As we wrote last week, the wind down of Treasury’s Supplementary Financing Program (SFP) begins today, with $35 B in the program not being rolled over, $24.3 B of which was initially allocated to primary dealers.  We have speculated that the effect will be similar to that of the quantitative easing/permanent open market operations (POMO) of the Fed whereby the resulting excess reserves are plowed into equities.  The impossibly high correlation of paint-the-tape closes to POMO days in the first few months of the rally made for an easy trading edge.  Equities have, of course, continued their tear, but the timing of equity ramps has become increasing erratic and can no longer be easily correlated with Fed operations.  This is expected because an easy trade cannot exist for too long when many know of it.  At best, for now we can only remain generally bullish until the operations are scheduled to stop.  For SFP, this will be the last Thursday of October.  However, the FOMC announced yesterday that Agency (Fannie/Freddie) and mortgage backed securities (MBS) buybacks (both permanent liquidity ops) will continue until the end of March 2010, with a gradual wind down.  The Fed may purchase a further $75 B in the former and another $600 B in the latter.  All in all, there is much more liquidity coming down the pipe.  We will likely not become long term bearish again until we see a steep drop in bank non-borrowed excess reserves, indicating the juice for the rallies has dried up.  Until then, corrections will be buying opportunities, though we expect some will likely be violent.

While much has been made of the expiration of the Federal Reserve’s $300 Billion quantitative easing program, there are still many more ways in which the Fed can pump the markets with liquidity that need never be paid back to the recipients.  In this article, we take a look at the ramifications of some recent developments with regard to the Treasury and Federal Reserve that will again provide fodder to the equities markets, as well as revisiting our previous work on how money supply has impacted the economy and what it tells us of the potential correction down the road.

As we wrote two days ago, Treasury is effectively winding down its Supplemental Financing Program, the stated intention of which on its inception in September 2008 was to, “drain reserves from the banking system, and therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.”  Delving into the mechanics of it, here is what happened:

Treasury announced special auctions for cash management bills, the proceeds of which were placed on deposit with the Federal Reserve in a special account (as opposed to the proceeds being kept by Treasury to fund the government).  This allowed the Federal Reserve to use these funds (which topped out at $558.9 Billion in November 2008) to borrow or buy securities primarily from banks and broker dealers to help “unfreeze the credit markets.”  The Fed could have simply borrowed or bought securities with money it printed, but this would have expanded its balance sheet by creating excess reserves in the accounts that banks are required to keep with the Fed.  These reserves can be multiplied by at least ten times and used by banks for lending.  At the time, the Fed was rightfully concerned about inflation becoming unmanageable once the credit markets thawed, and about being able to keep the Fed overnight lending rate (fed funds target rate) above zero.  Accordingly, Treasury’s SFP helped to keep the Fed balance sheet under control (if you can call a multiple hundred percentage increase “under control”).  The amount of money that flowed into the financial markets from the SFP was the same as it would have been had the Fed printed the money; however, SFP money could not be multiplied by banks.

Congress granted the authority to the Fed to pay interest on excess reserves held by banks on deposit with it as of October 1, 2008.  This new tool obviated the need for the SFP as the Fed could now simply incentivize banks to not lend against their excess reserves (by paying them interest to keep their reserves at the Fed).  Accordingly, in November 2008, Treasury announced it would reduce the SFP, and it has held steadily at $200 Billion for most of 2009.

On Wednesday, Treasury announced that it would allow the SFP to “decrease in the coming weeks to $15 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over.”  As we wrote above, Treasury issued special cash management bills as opposed to its standard arsenal of regularly auctioned bills (such as the 4 Week, 3 Month and 6 Month Bills).  We have identified these bills (all were 70 day duration) by their CUSIP, auction amount, primary dealer take (to be explained later) and maturity date (each of which is a Thursday):

Upon maturity, the SFP account at the Fed will be deducted by the total auction amount with the funds returned to the purchasers of the bills.  The consequences of this are:

1. Should the Federal Reserve require additional funds to finance its buying and borrowing of securities (Agency POMO, MBS purchase, TALF, etc.), it will need to print money in the amount that the SFP has been decreased.  This is not too much of a long term issue since, as we wrote above, it is able to pay interest on excess bank reserves to keep inflation in check.
2. Treasury can now issue longer term Notes and Bonds to replace the shorter term 70 day cash management bills.  This is more important to Treasury’s long term objectives, especially as it quickly approaches the $12.1 Trillion debt ceiling this fall.
3. Without the rollover of the $185 Billion in cash management bills, assuming constant demand for shorter duration bills, the regularly scheduled Treasury Bill auctions (4 Week, 3 Month, 6 Month, etc.) should experience increased demand, which will put downwards pressure on short term rates and keep the US Dollar carry trade alive and well (a topic for another article).
4. Because primary dealers will not be expected to buy any more of these SFP cash management bills, they may use these funds for other purposes.

As to 4, above, what might these purposes be?  As we have seen with the permanent open market operations (POMO), it appears that much of the stock market ramp (at least for the first half of the 2009 rally) was demonstrably accomplished with POMO funds paid to primary dealers that plowed the money into stocks.  We have also correlated large increases in bank non-borrowed excess reserves (green in chart below) with stock market ramps.  The chart from the previous post is updated here:

Indeed, because the major primary dealers are US banks, most of the $114.1 Billion returned to them upon maturity of the SFP bills will end up in this category of non-borrowed excess reserves.  Some of it may be required to support future Treasury auctions, especially if Treasury ups the longer dated auctions that have less foreign support (primary dealers are required to soak up excess supply at auctions).  Indeed, next week, the 2 Year, 5 Year and 7 Year offering amounts have each been increased by $1 Billion.  However, the potential is for at least a sizable portion of the $30 to $35  Billion to hit the equities markets each of the next six Thursdays after having been leveraged by 10 to 100 times or more.

Also, though quantitative easing in the form of Treasury POMOs is ending soon as it approaches the $300 Billion ceiling, the Fed is compensating with increased Agency POMOs (another $4 Billion bought today, $285 Billion to date), not to mention a total of $651 Billion in mortgage backed securities bought by the Fed this year.

The above is our warning to the shorts.  Now, our warning to the longs.  Below is our updated chart of M2 Money Supply Volatility, that we first brought to our readers’ attention in late July 2009.

The unprecedented contraction in money supply, as measured by 13 week percent change M2 non-seasonally adjusted money supply(yellow in chart), only intensified into early September 2008, as evidenced by the double dip at the far right edge.  What this tells us is that the equities rally is running on vapors (likely in large part from the bank non-borrowed excess reserves portion of M0), with nothing to back it up (in the form of money circulating in the broader economy) once the vapors disappear.

Interestingly, Wednesday’s rally to 1074 in the cash S&P 500 touched a crucial level in the heavily traded SPY (S&P 500 exchange traded fund), which is the volume  weighted average price (VWAP) of the entire down move from the October 11, 2007 high.  The bulls and bears are thus at a crucial equilibrium point, and the coming weeks will announce the medium term winner.

In short, traders should be mindful of the potential for massive buying sprees as the $114.1 Billion is returned to primary dealers over the next six weeks (along with continued Agency POMO and MBS purchases) and also of the potential for the floor to fall out from under this rally once the funny money dries up.  The next downturn will not be instantaneous, and there will be warning signs, which we will report on as always.

We are neither perma bears nor perma bulls, but are fortunate to have the luxury of reevaluating the markets on a day to day basis and to be able to adjust accordingly.  True to history, it will be the longer term investors that will ultimately bear the brunt of this monetary and fiscal malfeasance.

Disclosure: No positions as of time of publication.

11:24 am EDT:  We incorrectly identified Wed and Thurs of this week as the two days on which the Federal Reserve Bank of NY would conduct permanent open market operations (POMO).  In fact, it is today (Tues) and tomorrow (Wed).  This increases the likelihood of a correction to be underway by tomorrow (Wed), instead of Thursday.  Regret the error.  Today’s POMO results were for a meager $2 B, so quantitative easing could conceivably continue beyond this week with smaller auction amounts.

After an initial failed test of the 8:30 am spike high to 1048.75, longs have supported the ES in the expected area of 1037.25 to 1039.50 per our morning report.  If the ES accepts value in the upper half of the combined session range (1043.50 and higher), there could be a successful afternoon push to new highs, as we have seen in previous days.  Otherwise, the conditions for this morning’s high being the September high are partially in place.  We would like to have seen a directional push down by now, but a close under 1030 still signifies the top is in for us.  For this reason, we will not be buyers on any further weakness (including test of 1038.25 low), and will instead begin intraday shorting on a break of 1037.00, should it occur.

Hot off the Fed’s non-monetary printing press is the announcement of a change to the criteria of Agency (Freddie/Fannie) securities that it buys through permanent open market operations.  Newly inserted in the FAQ:

What type of GSE direct obligations will the Federal Reserve purchase under the program?

…Prior to August 31, 2009, purchases were focused on off-the-run securities in that category. Going forward, purchases will include on-the-run securities in that category. This change represents a technical adjustment designed to mitigate market dislocations and to promote overall market functioning.

So, the Fed will now buy newly minted Fannie and Freddie debt (are they running out of older debt?).  Overall, not a big leap (it’s only a $200 B program), but another small step up the ponzi pyramid.  Next, expect loosening of restrictions in the much larger TALF and MBS programs. 

Gaming the Market outlines a typical day at the FRNY trading desk.

Step One (08:30am):

• gather information, macroeconomic news
• desk telephones primary government security dealers
• large banks inform the desk about their reserve needs
• NY Fed gather data to provide forecasts of reserves

Step Two (10:30am):

• call to the Treasury concerning its forecast of its balance for the day

Step Three:

• formulate the actions for the day
• forecasts from Treasury, NY Fed, and Fed BoG combined
• interventions are formulated
• trading plan is formulated

Step Four (11:15am):

• conference call links…
• Manager (and staff)
• Director of the Division of Monetary Affairs at Fed BoG
• a Federal Reserve Bank president who sits on FOMC
• proposed actions for the day are detailed

Step Five (11:40am)

• desk traders contact primary dealers and execute day’s program

Update 2:58 pm:  We didn’t expect to proven correct so quickly!  The Fed just announced it is extending TALF (Term Asset-Backed Securities Loan Facility) from Dec 31 2009 to Jun 30 2010 for newly issued CMBS and Mar 31 2010 for newly issued and legacy ABS.  And, no longer will borrowers from the TALF be restricted to using primary dealers (who have the onerous requirement of buying up Treasuries at sloppy auctions).  Now, there are TALF Agents, with four non-primary dealers named today:

• CastleOak Securities, LP
• Loop Capital Markets, LLC
• Wells Fargo Securities, LLC
• Williams Capital Group, LP

No major changes to the Terms & Conditions of TALF, though we expect eligible collateral standards will eventually be loosened again.

Update 3:15 pm:  As to the above list of TALF Agents, all but Wells Fargo appear to be minority-owned and part of the Fed’s Partnership for Progress program.  So why was Wells Fargo thrown in?  Perhaps because it is the largest bank that is not already a primary dealer.

The Precise Take – Continued overnight weakness – will the day session get follow through?

Time Profile:  Today, the Federal Reserve Bank of New York conducts permanent open market operations (POMO) for Treasury securities.  The POMO tape-painting effect has all but disappeared, as evidenced by the charts on page 2. While the noticeable edge was a bullish first hour in July, August reversed the trend with a bearish first hour, mainly due to opening gaps.  Today, we expect an opening gap to the downside, continuing the August trend; however, we can offer nothing more as to the balance of the day from the Time Profile alone.

Trading Today:  Overnight, the ES filled within a tick the market profile volume gap that extended to 1010.50 after selling off at the September 09 contract’s highest point of control at 1025.50.  We would be sellers on an early retracement to the daily gap/pivot area of 1018.50 to 1021.75.  We would also sell a spike high and subsequent reversal on the 10:00 am reports as long as…

Continue reading here.

The Precise Take – Stocks able to bounce despite strong demand at 7 Year auction

Treasury Analysis:  We wrote yesterday that the inability of equities to make gains off bullish to neutral news this week was bearish.  However, their ability to rally in the face of the above average 7 Year auction yesterday is bullish.  It looks like the strong resistance area we noted yesterday in the 30 Year T-Bond futures is proving too difficult to traverse, and without money flowing into Treasuries for the time being, equities are able to gain. 

Time Profile:  Today is a day on which the Federal Reserve Bank of NY will be conducting Agency permanent open market operations (POMO).  The ES has been deviating more and more recently from the POMO Time Profiles, however, we believe it is prudent to be always at least be aware of the statistical tendencies.  For Agency POMO days (nearly all of which have been conducted on a Friday since June 09), there is a slight bullish bias for the day, especially from the 2:30 pm to 3:30 pm hour, with the final 45 minutes having a slight bullish bias, but tending to be more of a mixed bag as indicated by the range of Net Points (thin grey line).  The bullish bias for the day was much more pronounced from Mar 09 to May 09, but still exists and should be considered. 

Trading Today:  As we write, Personal Income & Outlays at 8:30 am has not moved the markets materially.  Accordingly, we have a bullish bias into Consumer Sentiment at 9:55 am, upon which any significant deviation from expectations will likely lead the direction of the markets for the day.  If it’s within expectations, we’ll likely have a…

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1:25 pm EDT:  Bid to cover ratio was 2.74 with non-primary dealers taking about 63%.  All in all, not bad, though the 30 Yr yield spiked up a bit (and subsequently retraced the spike) on the results. 

The day has turned from bearish to neutral now, so we don’t have a directional bias into the afternoon, except for the statistical tendency to have a bearish closing hour because of yesterday’s POMO.  Accordingly, we consider any positions entered in the middle of the day’s range to be aggressive, preferring to fade the range, with stops close to the extremes.

11:41 am EDT:  Paying head to the spike up and subsequent retreat on the 8:30 am reports this morning has paid off, as the ES has fallen, but found support at daily S2.  Though S2 was a potential reversal area marked in our morning report, we preferred to hold out for the 1008.50 to 1011.00 area before attempting any longs.  We will likely remain out of the market until after the 1:00 pm 7 Year auction.  If it comes out average or above expectations, we would expect a resumption of the down trend in equities for the day.  If it comes out poorly, equities could climb into the afternoon.  However, in this (unlikely) scenario, if the ES cannot break the day session high of 1027, by 3:30 pm, we would be wary of holding onto longs.

After further review of the 8:30 am reports and the prior days’ news, we find it bearish that equities have been unable to advance in the face of good (and at least not bad) news.  If the 7 Yr auction cannot move equities higher, there is still Personal Income and Consumer Sentiment tomorrow to close the week, but we do not expect an “upside surprise for economists”.  Further, even if equities head lower into tomorrow, the FRNY has announced today that it will conduct Agency POMO tomorrow, which tends to lift equities into the close, especially when the Thursday before was not itself a POMO day (as is the case this week).  All in all, while the prospects of higher highs in equities is looking dimmer into tomorrow, longs should not fear disaster unless multiple news items disappoint strongly.

The Precise Take – Equities rebound smartly into options expiration Friday

Treasury Analysis:  With the overbought condition of equities having been relieved and a decent turnaround yesterday to reverse a poor opening on Monday, the markets appear more or less neutral.  The 30 year T-Bond future that we monitor as a barometer of the health of long term Treasuries hit resistance earlier in the week, but has not sold off much in light of yesterday’s equities gains.  At 11:00 am today, the Treasury will announce the auction amounts for the slew of auctions that will occur next week to finish the month’s borrowing needs.  The trend has been for one record breaking month after another and we expect no less to be announced today.  It will be important for the 2, 5 and 7 year auctions to go well next week, especially after last month’s poor showing.  But, with the strength of the recent 30 year auction and recent equities correction, long term Treasuries are in a good position to weather a few hiccups.

Time Profile:  Today is the day after the FRNY’s permanent open market operations (POMO) and has typically had a slightly bullish edge into midday and a bearish edge thereafter, accelerating into the close.  Because the two POMO auctions this week on Monday and Wednesday have not produced the typical tape-the-paint closes (yesterday was simply up from the beginning), we are suspect of the pattern for the post POMO day (today) holding.  Rather, we believe it is likely the markets will consolidate yesterday’s action with a nominal new weekly high possible, but a strong directional movement in either direction unlikely.  Existing Home sales and options expiration tomorrow should be market movers and we will post the Time Profile pattern for OpEx days later today.  Thanks to Billy O’Nair for updating us on the upcoming POMO days—there are two next week on Monday and Wednesday and only one the following week.  Ironically, POMO was intended to support longer dated Treasuries, but has also allowed for the large equities run-ups.  With POMO winding down into October, further gains in the stock market will increasingly need to be made on strong fundamentals rather liquidity injections (that is, unless the FRNY comes up with something else in the interim).

Trading Today:  We don’t have a strong directional bias and would merely suggest longs be cognizant of the tendency of a bearish close after two POMO days in the week.  We are intraday bullish above…

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The likelihood of further downside action is increasing and we will still watch 973.25 as a potential reversal area, but are not as enthusiastic about fading long there as downside momentum could develop.  Nor will we short a retracement until the low is taken out at 977.50.  970.50 and 964.75 are the next downside targets after 973.25.  We won’t try to get long unless and until the market gets back above 985.00, with the possible exception of playing the POMO-close long in the late afternoon.