The Next Major Crisis Brewing

The Fed’s FOMC announcement came out…

We got exactly what I expected, a kind of wishy-washy, “hedging our bets” statement from the Fed. You have to remember that Bernanke was Greenspan’s right hand man for much of the bubble days of the ‘90s and early ‘00s, so the guy is an expert at walking both sides of the line when it comes to policy and public statements.

For instance, the Fed announced it would keep interest rates between 0% and 0.25% for an “extended period.” No surprise there. As I’ve noted previously, 80%+ of the $200+ trillion in derivatives sitting on US commercial banks’ balance sheets are related to interest rates.

For the Fed to hint at raising rates (let alone raise them) would kick off a systemic implosion that would wipe out the very guys the Fed has been bailing out. Suffice to say the Fed won’t be raising interest rates now or anytime too soon (within the next 3-5 years, unless inflation destroys the dollar).

The Fed also announced it would be slowing its purchase of Mortgage-Backed Securities (what I call the Fed’s “cash for trash” program). The Fed has stated previously that it will buy $1.45 trillion in mortgage-backed securities from US banks and that this program will end by the end of 2009. However, last week the Fed said it will be extending the program (but not the amount of money spent) until the first quarter of 2010.

Again, this is not much of a surprise. The Fed performed a similar act with its Quantitative Easing Program (extending but not increasing the amount). However, given the increasing public outcry about the Fed’s balance sheet, this issue of buying toxic debt (and the mortgage backed securities the Fed is buying are nothing if not that) may become a hot topic in the near future. If there is ever a successful audit of the Fed’s balance sheet, kiss the big banks’ equity (and share prices) good-bye.

The Fed did announce that it would let its Quantitative Easing program end in October. If you’re not familiar with this program, it’s basically a fancy way of saying that the Fed has been buying US debt in order to finance Obama et al’s massive deficit.

This particular development is key. A little known fact (and one totally ignored by the mainstream media) is that the Fed accounted for nearly half of all Treasury purchases in the second quarter ($164 billion out of $339 billion). In fact, the Fed bought more Treasuries than the next three largest purchasers combined!!

The Fed’s purchases outnumber foreign holders (foreign governments), US households, and Primary Dealers (mega banks) combined. One should also note that foreign holders reduced their purchases of US debt from $159 billion in 1Q09 to $101 billion in 2Q09 (a 40% decrease).

In simple terms, these numbers indicate that if it were not for the Fed, the US Treasury market would have almost assuredly had numerous failed auctions in the second quarter. It also shows us that foreign holders (China, Japan, etc.) are reducing their purchases of US debt at an incredible rate. This tells us two things:

1)China and pals are putting their money where their mouths are: refusing to service our debt as they did in the past

2)Treasuries will have to become a lot more attractive (higher yields) for foreign investors to start buying again

I’ve often stated that the Fed will have to sacrifice stocks or the US dollar. If the Fed does in fact end Quantitative Easing in October (as it has stated it will in last week’s FOMC), then we’ll see what the market really thinks of US debt as an investment class. It’s clear from the above data that foreign holders want higher rates (yields) in order for them to start buying more heavily. However, as I’ve stated before, the Fed cannot afford higher interest rates without blowing up US banks.

Keep your eyes on the Treasury market going forward. This could very well be the next major crisis brewing. It will certainly be our first taste of how a market operates without life support courtesy of the Fed.

I’m guessing the results won’t be pretty.