Tuesday, February 24, 2015

Fundamentally Flawed - Chapter 7, "The Taper"...BRICS sell Treasury's, BLIC's buy

by Chris Hamilton, February 2015
Dec 18th, 2013 Federal Reserve chairman Ben Bernanke announced a “taper” from the Fed’s $85 billion monthly program of buying Mortgage Backed Securities and Treasury notes and bonds, (a program whose intent was to overpay for bonds and push yields lower than free-market rates and maintain a ready buyer for MBS)…absent the Fed’s buying, it was assumed interest rates on the then $17.5 trillion US Treasury market would reset higher.  Rates rising was a “sure thing” among economists, bond traders, and generally any logical thinking person.  A quick glance at the Fed’s purchases of $2.2 trillion in Treasury debt since June of 2011 made it clear the Fed was the “market”.
But rates did not rise when the largest buyer slowed and eventually stopped its buying and rates instead fell in the US and likewise globally despite the reductions in the Fed’s monthly purchasing that began to wane in January and ceased by year end 2014.

Here, in the below chart, you see the interest rate movement of the US, Germany, and Japan over this period.  Yields collapsed…German 10 year yields fell 85%, Japanese 10 year yields fell 66%, and US 10 year yields down 45%.  Since the Feds taper announcement, rates have gone so low as to make much of the bond market un-investible…pushing real money to other markets in search of yield.

As you can see below; "BLIC" (Belgium, Luxembourg, Ireland, Cayman Islands (aka, Caribbean Banking Centers)), and Japan filled the Federal Reserve’s Treasury buying breach.  Interestingly, none of these nations had the foreign exchange reserves with which to make these purchases as OPEC, Hong Kong, or the BRICS did?!?  Seems fair to say these nations were used as fronts for some other entity doing the purchasing.

  • In this period (Nov ’13 – Dec ’14), “foreign” purchases of US Treasury debt increased by $437 billion despite the Fed’s signaling rates were likely to rise, and bond prices likely to fall.  In a free market, this would have been a signal to sell for the $6+ trillion in Treasury debt held by foreigners to sell in order to avoid losses.  But this didn’t happen…but it did begin selling in earnest by China and Russia.

Source, US Treasury, TIC Report
China and Russia were both net sellers in this period and the remainder of the BRICS made minimal purchases’.  These five nations have approx. 50% of the world’s foreign reserve currency holdings, primarily dollars, with which to buy Treasury’s and seemed disinterested in recycling new $’s into Treasury debt…and yet rates fell.

As a reminder…China, Brazil, Russia, and so many more are moving away from clearing their trade in dollars and instead utilizing the Yuan, the Real, the Ruble, etc.  Please note that Russia and Saudi Arabia are now the largest exporters of oil – and at least Russia is moving rapidly to settle in anything but the dollar…and the troubles in Saudi Arabia, Iran, Iraq, Libya, Syria, Ukraine, etc. are all symptomatic of this conflict for which currency(s) will be used to settle trade.

China is organizing itself and its trade partners in at least 24 separate agreements to transact in the Yuan rather than the dollar.  As of 2009, less than 1% of China’s global trade was settled in Yuan but by mid-2013, 17% of Chinese trade was being cleared in Yuan…almost entirely at the expense of the dollar.  And the trend and structure to allow far more has only accelerated throughout the BRICS.
Source, US Treasury, TIC Report
The chart below is a reminder of which nations have foreign exchange reserves, Treasury’s held within each, and the percentage of these reserves held in Treasuries within each nation.  Obviously, China holds in excess of 1/3rd of all foreign exchange reserves and dollars.  China’s hiatus from Treasury buying resulting in collapsing organic yields is simply unbelievable.  Notable also are the nations highlighted in yellow holding 100%+ of all dollar reserves in Treasury’s.  Japan, Brazil, Canada & UK hold unusually large positions but Belgium, Luxembourg, Cayman Islands (Caribbean Banking centers), and Ireland hold positions ranging from 4,000% to nearly 13,000% in advance of dollar reserves held there…and these are all new buying locations since 2011.
Global Foreign Exchange Reserves*, Billions
Global Foreign Reserves, Total % by Country
Reserves in $'s, Billions (Assuming 60% of total in $'s)
Treasuries Held by Country, Billions
Reserves held in Treasuries (% of $'s)
 Saudi Arabia
 Hong Kong
 United   Kingdom
Belgium / Luxembourg
Caribbean Banking centers
*Includes For-Ex, Gold, SDR's, IMF Reserve Positions
** Less than $10 b
***All OPEC exporters combined
****Caribbean Banking Centers include Bahamas, Bermuda, Cayman Islands, Netherlands Antilles, and Panama
Source, US Census, Trade, Source, Treasury, TIC report
And now in a Post Federal Reserve QE Era
The Fed’s balance sheet was driven to record highs to push interest rates to record lows and maintain a market for long end Treasury’s and Mortgage Backed Securities.  The Fed’s balance sheet peaked January 15th of 2015, and is now contracting as the US Monetary base has already fallen over $250 billion (below)…and the price of oil has been falling with the falling monetary base (representing a strengthening dollar). 
Plainly visible below is the Fed’s role to fill the debt void left by shrinking mortgage debt creation.  However, without more Fed QE and no upturn in mortgage debt origination (despite record low interest rates and falling down payment guidelines, back to 3% down payments)…the dollar will “strengthen” as inadequate dollars are created to service all the global dollar debt…
Below, the rising mortgage debt and rising oil price are well correlated until the oil price spikes in ’07-’08 and mortgage debt accumulation ceases with the culmination of the growing working age population in ‘08…but from ’08 through ’14, the Fed stepped in to fill the void from the declining 25-54 yr/old population. 
Now, without more Fed QE or U.S. mortgage debt, there isn’t an adequate debt engine for continuing the necessary ramp in dollar creation to feed the global asset beast.  And the price of oil (and commodities in general) are signifying a global depression is imminent unless the credit machine can be reignited.  As the chart above shows, the gap between actual mortgage debt vs. trend debt since ’08 is missing nearly $9 trillion…the Fed bridged about half that with its $4.5 trillion in QE and Operation Twist.  However, as of now, the monetary base is falling and the Fed’s balance sheet has likewise peaked and is slowly receding, leaving the over-indebted globe to deal with a global depression absent monetary heroine?!?  

However, anyone who has watched the US government and Federal Reserve since ’08 (ok, since the Fed’s creation) should know the Fed will use its magic money machine to create cheaper money and more money to (temporarily) delay the pain of a global bankruptcy and the readjustments necessary to establish a national and global re-balancing.  Prepare for more of the same we’ve seen since ‘08…but the real question will be, what is the result of more QE in a changing monetary regime? And who will be the winners and losers of this policy?