The Fed goes bust, the dollar goes up...

Could the Fed run out of money? It may seem a ridiculous question; after all as 'Helicopter' Ben Bernanke has opined controversially before Congress, they can always just print the stuff (although shades of Zimbabwe or the Weimar Republic make that a last resort). However, the chart above (from the Fed's own latest Quarterly Report) is a shocking indicator of just how stretched the Fed's balance sheet (totalling about $900bn) has become as it chucks $200bn lumps of cash at the interbank markets and opens its funding window to hungry investment banks in an attempt to lubricate the crunching credit system. What the chart shows is how degraded the Fed's balance sheet has become as it swaps Treasuries for mortgage securities and other commercial bank assets of dubious credit quality. The dramatic halving of the Fed's own Treasury holdings in a year indicates that this reliquidion process is finite and they better start revving up that helicopter. Lehman's latest wheeze reported today indicates the financial detritus now being shovelled onto the Fed's books in exchange for crisp new dollars. Treasuries now account for just 3.5% of the debt issued by the US financial sector, down from 8.5% in 1996. In broad terms, the Fed's capacity to provide bailouts to the financial system without resorting to the printing presses is 60% less than a decade ago. And this is before we account for the considerably higher risk being carried by the financial system as a whole versus a decade or more ago. The current strategy of indirect support for the private sector financial system is running out of headroom fast, so expect more direct intervention at the heart of the crisis, the housing market. It is not inconceivable that a large chunk of sub-prime/foreclosed mortgage debt is effectively nationalised (as PIMCO no less have advised) in the next few months. At the rate the Fed is currently hoovering up tainted assets from Wall Street banks, Mr. Bernanke and Co. are effectively running the world's largest hedge fund, which has many remarkable implications, not least that they're being grossly underpaid!


This is another interesting chart tracking the inflection point for the dollar in previous recessions and it supports my view that the dollar is poised to surprise against consensus and bounce strongly over the next few months; I'm long far quarter $/Euro (see Buck Stops Here post). Although it sounds counter-intuitive that the dollar should recover in the middle of a recessionary period, it may simply be a case of first in, first out where the bad news is priced in comprehensively to US assets whereas complacency reigns elsewhere as economic contagion risks are always underestimated. Time to buy that dream Miami beach front condo or Rockies ski lodge? For an overseas buyer of US prime real estate this may be as good as it gets with currency adjusted prices down 30-50% from the 2006 peak. If, as I believe, the Fed rate cutting is now pretty much over while Eurozone and Asian growth is set to slump, the rally could be dramatic indeed and this would have very negative implications for the speculative commodity bubble, particularly precious metals and energy. Mining stocks look very vulnerable to a deep correction on this view and are also technically overbought; they may lead the way down on my view that the bear rally has pretty much run it's course.

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