they couldn’t wait to loan money to the same binge borrower for 7 years.  Really?  It appears so.  Or does it?

Thanks to some intrepid research by Chris Martenson it is evident that the Fed is the one who provided the “Solid Demand” at the 7-year auction by buying over $4.753 billion of the $28 billion in bonds being sold.  Chris was able to match the unique CUSIP identifying number that identifies each bond sold at the auction with bonds subsequently purchased by the Fed a few days later.  In other words, the evidence presented shows that the Fed was the actual purchaser of the bonds through a third party (ex. primary dealers).  These are interesting revelations to say the least.

Sadly, this has actually become standard practice for the Fed as of late.  Brian Benton, in an article published yesterday entitled “”Lending” a Helping Hand”, takes the above analysis a bit further.  He indicates that,

“This is not atypical as there are many examples where the Fed executed large purchases of securities in close proximity to the actual auction of those securities…It makes you wonder if the Fed is not encouraging primary dealer participation in these auctions by making it abundantly clear that the Fed will absorb a sizable portion of their inventory quickly, while still assuring dealer profits.”

I don’t “wonder” about this at all.  It is very likely that the Fed is purchasing treasury debt through third parties in order to conceal the lack of interest by its traditional investors in buying treasury debt, in particular the absence of foreign governments such as China and Japan.  It is likely because a great deal of the treasury debt being sold at auction is winding up in the Feds inventory after the fact.

I hope it is plain to readers that the only way you can lend yourself money that you don’t have is by creating it out of thin air.  As was demonstrated (hopefully persuasively) in my last essay, “Meanderings…”, this is a direct inflation of the money supply and will lead to higher prices in the future.  Sooner or later, this newly printed money will be used to purchase things and the price of these things will inevitably rise, perhaps dramatically, hence the case that the Feds current policies are hyper-inflationary.  Because this new money often finds itself in the hands of large financial institutions (ex. Goldman and JP Morgan), its first destination is into financial markets resulting in temporary surges in prices.  Anybody been watching the stock markets lately?

There is so much wrong with these revelations, that it is hard to know where to begin.  Even if printing money was a sound practice that inured to the benefit of the American people, this behavior to deceive the public and investors (no matter how poorly executed) is unethical, in bad faith and perhaps illegal.  But, borrowing and printing endless amounts of money is not in the best interest of the citizens of the U.S., or anybody else for that matter, and therefore whose interests does the Federal Reserve protect?  The question is a rhetorical one as the answer is, they are protecting their own interests and that of the political establishment in Washington, the banking and Wall Street crowd and select corporate interests that run parallel to their own.   But I digress.

The Fed is not covering its tracks very well with these shenanigans, which begs the question, how desperate have they become?  If the two authors quoted above were able to uncover these practices without much difficulty, then one would think that certainly the Chinese and others are aware of them.   Which brings us to some additional eyebrow raising behavior from the Fed as of late.

Ben Bernanke was grilled in July before the House Financial Services Committee by Congressman Alan Grayson [YouTube Video] over the purpose of an unprecedented US$500 billion dollar currency swap with 14 different foreign central banks.  A currency swap is exactly what its name implies.  The U.S exchanges US dollars with foreign central banks for other foreign currencies.  A couple of reasons for such swaps are to secretly provide desperately needed foreign exchange reserves on an emergency basis and to hopefully make the swap without impacting exchange rates.  This is tricky business.  Imagine the downward impact on the dollar if the Fed had tried to sell US$500 billion in the open market.  When queried as to what these foreign central banks did with the money, a visibly and audibly nervous Ben Bernanke indicated, “I don’t know”.  Given the desperate concern that Treasury and Fed officials have that there will be no buyers of US treasury debt,  it is reasonable to assume that at least some of this money was provided to foreign central banks to ensure that they showed up at pending treasury auctions.

If the intent of the Treasury and the Fed is to fool the markets and the general public into believing that the world is happy and eager to continue loaning the US ever more ridiculous sums, it does not appear to be working.  They are not likely fooling anyone with these machinations.  So, it begs the question, what do they think they are accomplishing?  Or, are they simply desperate and therefore exhausting every possible trick they can think of, no matter how obvious or absurd?  They can’t be trying to fool other central banks and large financial concerns around the world because some of these institutions are cooperating to a limited extent with this charade and the others would have to suspect or have inside information.  They can’t be trying to fool the financial community in general because they have left a trail of evidence that is not hard to follow.  So who is this show for?  I’m at a loss.  These guys are either idiots, acting out of desperation with limited options, or up to something more subtle and nuanced than has yet been perceived.

In retrospect, we really shouldn’t be surprised.  Ben Bernanke indicated in his now famous 2002 speech, entitled “Deflation: Making Sure “It” Doesn’t Happen Here”, that the Fed can and should resort to just about anything to avoid debt deflation and “…expand aggregate demand and economic activity…”, including psychological and market manipulation as well as printing money, devaluing the currency, and purchasing any and all assets to manipulate prices and interest rates as deemed necessary.  This speech makes for fascinating reading as he makes it clear that anything goes in the battle against deflation and he highlights that in order for these efforts to be successful there can be no policy constraints imposed on Fed and Treasury actions.  In short, they have to be free to do whatever they deem necessary without consideration for legality, accountability, transparency, advisability of such actions, good faith or any other ethical constraint.  However, he concedes in this speech,

“…that once the policy rate [i.e. interest rate] has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory…Hence I agree that the situation is one to be avoided if possible”

It is safe to say that the Federal Reserve is operating in Ben Bernanke’s uncharted waters with these confidence games.  The question now becomes, how long will the market cooperate with these shenanigans before the Fed is forced into the extreme position of printing money to buy all of its new debt, commonly known as Quantitative Easing (QE).  The Fed has indicated that it intends to end this 6 month program of monetary inflation in October as scheduled because of “…the improvement in financial markets that’s going on.” On August 2nd, no less than the venerable Alan Greenspan said “…that the recession seems to be ending…” If you believe that, I have a big orange bridge for sale.  Send me an email and I’ll send you some pictures.  How else are they going to fund the insatiable and exponentially growing borrowing needs of the US government?  Despite today’s official pronouncements to the contrary, ending the QE program in October is not a likely outcome.  If the history of such things and our recent experience with the current Fed is any guide, these purchases are likely to continue whether overtly or covertly.  The recession is not over with only increasing bad news on the short term horizon.  The US budget deficit and projections for future budget deficits continue to balloon.  With tax receipts falling off dramatically and traditional investors losing their appetite for lending the US more money, where will the shortfall come from?  Until these trends do an about face, the Fed will have no choice but to print money to cover the shortfall.

Corollaries to this question are, how long before the market punishes the Treasury by either increasing the size and speed of divestment from US treasuries or at least demanding a much higher interest rate to compensate them for the rapidly increasing risk of a steep decline and permanent devaluation of the US dollar looming in the not too distant future?  Both paths would have disastrous effects on the US government and the US economy as a whole, and one or both also seem inevitable.  One thing is for certain.  This can’t last.

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Regards,

- The Falcon

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