I have a treat for you today. Casey Research Chief Economist Bud Conrad takes center stage in this edition of The Room, to explain a new tool in the Federal Reserve’s monetary arsenal—one that the Fed is using to quietly drain cash from the economy with almost no one noticing.
Bud’s analysis is excellent, and as far as I know, he’s the first to unearth the implications of the Fed’s new program.
Then Doug French follows with a thought-provoking piece about the exploding price of whiskey.
Let’s get to it.
The Fed’s Stealth Tightening
As expected, the Fed tapered its purchases of mortgage-backed securities on Wednesday to $15 billion per month and its purchases of longer-term Treasury securities to $20 billion per month.
That means total monthly purchases, which were $85 billion last year, are now down to $35 billion. That’s a significant cut.
The Fed also cut the range of its full-year 2014 real GDP growth forecast, from 2.8%-3.0% down to 2.1-2.3%. That was no surprise, considering that GDP in Q1 was negative 1%, and it may have been a bit of a warning.
If you’re familiar with my work, you know my no-confidence stance on Fed prognostication. But just to make my opinion clear: I think the Fed is in the business of obscuring the truth. Official inflation numbers vastly understate actual price rises:
- Housing in California is back to its pre-crisis peak;
- Stocks are at record levels;
- Food prices jumped 0.7% in May alone; and
- Anyone who drives knows that a tank of gas is far more expensive than it was a year ago.
The Fed’s claim that inflation is contained and that there is no need to raise interest rates is just a show put on for people who believe the government. If we applied a more accurate inflation rate to GDP calculations, real GDP would not be growing at all.
My point is that the Fed and the media tell us things are better than they actually are. Meanwhile, the Fed is taking secret actions that reveal where Yellen and friends really think the economy might be headed.
The Fed’s New Tool: Reverse Repo
Traders have used Repurchase Agreements ("repos") for decades. A repo is essentially a collateralized loan. A borrower sells government securities to a lender and buys them back later at an agreed-upon date and slightly higher price. The lender takes on very little risk, to earn a small amount of compensation while it holds the government securities as collateral.
Repos can last for any amount of time, but they are often ultra-short-term. Overnight repos are the most common.
The Fed has announced that it’s using “reverse repos” as a new tool to manage monetary policy. Don’t let “reverse” confuse you: Reverse repos are just a way the Fed soaks up cash from financial institutions. The Fed is the “borrower,” swapping its Treasuries for banks’ cash. You might call it the opposite of quantitative easing: reverse repos drain money from the financial system.
I was surprised to find that the use of reverse repos has exploded since last September, by about $200 billion, bringing their total to $300 billion:
The Fed can also use repos to add money to the system, as it did in the early stages of the 2008 Credit Crisis:
By netting repos with reverse repos, we can see their combined effect on monetary policy over time:
As you can see, the Fed is quietly using reverse repos to drain the money supply. Remember, this is on top of the taper. Net, the Fed is being less accommodative than most are aware of.
How Repos Fit into the Fed’s Balance Sheet
The following chart illustrates how the Fed’s liabilities (sources of funding) changed dramatically during the financial crisis.
The Fed funded and continues to fund its quantitative easing programs with bank deposits. Here’s the rundown on how that works:
- The Fed creates cash from thin air.
- The Fed buys Treasuries and mortgage-backed securities (MBS) from banks with that freshly minted cash.
The Fed pays banks 0.25% interest as an incentive to keep the new cash on deposit at the Fed.
That huge $2.8 trillion in deposits is a risk source, because the financial institutions could withdraw those funds at any time, if they think they can generate better returns than the 0.25% interest that the Fed pays.
Reverse repos are also a source of funding for the Fed: they provide cash for the Fed to continue purchasing Treasuries and mortgage-backed securities.
Though reverse repos are only a small portion of the Fed’s balance sheet, they are important. As the growth of the yellow “deposits” have tailed off, reverse repos have picked up much of the slack.
In effect, the Fed has sopped up $200 billion in the last nine months in “stealth tightening.” I use the word "stealth," because most investors, and even most Fed watchers, aren’t aware of the effects of reverse repos.
You’re probably wondering, "What’s the Fed’s ultimate plan here?" I think that the Fed is using reverse repos to build up a hidden source of funding so that it can unwind its tightening quietly, if need be. The Fed now has $200B in “ammunition” that it can deploy without much (or any) fanfare, because nobody is following this closely. “Reverse Repos” isn’t the headline grabber that “Quantitative Easing” is.
As a side note, notice that the Fed’s capital is so small that you can barely see it. If the Fed were a bank subject to market forces, the slightest negative surprise would render it insolvent. But of course, it has a monopoly over the printing press, so it needn’t worry about such things.
One last reason the Fed might be secretly building a rainy day fund: As my analysis in the newest issue of The Casey Report demonstrates, foreigners have recently stopped lending money to the US. That’s a huge problem for a country that had a $111.2 billion trade deficit in the first quarter alone, and will spend half a trillion more dollars than it takes in during 2014.
As I said earlier, the Fed has been very quiet about this repo program, so we can only surmise what its true motivations are. But as the US government’s lender of last resort, the Fed may be raising this source of cash so it can lend more money to the US government as foreign lending continues to dry up.
In conclusion, the credit crisis of 2008 changed our financial system in many ways. Whether this latest repo experiment is just another Band-Aid on the money balloon, or something more, it’s well worth keeping an eye on.
[Editor’s note: You can find Bud’s data-driven analysis in every single edition of The Casey Report. Start your 90-day risk-free trial now to read the current issue plus two more, access all of the current stock picks, and peruse the archives before deciding if The Casey Report is for you. If it’s not, no problem—just call or email for a full and prompt refund. Click here to start your no-risk trial subscription to The Casey Report straightaway.]
Whiskey: For Drinking or Hoarding?
A comedian quipped a few years ago, “You might be a redneck if your 401(k) is invested in NASCAR decanters.”
When cheap money creates bubbles, suddenly the absurd become investment strategies. Whiskey, for instance, isn’t just for drinking anymore. There’s a bull market in hoarding this precious liquid.
Beyond the deluge of new high-end brands and colors added to Johnny Walker’s rainbow, Charles Passy wrote in the Wall Street Journal, “Spirits and collectibles experts say we’re in something of a bull market for whiskey.” Scottish company Whisky Highland says, “Prices for the 1,000 most-prized releases of single-malt Scotches have risen around 175% since 2008, based on auction figures.”
And the prices of high-end brands are not the only ones climbing upward. The price of a 750ml bottle of Cutty Sark (1970 vintage), a middle-of-the-road blended Scotch, went for $67 in 2008. The price was flat to down until late last year, but now that bottle goes for $107.
A metric fifth of 1970 Dewar’s White Label fetched $131 in August 2012, then fell to $104, but will now set you back $167—the same as a 12-year-old bottle of 1970 Chivas Regal. That’s a strange anomaly given that Chivas’ retail price of $35 is considerably higher than Dewar’s, at $25.
If you’re wondering how central bankers can possibly be worried about flat-to-falling prices amidst this whiskey-flation, consider the price of a bottle of 1980 Johnny Walker Blue Label. During my boom-time, Scotch drinking days, Blue was the taste of heaven. Strangely, its price has gone nowhere. In January 2007, a 1980 vintage bottle went for $213. Last month: $214.
No wonder Janet Yellen and Mario Draghi lay awake at night worrying about deflation. They could use a drink.
For years Doug Casey has recommended stocking up on “consumer perishables,” such as motor oil, ammunition, light bulbs, toilet paper, cigarettes, dried beans, soap, sugar, and of course, liquor. In the coming “Greater Depression” a good supply of these items will give you plenty to trade and may be the difference between survival and something worse.
But Doug isn’t talking about paying outrageous prices for whiskey as if it were precious art. Last year, 20,211 bottles of collectible whiskey were sold at auction, nearly four times more than the 5,431 that were sold in 2010. “And in some cases, bidding has reached the kind of frenzy previously seen only at sales of the most famous artists,” writes Mr. Passy.
“Earlier this year, Sotheby’s set a new benchmark for the most-expensive whiskey sold at auction: a rare six-liter bottle of Macallan, a famed single-malt Scotch producer, that went for $630,000.”
People Drink While Central Bankers Print
While the monetary mandarins surely like punters to dole out six figures for whiskey, they also prefer consumers to hoarders. According to the Distilled Spirits Council of the United States, domestic spirits consumption increased more than 105% over the 13-year period from 1999 to 2012, which included both the dot-com and real estate booms and busts. Throw in beer and wine, and alcohol consumption per capita increased nearly 43% during that same period.
But it’s the hard stuff that’s driving growth. Last year, non-collectible whiskey sales grew 10.1%, and single-malt sales gained 14.7%.
That’s impressive growth for alcohol consumption, but it still pales in comparison to the 157% growth in the M2 money supply since 1999.
Booze Shares Get High
Investors who lack the space to store bottles are bingeing on booze stocks. Diageo PLC, owner of Johnny Walker and J&B, is trading at nearly 19 times earnings. Pernod Ricard, the owner of Chivas and The Glenlivet, trades at 20 times earnings. And Brown-Forman, owners of Jack Daniels and Early Times, trades at over 30 times earnings.
Why so expensive? Because cheap money and lots of drinking doesn’t just lead to hangovers, but to takeovers too. Suntory Holdings Ltd. purchased Beam Inc. this year for $16 billion. Suntory’s offer valued Beam at about 20.5x EBITDA (earnings before interest, taxes, depreciation, and amortization). That’s a steep premium compared to the 12x EBITDA median paid in 16 purchases of wine and spirits businesses over the past five years.
Tulips or Whiskey, There’s Always a Bust
Sure as a screaming hangover follows too many drinks, the booze boom can’t last forever.
“Some experts say too many distillers are rushing to find whatever older barrels they can in their warehouses and releasing product that isn’t necessarily collectible,” writes Passy. “And putting the whiskey in special packaging—say, a pricey crystal bottle—doesn’t make the actual liquid any more valuable.”
Like in any boom, this whiskey one has its doubters. But at least as many are drinking the, um, Kool-Aid. Passy says there are “experts who insist that investors in quality whiskey will be protected. Some suggest focusing on respected, popular Scotch distilleries—such as Macallan, Dalmore, Bowmore, Ardbeg, Glenfiddich, Glenlivet, and Port Ellen—and on whiskeys that are truly limited in release.”
Don’t bet on it, though. Expensive bottles won’t save you from a crash. During the great tulip bulb crash in January 1637, rare bulbs plummeted along with common ones.
When this bender ends, a whiskey-price hangover will surely follow.
John Oliver Explains FIFA Corruption
That’s It for this Week
Have a fantastic weekend!
Managing Editor of The Casey Report