Good Luck Unwinding That

A few months ago, when discussing the most pertinent topic for Bernanke and his merry central-planning men we said that “with every passing week, the Fed’s creeping takeover of the US bond market absorbs just under 0.3% of all TSY bonds outstanding: a pace which means the Fed will own 45% of all in 2014, 60% in 2015, 75% in 2016 and 90% or so by the end of 2017 (and if the US budget deficit is indeed contracting, these targets will be hit far sooner). By the end of 2018 there would be no privately held US treasury paper. Still think QE can go on for ever?” What followed was 3 months of heated debate on whether the Fed will or will not taper which for some reason were focusing on the wrong thing – the economy. Ironically, how the economy is doing has nothing to do with the Fed’s decision, which is entirely decided by the increasing shortage of private sector “quality collateral” i.e., bonds.

How big is this shortage? As noted above, the Fed’s literally absorbs ~0.3% of the bond market each week. And according to the most recently released Fed balance sheet data, this is indeed the case. According to SMRA calculations, the Fed owned about 31.47% of the total outstanding ten year equivalents. This is above the 31.24% from the prior week, and higher than the 30.99% from the week before – a rate of increase almost in line with what we predicted. Inversely this means that the percentage of ten-year equivalents available to the private sector decreased to 68.53% from 68.76% in the prior week. Long story short, the Fed just soaked up 0.23% of the bond market in one week and half a percent in two weeks, a ratio that will only increase in time, and unless there is a taper, may reach 0.5% per week.

At that level of bond market “takeover”, the liquidity in what was once the world’s most liquidity bond market, already lamented by the TBAC as we showed earlier this week, will evaporate entirely and the daily bond halts that were a norm in Japan in April and May will promptly come to the US. Only at that point, unlike the BOJ which had the Fed to fall back on, there will be no Plan B, as the opportunity cost of an illiquid bond market is the reserve currency status of the dollar and the credibility of the Fed – the two are interchangeable. Which also means the future of the entire global fiat system will be on the brink.

Which brings us to the point of this post.

Clueless economists and pundits are happy to trot out every now and then a chart showing the ratio of the Fed’s balance sheet to GDP, which supposedly is meant to indicate that the Fed owning 20% of US GDP on its books is normal.

What said clueless economists never seem to grasp is that a Fed whose balance sheet is full of 3 month bills is completely diffrerent than a Fed whose balance sheet is full of 30 Year bonds. And the best way to represent that is by showing the 10 Year equivalent holdings of the Fed.

Presenting Exhibit A: the Fed’s balance sheet represented in the form of 10 Year equivalent holdings.

The long-term average is ~4%. As noted above, it just hit 31.47% this week. And even with a taper (especially since the untaper will be just around the corner once the market crashes and the Fed has no choice but to jump right in), we fully expect that the Fed will hit its current SOMA limit of 70% of any and every CUSIP across the curve by 2016.

Take one look at the chart above, and extrapolate it reaching twice as high.

And then imagine how this Mt. Everest of 10 Year equivalents will be unwound.

Good luck with that.


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