The Atlanta Fed’s Weekly Highlights points out that only $12.7B of the $175 agency debt and $110B of the agency MBS purchase programs remain to be deployed. With the $300B in Tsy purchases dried up already from last fall, this means 92.5% of QE liquidity has been injected, and less than $125B remain.
This has drastic consequences for risk assets, which have been running up based on carry trades dependent on hot money inflows from QE injections and a declining USD (also a consequence of QE, among other liquidity injections). Factor in the fractional-leverage potential of the Treasuries portion of QE (which were deployed ultimately to Primary Dealers, many of which are banks that can speculate in securities) at a 10:1 baseline leverage ratio, and the amount of liquidity that has already been injected inches up to 97.4% of total liquidity.
Clearly there are significant demand holes in both the Treasury and mortgage markets that will require a second iteration of quantitative easing, but with Bernanke’s reappointment itself not even certain, there’s going to need to be a resurgence in political capital for any substantive QE 2.0 to occur. And yes, of course, that means asset declines. Be watching to see if Bernanke drains excess liquidity through TOMOs, as unwinding the permanent purchase portion of the Fed’s asset book seems highly unlikely at this point, considering an expansion in fact is the more likely (and necessary) scenario. Also be watching the Exchange Stabilization Fund operations to see if there’s any USD reverse repos funded by EUR or JPY sales from the ESF asset books. The Treasury did this back in the summer of 2008 during the commodity bubble to stabilize the dollar via reverse repurchase agreements with interest paid in foreign currencies.
Dollar liquidity runs the world at this point, and will continue to do so until dollar-denominated debt is cleared from the system, most likely primarily through debt inflation with small episodes of deleveraging and writedowns to replenish political capital for more injections. The declining dollar (caused by dollar liquidity injections) is responsible for short-term credit access for foreign banks and domestic banks, as well as driving up risk assets via carry trades. That marginal liquidity is all but gone and the real-economy level cash flow problems are sufficient to cause deleveraging and a rush to USD, if excess marginal liquidity is taken out of the picture. Whether the Fed or Treasury intervene through TOMOs or ESF EUR- or JPY-funded reverse repos may turn out to be irrelevant, because of the secular credit crunch. But a rush to dollars (and especially dollar-denominated debt) is absolutely necessary for the United States at this point, and the sovereign funding crisis is going to be bigger issue going forward in 2010 than financials solvency crisis. It’s a circular process, from (1) natural deleveraging and credit crunch, to (2) reactionary injected liquidity (which causes a declining USD), to (3) capital outflows from Tsys, to (4) reactionary liquidity injection cessation or even liquidity drain, to (5) inflows into Tsys and back to deleveraging and credit tightening.
With 7.5% of QE liquidity remaining, we are somewhere between (3) and (4), if not between (4) and (5). Caution is prudent.
The Atlanta Fed’s paper is republished below.