Thursday, November 09, 2006

Drowning in the stuff and no way to control the tap

Barry Ritholtz has pointed us to an unlikely source of simply scandalous material. If the speculation raised by the data unearthed is at all true, the Bush administration will have effectively completed his assigned task to have the executive assume absolute control of every conceivable and heretofore independent branch of the government. That is, until the voters went to the poll yesterday.

The last bastion of independence conquered? The US Central Bank, the Federal Reserve Bank. And the Trojan Horse that did it? The US Treasury.

By way of simplified background, it has become pretty much an uncontroversial given that the price level of any asset is not entirely a simple function of supply and demand of the asset. Rather, price, being a function of money, is dependent on the quantity of money at hand at the time price is determined. In shorthand, we say that liquidity (the amount of available cash in the system) is a significant factor in determining price. Assuming no change in the supply/demand equation, we can alter price by altering liquidity; the more liquidity the higher the price.

And a consequence to add to your pipe for your smoking pleasure is that higher prices tend to result in higher inflation. And, inflation is the bain of every Central Bank.

Thus, when trying to understand the "unusual" price moves in an asset, such as housing, we tend to point to low (or high) interest rates which quite often are manufactured by Central Banks' purposefully raising (or lowering) the amount of liquidity in the system. Indeed, it is the primary responsibility of the Reserve Bank to regulate the value of US money and price stability and, apart from setting short term interest rates, which tend to draw an over-abundance of political and commercial attention, the most effective way to achieve its goals and effect monetary policy, is to control the money supply.

It is a corollary of the notion of Central Bank independence that it have the sole power of effecting its control over monetary powers. Where the Executive usurps any of that power, it diminishes the independence and effectiveness of the Central Bank and the Bank's policies.

So, the markets get kinda twitchy when Executive agencies cut in on the Central Bank's game. Moreover, with the Executive delivering more money supply via Treasure action, it will have the same effect as fiscal stimulus, as far as the Central Bank is concerned, and require concommitant monetary action to contrain the Executive action. Antidote: higher interest rates.

That said, consider what Barry Ritholtz pointed us to:
Whenever we discuss some of the darker theories of a conspiracy or market manipulation, I seek to discover a market mechanism that can explain the actions. For example, I was quite doubtful of accusations of energy price manipulation -- until Bill King identified the changes in the Goldman Sachs Commodities Index (GSCI). That change led to $6 billion of gasoline futures hitting markets in September and October -- and the subsequent 30% drop in gas prices over a few weeks.

Might there be any similar mechanism around impacting equities?

One possible answer comes from John Crudele of the NY Post. Crudele has long been a skeptic of government data; its no surprise he looks askance at some of the actions of ther Fed and Treasury.

And indeed, it is the Treasury Department that comes under his watchful gaze. Yesterday, Crudele wrote:

"FOR the past few years the U.S. Treasury has been quietly involved in what the financial markets call "repo" agreements and this near-secret operation could explain why the nation's money supply seems to be confoundingly large.

It might also explain why Washington decided earlier this year to stop publishing M3 money supply figures, the broadest and most popular measure of money in circulation. Repurchase agreements - or repos - have long been used by the Federal Reserve to get money quickly into the hands of financial institutions, which in turn can put the money into circulation in the form of loans.

Last Thursday, for example, the Fed executed $2.5 billion in overnight repos and $8 billion in 14-day repurchase agreements. These were reported on the financial wires. The Treasury completed a $5.5 billion repo operation on the same day under what it calls the Term Investment Option. There was no mention of the Treasury operation on the wires. In the Fed's repo deals, the banks temporarily turn over securities to the central bank in exchange for cash. The Treasury TIO program works in a similar way, except the financial institutions pledge securities as collateral in exchange for the cash."

What does this mean? Well, instead of the (theoretically) independent Federal Reserve controlling Money Supply, we see the Treasury department has had an "unseen" hand. MZM, M2 and credit growth has been soaring. This has the effect of providing the fuel for increasing the leverage and risk in the system.

This repo action is not reported by the Treasury Department, and Crudele that "financial institutions have been using it for three years to increase their liquidity." Surprisingly, it is not well known by the investment community.

What's the problem with this? Crudele notes:

Experts worry whenever there is too much money - liquidity - in the financial system because it can lead to things like price spirals in the housing market and bubbles in stocks. But even more worrisome for the financial markets than too much liquidity would be an inability to track the amount of money being pumped into the financial system.

Unless I find out differently, it looks as if the Treasury has created a way to duplicate the Fed's power. And that is a disturbing possibility unless it is somehow monitored.

Bill King adds:

"$20B was added to the system last Thursday and Friday. Where is it going with the economy ebbing? Of course it goes to the ‘new economy’, which is financial speculation and asset grabbling . . . The astute know that the repo world runs The Street. It is the lifeblood of The Street, and ‘The Money Desk’ of each big firm is the heart of the organization. Other traders garner the headlines and TV spots but the ‘money desk’ reigns supreme on The Street. Just ask the ex-principals of LTCM."

For those who, unlike Ritholtz, really prefer a really bad conspiracy theory to any plausible real world explanation, have a read of this.

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