August 14, 2013

Infinite Money Theorem

“What do you see out there?”

Out here in Crested Butte, CO, where the overnight temperature was 35 degrees, we see vast beauty, perhaps unparalleled on the planet.

As for the other “out there,” it’s the No. 1 question we’ve gotten the past two weeks, even with clients reporting financial results. They’re most concerned with the macro view: What do we think will happen to the stock market if and when the Fed stops buying government-backed securities?

Some observers predict doom. If the Fed quits printing money, the helium goes out of the balloon and down it comes. Others see the opposite. Just yesterday Jim Paulsen at Wells Capital said the Fed’s exit means markets can normalize, shifting from arbitraging data to investing in economic growth. He says stocks will rise.

It’s important to understand what the Federal Reserve is doing. The Fed isn’t printing money per se. It’s in effect engaging in a massive derivatives swap – trading one thing for another, neither of which is a hard asset. The Fed buys about $85 billion of Treasury securities and government-backed mortgage derivatives every month. Since these instruments are backed by US taxpayers and derive from either future tax receipts or underlying mortgages, both are derivatives.

The Fed is trading another obligation of taxpayers, US currency notes in digital form, for these. On balance sheets, the process functions like a swap, with the notes increasing bank reserves and the securities purchased by the Fed expanding the Fed’s balance sheet.

Risk arises from the logistical impact of the process. When the Fed buys mortgage-backed securities, it’s displacing prudently pooled private capital, and artificially expanding the market, producing residential real estate growth that might not occur on private dollars. Will private money step in to replace the Fed? Sure. Real estate is a tremendous asset class. But it’s unlikely to provide capital at the same cost.

Second, the Fed buys Treasury securities from the Too Big to Fail banks – the primary dealers who make bids every week at Treasury auctions. These same banks are responsible for over 95% of the derivatives market, over 50% of equity trading, perhaps 70% of currency trading, most bond underwriting and over 90% of IPO underwriting. The Treasury auctions roughly $600 billion of notes, bills and bonds every month, though only $50 billion of it is new debt. The rest is refinancing, generating commissions for dealers and keeping rates low.

If an infinite money supply becomes finite, the ramifications are larger than $40 billion. When the Fed stops buying $40 billion of new debt, the Treasury will cease refinancing at the same level because rates will rise to levels comfortable for private money to take up the slack. Primary dealers provide services to traders and investors too, as prime brokers. Without the Fed in the market, risk rises, decreasing prime-brokerage capacity and increasing its cost. Bank commissions will fall. And without continuous refinancing creating the impression of a vastly liquid market, rising fixed-income costs could ripple into every asset class.

If that happens, asset prices will adjust. So the Big Question that no one can answer because we have never, ever in human history trod a similar monetary path, is this: Will human beings compensate for the absence of the Infinite Money Theorem?

They might. The only truly infinite commodity is human resilience. However, we don’t believe any model has properly accounted for the Fed’s tentacles. When this reality arrives, it’ll be abrupt. That won’t happen until after the Fed stops.

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