The Fed Actually Begins its QE Unwind

But what's happening with mortgage-backed securities?

Thursday afternoon, the Fed released its weekly balance sheet for the week ending November 1. This completes the first month

of the QE unwind, or "balance sheet normalization," as the Fed

calls it. But curious things are happening on the Fed's balance sheet. On September 20, the Fed announced that the QE unwind would begin October 1, at the pace announced at its June 14 meeting. This would shrink the Fed's balance sheet by $10 billion a month for each of the first three months. The shrinkage would then accelerate every three months. A year from now, the shrinkage would reach $50 billion a month – a rate of $600 billion a year – and continue at that pace. This would gradually destroy some of the trillions that had been created out of nothing during QE. Over the five weekly balance sheets since the QE-unwind kick-off date, total assets rose initially by $10 billion from October 4 to October 18 and then fell by $14 billion, for a net decline of $4 billion. By November 1, total assets were $4,456 billion:

The Fed is supposed to unload $10 billion in October. Instead it unloaded $4 billion. And the variations from week to week are entirely in the normal range of the prior months.

The chart below shows the Fed's total assets since 2007, covering the entire QE period from the Financial Crisis on. The tiny $4-billion decline in October gets lost in the massive table mountain of assets:

BBut a first real step has happened.

As part of the $10 billion that the Fed said it would shrink its balance sheet in October, it was supposed to unload $6 billion in Treasury securities.

The way the Fed undertakes the balance sheet normalization is not by selling Treasury securities outright but by allowing them, when they mature, to "roll off" the balance sheet. In order words, when they mature, the Treasury Department pays the Fed the face value of those securities. Then, instead of reinvesting the money in new Treasuries, the Fed destroys the money. This is the opposite of what it had done during QE when it created the money to buy securities.

On October 31, $8.5 billion of Treasuries that the Fed had been holding matured. If the Fed stuck to its announcement, it would have reinvested $2.5 billion and let $6 billion (the cap for the month of October) "roll off." The amount of Treasuries on the balance sheet should then have decreased by $6 billion.

And that's what happened. This chart of the Fed's Treasury holdings shows that the balance dropped by $5.9 billion, from an all-time record 2,465.7 billion on October 25 to $2,459.8 billion on November 1, the lowest since April 15, 2015:

So the QE unwind of Treasury securities has commenced.

But mortgage-backed securities?

As part of the $10 billion unwind in October, the Fed was also supposed to unload $4 billion in mortgage-backed securities (MBS). How did that go so far?

On October 4, it held $1,768.2 billion in mortgage backed securities. On October 18, this spiked by nearly $10 billion to $1,777.9 billion. Since then, it has fallen by $7.3 billion to $1,770.6 billion, but remains $2.4 billion higher than at the outset of the QE unwind:

Clearly, the Fed has not yet kicked off the unwind of its MBS portfolio. Since the end of QE, the Fed's Open Market Operations (OMO) has continually purchased small amounts of MBS in the market. Residential MBS are different from bonds. They regularly forward principal payments to their holders as underlying mortgages get paid down or off, and the principal shrinks until whatever is left is redeemed at maturity. To keep the MBS balance steady, the Fed has to buy MBS in the market.

And it has continued buying them in October with stoic routine.

This bifurcation – that the QE unwind is happening with Treasury securities but not with MBS – is curious. But MBS take a while to settle, which could explain some of the delay. After the on-target $6-billion drop in Treasuries, however, I'm tempted to think that the QE unwind of MBS will also eventually materialize, and that the overall package will proceed as announced.

For now, the amounts are small. By next year at this time, the QE unwind, if it happens as announced, will proceed at a rate of $600 billion a year, a momentous monetary policy change, partially reversing the effects of QE, including QE's effect on asset prices.

And the surge in asset prices has been a doozie.

The Year Was 1989...

These folks were probably worth more than Justin Bieber.

And this guy was still alive... and even though dressed like a peacock, amazingly popular.

1989 was also the year the Japanese stock market topped out. Background Most economic crises are the result of an economic boom which leads to investors getting all giddy, bidding up assets to the point where they become completely disconnected with reality. Japan in the 70's and 80's was no different. People are people, everywhere and always. Even if they do eat oodles of raw fish and seaweed.

In the 70's, after they'd nicked a lot of German ideas, Japan managed to produce the world's second-largest gross national product (GNP) after the US. And, get this: By the late 1980s, Japan ranked first in GNP per capita worldwide. Record-low interest rates had fuelled a stock market and real estate speculative boom that sent valuations screaming throughout the 80's. In fact, at one point a piddly little 3-square meter piece of dirt (enough to stick a portaloo on) near the Imperial Palace sold for $600,000. The Imperial Palace itself was worth more than the entire state of California. If it sounds crazy, it's because it was. Upon realizing that the bubble was unsustainable and potentially destabilising for the economy, Japan's Finance Ministry ratcheted up interest rates to try and curb the rampant speculation. It was all far too late, and the move quickly led to a stock market implosion and debt crisis as borrowers failed to make payments on debts, many of which were backed by assets which themselves had been bid up in a speculative frenzy and now worth a whole lot less. In the bloodbath that ensued, Japanese investors lost their shirts kimonos, and the Imperial Palace could no longer be sold to buy George Clooney's Hollywood bathroom. Fast forward to today and you'd be forgiven for thinking the place was about to be nuked by young Kim, who is more likely to have his shiny rocket wobble about in the sky for a bit before crashing... or not taking off properly at all. The point is: If you were to run a poll today, you'd probably find that the the perception amongst money managers is that the only folks who've been buying Japanese equities, (which includes us) are ones who've taken a knock to the head or been dropped on their head at birth. And that's not all. Bloomberg recently pointed out that less than 10% of Japanese households own any equities. That's basically none. Zero. Zilch. Nada. Marginal Buyers Which brings me neatly to another much lovedthesis of mine. It was Mark Twain who said: "Courage is not the absence of fear; it is acting in spite of it." Well, I say, risk is not the absence of consensus; it is the deafening roar of it. So what's the risk today? Well, risk is highest when your pool of marginal buyers are the smallest, and consequently the lowest when your pool of marginal buyers the greatest. I always look for markets where marginal buyers are either exhausted (none left, everybody is already in) or they're sitting there at the train station watching the rain, just waiting for a reason to board the next train. Bad News... Pffff Something else. I've always looked at turning points in markets and one of the best signs of a stealth bull market I've ever seen is a market which continues to rally on bad news. And there's been a fair bit of that in the land of the rising sun. Toshiba — Japan's answer to Enron:

Mitsubishi, after admitting to falsifying fuel efficiency data. Naughty, naughty!

Kobe Steel with their own scandal. Very naughty!

These follow scandals at Nissan, Toyota, and Takata Corp. And the market? Rallying. Who Leads? Another thing I look at is small caps. Why? Because small caps are like Mahatma Gandhi — they're natural leaders. Here's the small caps:

One word. En fuego! (Ok, I lied... 2 words). Not only that. They actually make money and pay shareholders. How unique! In fact, if like me you're on the lookout for stuff like this you'll realise that this market actually got cheaper over the last decade...while it's gone up. How so? Dividends grew faster (97.5%) than prices (29.2%), so on a price-to-dividend basis they're even cheaper today... all the while we've been making money.

And for you technical geeks out there, here's something to chew on. The Nikkei 225 just broke a key 38.2 percent Fibonacci-retracement level. The next retracement of 50% stands at 22,981.49. Today, as I write this we trade at 22,539. Mmmm So marginal buyers are large. Bad news is being bought not sold. Technicals couldn't be better. Companies actually make money. And today you could buy much of the Japanese banking industry if you were to liquidate Elon's vanity project that incidentally incinerates cash and uses funky math.

WORSE THAN 2007': Top banker warns of looming wave of worldwide bankruptcies

The world's financial system has become dangerously unstable and faces an avalanche of bankruptcies that will test social and political stability, according to a leading global banker.

William White, chairman of the OECD's review committee and former chief economist of the Bank for International Settlements, who suggests the stresses in the financial system are now "worse than it was in 2007".

Speaking to the UK Telegraph's Ambrose Evans-Pritchard before the start of the World Economic Forum in Davos, White warned that macroeconomic ammunition to fight further economic downturns is essentially "all used up".

"Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief," he told the Telegraph.

"It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something."

Instead of pondering whether or not bankruptcies will occur, White suggests the only question that needs to be answered is "whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly".

White suggests that the US Federal Reserve, fresh from raising interest rates for the first time in nearly a decade in December, is now in a "horrible quandary", carrying the unenviable task of trying to foster an economic recovery while moving away from ultra-easy monetary policy settings.

He believes that easy money policy settings from the Fed, and others such as the European Central Bank and Bank of Japan, simply brought spending forward from the future, creating dangerous cycle that is now losing its potency to spur demand.

"By definition, this means you cannot spend the money tomorrow," he told the Telegraph.

Aside from being demand forward in developed economies, another consequence was to exacerbate asset bubbles in emerging markets such as Asia, pushing asset prices higher on the back of what was - at the time - cheap US dollar denominated debt.

According to Evans-Pritchard, this saw combined public and private debt in emerging markets surge to 185% of GDP, up an alarming 35 percentage points since the peak of the previous credit cycle in 2007.

In OECD nations a debt boom of a similar scale also occurred, taking the overall debt-to-GDP ratio for 34-member group to 265%.

China, at the epicentre of market concerns in recent months, has seen its debt loading climb from 158% of GDP to over 282% over the same period according to analysis from Bank of America-Merrill Lynch.

The chart below reveals the alarming acceleration in the nation's debt loading.

It's little wonder that White, and others, are concerned.

Debt has ballooned while global growth has slowed to a crawl - all at a time when many central banks are already pushing the absolute limits of what stimulus monetary policy can deliver.

If monetary policy, after creating the issue, is no longer in a position to solve it, what can possibly be done to address the situation?

White believes governments hold the key, telling the Telegraph that "they should return to fiscal primacy - call it Keynesian, if you wish - and launch an investment blitz on infrastructure that pays for itself through higher growth".

It's a controversial call, particularly as it would almost certainly require governments to take on even greater amounts of debt.

World Bank & IMF: The World Could Be Heading For Another Financial Crisis, Volatility Products Loom As Next Big Market Shock… Any Time Now?

WB Concerned Over Global Debt Overhang

The World Bank has warned that unless countries across the globe address issues relating to borrowing, the world could be heading for another financial crisis.

In its World Economic Outlook report for October 2017, it noted that discouraging further debt build-up through measures that encourage business investment and discourage debt financing will help curb financial risk taking is the only solution out of a potential crisis, news outlets reported.

In its 'Africa's Pulse' report released earlier this month, the financial institution had warned on the growing debt overhang and how it was impacting negatively on development. Interestingly, there are fervent calls for the federal government to cut down on its borrowing which many economic watchers say is sustainable. The report also noted the need for monetary and fiscal authorities to provide clear paths for policy changes as it will help anchor market expectations and ward off undue market dislocations or volatility.

According to the World Bank, central banks should ensure a smooth normalization of monetary policy through well-communicated plans on unwinding their holdings of securities and guidance on prospective changes to policy frameworks.

"Financial authorities should deploy macro-prudential measures, and consider extending the boundary of such tools, to curb rising leverage and contain growing risks to stability.

The International Monetary Fund has warned that the increasing use of exotic financial products tied to equity volatility by investors such as pension funds is creating unknown risks that could result in a severe shock to financial markets.

In an interview with the Financial Times Tobias Adrian, director of the Monetary and Capital Markets Department of the IMF, said an increasing appetite for yield was driving investors to look for ways to boost income through complex instruments.

"The combination of low yields and low volatility facilitates the use of leverage by investors to increase returns, and we have seen rapid growth in some types of products that do this," he said

Equity market volatility has plumbed to its lowest level in a decade, with the Chicago Board Options Exchange's implied volatility index, also known as the Vix, sitting at a level close to 10 compared with an historical average of about 20.