Market Observations with Rob Kirby

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In Whose Best Interest?

by Rob Kirby, Kirby Analytics. May 5, 2008

Last week the Federal Reserve's FOMC [Federal Open Market Committee] met and bestowed upon us their latest decision in monetary policy – a further cut of 25 basis points to lower the Fed Funds rate to 2%.

As MSNBC reported:

"The rate reduction, the third this year, was needed to energize national economic growth, Fed officials explained. The deepening housing slump is affecting the behavior of consumers and businesses alike."

Put another way, the FED is cutting rates in hopes of spurring credit demand which in turn spurs on an up-tick in now moribund economic activity.

But with rates again approaching historic lows, economic activity remains stagnant or contracting. Much of this well documented malaise is centered on the housing/sub-prime mortgage bust – where "the hens are coming home to roost" after Mr. Greenspan's experiment with 1% Fed Funds, circa 2003, inspired reckless borrowing, overbuilding and a flourishing trade in new fangled mortgage derivatives to perpetuate the party.

What's different about this round of rate cuts?

First, let us take a peek at money supply growth now versus then [2001]:

Chart compliments of

We can clearly see that broad money growth today is significantly higher than 2001.

From a purely economic standpoint, much of this money growth is simply "offsetting" money destruction as financial institutions "write down" formerly unimaginable amounts stemming from the realization of "off-balance sheet derivatives losses" on mortgage derivatives.

From a moral standpoint, this money growth has had unconscionable effects: namely, creating inflation and undermining international confidence in the dollar.

A Peek at the Past

When credit markets seized up last August [2007] in the wake of reported mortgaged backed securities Hedge Fund troubles at Bear Stearns, the mainstream financial press widely attributed a "stunning" rally in short term interest rates as "a flight to quality trade."

From the chart above, we can see that there never was a flight to quality. In fact, investors were exiting dollars, as evidenced by the collapse of the US Dollar Index [counter-intuitively] at the very same time as dollar denominated debt instruments were going up in price [yields going lower].

So what really happened?

If we take a look at the short term interest rate component of J.P. Morgan's derivatives book – from data supplied by J.P. Morgan to the Office of the Comptroller of the Currency – we can see how the "less than one year" component bloated by 7.5 TRILLION of notional in Q3/07. In Q4/07 this same component contracted by roughly the same 7.5 TRILLION:

The extent of the bloat in this portion of J.P. Morgan's derivatives book, and the fact that virtually ALL of it "ran off" or matured 3 months later, shows that J.P. Morgan "strapped on" many Trillions worth of short term interest rate products that induced the rally in government securities despite the fact the dollar was failing.

Knowing how Mr. Bernanke places so much consideration of "perceptions" and "expectations" where inflation is concerned, it is understandable that the FED would have wanted a "bank" initiating the dramatic rate cuts to come. This is why all the blankedy-blank is fomented in the media about whether or not the FED is "behind the curve" or not. Another ruse.

A 7.5 Trillion intervention of this type could only be the work of a Central Bank.

Unintended Consequences

Despite the notion that the Federal Reserve is seemingly using J.P. Morgan's derivatives book to manage interest rates, market rigging typically brings with it unintended consequences, or in medical parlance, SIDE EFFECTS.

Here's one of them – a "Tell"

Note the time lines and, as 3 month treasury bills plummeted in yield [the ruse of a flight to quality], banks were reluctant to lend, hence libor rates [a gage of where business and consumer can borrow money] lagged [spreads widened] the rally in treasury bills.

And here's the manifestation of the attempted "patch job" on the "tell" above:

Bankers Cast Doubt On Key Rate Amid Crisis
April 16, 2008
The Wall Street Journal

LONDON -- One of the most important barometers of the world's financial health could be sending false signals.

In a development that has implications for borrowers everywhere, from Russian oil producers to homeowners in Detroit, bankers and traders are expressing concerns that the London inter-bank offered rate, known as Libor, is becoming unreliable.

Libor plays a crucial role in the global financial system. Calculated every morning in London from information supplied by banks all over the world, it's a measure of the average interest rate at which banks make short-term loans to one another. Libor provides a key indicator of their health, rising when banks are in trouble. Its influence extends far beyond banking: The interest rates on trillions of dollars in corporate debt, home mortgages and financial contracts reset according to Libor.

In recent months, the financial crisis sparked by subprime-mortgage problems has jolted banks and sent Libor sharply upward. The growing suspicions about Libor's veracity suggest that banks' troubles could be worse than they're willing to admit.

The concern: Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates. Fibbing by banks could mean that millions of borrowers around the world are paying artificially low rates on their loans. That's good for borrowers, but could be very bad for the banks and other financial institutions that lend to them.

True Borrowing Costs

No specific evidence has emerged that banks have provided false information about borrowing rates, and it's possible that declines in lending volumes are making some Libor averages less reliable. But bankers and other market participants have quietly expressed concerns to the British Bankers' Association, which oversees Libor, about whether banks are reporting rates that reflect their true borrowing costs, according to a person familiar with the matter and to government documents. The BBA is now investigating to identify potential problems, the person says...

Three month Libor and 3 month Eurodollar Futures historically trade tic-for-tic with each other. Their divergences outlined above show the "shock" of J.P. Morgan establishing their 7+ Trillion in positions and the "cold turkey" effect when these positions matured.

Conclusion[s]: Interest rates no longer perform their historic function – that of prudently rationing credit. Rates have been engineered to artificially low levels to promote credit creation – the life blood of any fiat money system.

But players in the system, even banks, have lost faith in the rigged system. This is evidenced by their unwillingness to lend, even to one another.

Debt is being monetized and money is being printed at unprecedented rates.

History tells us that ownership of tangibles, especially precious metals, preserves purchasing power by insulating investors from the debasement of fiat money.

Have you adequately protected your assets?

Today's Market

Overseas equity markets began the week on a positive note with Japan's Nikkei Index gaining 282 points to 14,049. North American Markets didn't fare as well with the DOW dropping 88.70 to 12,969.50, the NASDAQ giving up 12.87 to 2,464.12 and the S & P losing 6.40 to finish the day at 1,407.50. NYMEX crude oil futures ended the day at 120.05 per barrel – up 3.73 on the day.

On foreign exchange markets the U.S. Dollar Index fell by .25 to 73.21.

Interest rates ended the day with the 5 yr. government bond yielding 3.16% and the 10 yr. bond at 3.86%.

Precious metals were higher across the board with COMEX gold futures adding 18.10 to 874.50 per ounce while COMEX silver futures gained .35 to finish at 16.77 per ounce. The XAU Index added 5.45 to 174.50 while the HUI Index gained 8.77 to 408.31.

There is no economic news of note due for release tomorrow.

Wishing you all a pleasant evening as well as health, wealth and prosperity!

Rob Kirby

© 2008 Rob Kirby

Contact Information

Rob Kirby | Proprietor, Kirby Analytics Newsletter - Proprietary Macroeconomic Research
Toronto, Ontario, Canada | Observations | FSU Editorials | E-mail

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