Seeing Past the Fed's Rhetoric

 | May 28, 2014 | 6:00 PM EDT  | Comments
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I wrote Tuesday about the Federal Reserve's possible motivation for tapering and signaling to the markets its intention to normalize the Fed Funds Rate over the next two years was driven not by the fact that quantitative easing has succeeded and the economy is on the verge of growth, but because QE has failed and the economy is not growing. Although there may be some degree of rationality for pursuing such a strategy, it is only conjecture on my part.

What concerns me most about the Fed, its leader, its governors and its bank presidents is that they individually and collectively do not exhibit an understanding of the real state of the U.S. economy right now, and have not for several years.

Former Fed Chairman Alan Greenspan missed the subprime and housing bubble, even though anyone with a basic understanding of the exponential function could determine that a crisis was a mathematical certainty. His successor, Ben Bernanke, waffled between QE on and off repeatedly for five years, even as economic activity did not respond. Current Chair Janet Yellen and the Federal Open Market Committee are now tapering QE, signaling the intention to raise rates even as U.S. economic activity is actually contracting.

Putting aside the Fed's rhetoric, if they were following their mandate and historical standard operating procedures, the most logical course now would be to reverse the taper and increase QE. If they were to do so, they would also logically (and historically) telegraph the intention of reversing the tapering process because of the declining economic activity.

But they are doing the opposite, which must cause anyone following these events to question whether or not the Fed and the FOMC members are aware of the real state of the U.S. economy. Perhaps the Fed members are simply reiterating and responding with policy rhetoric to the consensus for increased economic activity and growth rates this year, as announced by the money centers and primary dealers.

Halfway through the first quarter, the consensus for real annualized GDP growth as reported by Federal Reserve Bank of Philadelphia was 2%, revised down from 2.5, even as the majority of the severe weather that could negatively affect economic activity was already known. Two-and-a-half months later, the advance estimate was announced as 0.1%. Thursday, the second estimate will be released with consensus now being a contraction of 0.5%.

This degree of error is so large that it should have caused everyone -- Fed members and the private sector -- to fundamentally re-evaluate their methods of estimating economic activity, with a logical conclusion of reduced rates of growth for the rest of 2014. Instead, 12 days ago, these same professionals increased their estimates for GDP growth for each remaining quarter this year.

The logic appears to be that the weather-related slowdown of the first quarter caused pent-up demand that will be exhibited in the remainder of the year. That logic would also stipulate then that long-end Treasury yields should rise.

But that's not happening.

Ten-year Treasury yields have been steadily declining all year, a signal by bond-market participants that they do not agree with the growth expectations announced even by their own firms' economists. This is even more important as it has been occurring while Fed purchases of long-end Treasuries and mortgages has decreased, which should have allowed yields on them to rise if economic activity was increasing and expected to continue doing so.

The question then needs to be asked: Who's buying the Treasuries that the Fed is no longer buying? The answer is the same money centers that are publicly estimating that economic activity is going to increase this year.

In the first quarter of this year, Treasury purchases by banks surged to a 10-year high, with total holdings in the banking system increasing by about $44 billion, to $237 billion from $193 billion -- a 23% increase in one quarter.

This is almost totally accounted for by purchases by the money centers. Bank of America (BAC) Treasury holdings increased to $27 billion from $6 billion; Wells Fargo (WFC) increased to $6 billion from $500 million; and Citigroup (C) went to $83 billion from $69 billion. These three firms alone purchased more Treasuries than the Fed reduced buying through the taper, sending long-end yields down in the U.S. in the process.

In the past month, since the first-quarter GDP estimate was announced and future GDP estimates were raised, which should have caused the 10-year Treasury yield to rise; it has instead declined by 22 basis points. The lack of continuity between the words and actions of the Fed and the banks should give every investor pause.

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