QE Unwind is Really Happening: Fed Assets Drop To Lowest Level In Over Three Years

The Fed's balance sheet for the week ending December 6, completes the second month of the QE-unwind. Total assets initially zigzagged within a tight range to end October where it started, at $4,456 billion. But in November, holdings drifted lower, and by December 6 were at $4,437 billion, the lowest since September 17, 2014:

"Balance sheet normalization?" Well, in baby steps. But the devil is in the details.

The Fed's announced plan is to shrink the balance sheet by $10 billion a month in October, November, and December, then accelerate the pace every three months. By October 2018, the Fed would reduce its holdings by up to $50 billion a month (= $600 billion a year) and continue at that rate until it deems the level of its holdings "normal" – the new normal, whatever that may turn out to be.

Still, the decline so far, given the gargantuan size of the balance sheet, barely shows up:

The Fed is unloading its Treasuries alright.

As part of the $10-billion-a-month unwind from October through December, the Fed is supposed to unload $6 billion in Treasury securities a month plus $4 billion in mortgage-backed securities (MBS) a month.

The Fed doesn't actually sell Treasury securities outright. Instead, it allows some of them, when they mature, to "roll off" the balance sheet without replacement. When the securities mature, the Treasury Department pays the holder the face value. But the Fed, instead of reinvesting the money in new Treasuries, destroysthe money – the opposite process of QE, when the Fed created the money to buy securities.

This happens only on dates when Treasuries that the Fed holds mature, usually once or twice a month.

In October, the big day was October 31, when $8.5 billion of Treasuries on the Fed's books matured. The Fed reinvested $2.5 billion and let $6 billion "roll off." Hence, the amount of Treasuries fell by about $6 billion from an all-time record $2,465.7 billion on October 25 to $2,459.8 billion on November 1.

In November, there were two big maturity dates:

November 15, about $11 billion in Treasuries matured. The Fed allowed $3.4 billion to "roll off" without replacement.

November 30, about $7.9 billion matured. The Fed allowed $2.5 billion to roll off without replacement.

For all of November, the balance of Treasuries fell by $5.3 billion to $2,454.5 billion, in line with the plan, and the lowest level since October 8, 2014:

Mortgage-backed securities are a different animal.

As part of QE, the Fed acquired residential MBS guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Now, as part of its $10-billion-a-month QE-unwind, the Fed is supposed to shed up to $4 billion a month in these MBS. And?

At the beginning of October, the Fed held $1,768.2 billion in MBS. The balances then jumped up and down on a weekly basis and ended October at $1,770.6 billion, or $2.4 billion higher than at the beginning of the QE-unwind.

Same scenario in November, though they have started to edge down overall just a tiny bit to $1,767 billion, the lowest by a smidgen since March 8, 2017:

Residential MBS differ from bonds. Fannie Mae et al. regularly pass through principal payments to MBS holders as underlying mortgages get paid down or get paid off. Thus, the principal shrinks until the remainder is redeemed at maturity.

To keep the MBS balance steady, the Fed, via the New York Fed's Open Market Operations (OMO), buys MBS in the "to-be-announced market," or "TBA market." This is a trade where the actual MBS is not designated at the time of the trade but will be announced 48 hours before the established settlement date, which can be two to three months later.

But the Fed books its MBS holdings on a settlement-date basis. So there is a mismatch between the date the Fed receives principal payments and the date reinvestment trades settle. Hence the jagged line in the chart above.

So when will the $4-billion-a-month in MBS reductions show up on the Fed's balance sheet?

The first MBS reinvestment trades under the QE-unwind plan were conducted in October. Given the lag to settlement date of two to three months, the first visible impact on the balance sheet would start no earlier than December. This is where we are now, on the verge of seeing it.

The line in the MBS chart will always bounce up and down due to the mismatch between the date the Fed receives principal payments and the date reinvestment trades settle. But the line should start trending down, with noticeably lower lows and lower highs.

For the first three months, the QE unwind only removes about $10 billion a month, a negligible amount, given the vast markets and excess liquidity. But it picks up steam every three months. By October 2018, if the plan is still on, the QE unwind will remove $50 billion a month from the markets. This process will do the opposite of what QE had done: it will gradually destroy some of the $3.6 trillion that the Fed had created during QE. And by that time the broader effects of QE – asset price inflation – should also start to reverse.

The Dumbest Dumb Money Finally Gets Suckered In

Corporate share repurchases have turned out to be a great mechanism for converting Federal Reserve easing into higher consumer spending. Just allow public companies to borrow really cheaply and one of the things they do with the resulting found money is repurchase their stock. This pushes up equity prices, making investors feel richer and more willing to splurge on the kinds of frivolous stuff (new cars, big houses, extravagant vacations) that produce rising GDP numbers.

For politicians and their bureaucrats this is a win-win. But for the rest of us it's not, since the debts corporations take on to buy their own stock at market peaks tend to hobble them going forward, leading eventually to bigger share price declines than would otherwise be the case. 

The ultimate loser? The only people traditionally willing to buy in after corporations are finished overpaying for their stock: Retail investors, of course. 

Let's see how it's playing out this time. 

First, corporations spent several years elevating stock prices with share repurchases. Note the near perfect correlation between the two lines:

Now they're scaling back their purchases: 

Saying Bye to Buybacks

(Wall Street Journal) – Companies in the S&P 500 are on pace to spend the least on buybacks since 2012

Large companies are repurchasing their shares at the slowest pace in five years, as record U.S. stock indexes and an expanding economy propel more money out of flush corporate coffers into capital spending and mergers.

Companies in the S&P 500 are on pace to spend $500 billion this year on share buybacks, or about $125 billion a quarter, according to data from INTL FCStone. That is the least since 2012 and down from a quarterly average of $142 billion between 2014 and 2016.

Buyback activity among top-rated nonfinancial debt issuers, many of which have regularly borrowed money to finance share repurchases, declined for the third straight quarter in the July-to-September period, according to Bank of America Merrill Lynch. Meanwhile, mergers and acquisitions among that group of companies had their biggest quarter of the year, analysts at the bank said.

Factors including high stock price, historically high share valuations and uncertainty over the future shape of the tax code mean that "companies may be less likely to favor buybacks over other uses of cash in 2018," analysts at Goldman Sachs Group Inc. said in a report this week.

And – here's the really sad part – individual investors are taking up the slack: 

The emboldened retail investor may be a new catalyst to help take stocks higher — for now.

(CNBC) – "The level of enthusiasm about the market … has been building. We're seeing more individuals come in," said Liz Ann Sonders, chief investment strategist at Charles Schwab.

Sonders said she's anecdotally seeing signs of more individuals putting money to work in the stock market in the last several months, after years of skepticism and concerns about "every variety of doom and gloom."

She says she is getting fewer investors asking about bubbles or about what's the next shoe to drop.

"I think it's finally starting to suck people in … emotionally, and actually it's hard to judge why now all of a sudden, but maybe it's because of how persistent the move has been with so little volatility on the upside and on the downside," Sonders said. "This year has been different. This kind of year pulls people in."

Retail brokers have been reporting an influx of accounts. Charles Schwab, in its earnings release, said clients opened more than 100,000 new brokerage accounts a month in the third quarter, making for a record-breaking 10-month streak of new accounts topping 100,000. Its rival, TD Ameritrade, said on its earnings call last month that new accounts, asset inflows and other indicators are at the highest since the financial crisis.

What's frustrating about this is the repeating pattern of government creating conditions in which smart money (that is, the guys who donate big to political campaigns) is allowed to get in early, make huge profits, and then hand the bag to regular people who aren't connected or sophisticated enough to see what's happening. The rich, who are or will soon be shorting the hell out of this market, get richer and the rest see their hopes for a decent (or any) retirement dashed one more time. 

And the political class wonders why voters don't like them anymore.

Systemic Risk? Pffft! THIS, My Friends, Is Systemic Risk

Have you ever asked yourself what happens when you place a trade?
I hadn't given it much thought until about 10 years ago when something happened which opened my eyes to a single company that holds what is probably the most concentrated risk position in the US market. Here's what happened...

So, I took a position in a private placement. The shares came free trading after a 6-month lockup, and the stock had been running like the cops were after it.

It had a half warrant attached, which was deep deep in the money, and I wanted to scoop a healthy chunk of money off the table. Heck, this was a bloody drill play which, as you probably know, are more often than not burning matches. Bright and brilliant until they burn your fingers.

So, I'm busy scrambling to get the stock placed with a broker so that I can trade it.

First up was a very well known broker whose name I'll keep out of the spotlight (I like the guys and gals there and it's not that important). I'll call them broker X.

I have an account with them and they said, "Sure, no problem." A week later, "Ah sorry Sir, we're having some questions from compliance." And then another week passes and "No, so sorry, we can't take that one."

I can't remember the reason now but at this point I'm two weeks down, the stock's "en fuego," and I'm getting antsy. I quickly call my broker at Sprott and they took the stock. This took only a couple of days.

Now, with the stock placed I'm free to trade it. And I do. The same day, I pull up my account at broker X and looky here. There is the original stock sitting in my account. Wait! What?! That can't be. So I pull up my online account at Sprott thinking someone slipped my something in my drink but no...there she is. This is voodoo, or magic, or a cock up. It's in two places at once.

I'm sure if I hit the sell button at broker X their back office will spasm, and before the bean counters can have a heart attack the system will vomit up the true position. Plus, I'm not an ass and knowing the truth I can't in good conscience do that. I only own a certain position, not double it as much as I might wish that was the case.

Down the Rabbit Hole

And so this is what led me down the rabbit hole of actually looking at what takes place when you place a trade.

I contacted broker X and we finally sorted out the problem. They performed their accounting magic and the position disappeared from my account but this is where it scared the isht out of me.

When I asked my broker how did they typically account for client positions I was told that the Depository Trust & Clearing Corporation (DTC) holds the securities.

All securities, I asked?

Yes, all. Or at least 99.99% of all outstanding securities. So broker X (and indeed all brokers) have an account with the DTC, and the two accounting systems need to match, showing "brokers' clients'" securities, which need to reflect the securities held at the DTC on a netted basis.

Ok, I got it. It's a central clearing house. Duh. I'd just never really given it any thought until that day... and it was then that I instantly realised the truly massive concentrated risk.

Massive Concentrated Risk

When you buy a stock, you think you own it. But you don't. What you own is an IOU to your broker dealer. Much like your bank deposit isn't yours because that, too, is an IOU from your bank. Anyone who's ever been caught in a bank run gets this. And anyone who's even read about one gets it.

So like a traditional bank the DTC acts in a similar way. By the way, in Europe Euroclear and Clearstream perform exactly the same function as the DTC does in the land of apple pie.

The DTC was actually formed back in the 70's after the back-office scandals at that time. It was a solution for the increased trading volume on Wall Street, which had become too much to handle, with brokerage firms falling behind with mountains of paperwork, and trades taking forever to clear, and counter-parties not knowing when, where, or who.

The result was that the Wall Street firms could more easily track shares by having to deal only with themselves and the DTC. Companies were and still are eliminated from the process.

So now when a listed company you own look at their share registry, they don't see your name in there. They only see the DTC. And when brokers trade stock, all that happens is a ledger entry at the DTC with a netting taking place. You just own a derivative. Lucky you.

In fact, if you own an option contract, or a warrant, or any sort of derivative, you own a derivative of a derivate. Fun heh!

But That's Not All

Lots of crazy isht can take place here. For example, instead of executing a trade in the market (where it's transparent) brokers can transfer shares between clients and book the trade as a sale.

Transparent? Not so much. Sure, they've an obligation to get you the "best" price in the market, but how's that possible without actually putting it up for sale in the market?

Brokers can and do also lend out your shares to someone who wants a borrow in order to sell short the stock. Often you don't even know about it....small print, being...well small.

Imagine someone borrowed your car because the car park attendant lent it out to them. His job being the safe keeping of your car, and here he is making money by lending it out. If that doesn't make you livid, you're a weirdo. For the rest of us we're none too happy.

Now, this brings up another super crazy setup.

Imagine this: You buy some Tesla stock (silly I know, but let's play the game). You think you own it. You even report it to the tax man. Your broker reports it on his balance sheet, too.

But then he lends it out to a short seller who goes through another broker who, too, reports it on his balance sheet. One security is being reported by multiple parties on their balance sheets. Fractional reserve banking in the securities market.

In fact, there are 5 separate institutions in each trade. Your broker, who processes to the custodian, then from the custodian to the DTC, who then process to the next custodian, who then process to the broker on the other side. No wonder it takes 3 days to settle a trade.

Thank heavens these institutions in this daisy chain aren't levered and at risk of failing. Imagine they were levered.

Oh wait... What am I saying? I'm sorry, I've not had my medication.

So we buy and sell with our fingers crossed that in the trade settlement process (either T+2 or T+3, which I dare say is horse and buggy slow) nothing goes wrong to screw up our trade, leaving us with an IOU from the next Bear Stearns, Lehman Brothers, or MF Global.

Of course, once settled we're still left with this queasy feeling in our stomach because we've got this entity that holds trillions of dollars of stocks, bonds, and derivatives. One single entity. Think about that.

This entire fustercluck of a setup hasn't really changed since the early 70's. Think about what that actually means.  Here's technology from that time.

70's ground-breaking technology

There's a reason we no longer use this stuff. It's antiquated.

And this brings me to something else I've been harping on about here: Cyber security, where I showed you this:

Consider recent data hacks in the corporate sector:

• eBay (NASDAQ:EBAY): 150 million passwords
• JPMorgan Chase (NYSE:JPM): 73 million emails
• Target (NYSE:TGT): 40 million credit card numbers
• Yahoo (NASDAQ:YHOO): 1 billion accounts

So would someone, anyone potentially, be hacking the DTC? Is the Pope Catholic?

When every security is held in one centralised location, is this not the epitome of concentrated risk?

There is, however, an answer to all of this mess...

"Put all your eggs in one basket... the handle's going to break. Then all you've got is scrambled eggs."  (Nora Roberts)