Hussman Weekly Market Comment: A Wile E. Coyote Market
The overall effect of the incoming economic data is to suggest that while upcoming earnings reports may be reasonably good from a rear-view perspective of the second quarter, earnings guidance for the second-half of 2011 could tend to be either weak or non-existent.
Unlike 2010, there appears to be little latitude for a robust fiscal or monetary response to the weakening in leading economic measures. Not that we would view any of those responses - aside from facilitating debt restructuring - as promising in any event. Before contemplating a round of QE3, the hawks on the Fed are likely to ask what benefit QE2 provided to the real economy, aside from Fed sponsored speculation, market distortions, and commodity price inflation.
Moreover, as of Wednesday July 7, the Fed's consolidated balance sheet shows $2.87 trillion in assets, versus $51.7 billion in capital, for a leverage ratio that is now up to 55.6-to-1. This isn't getting any better, and is far beyond where Bear Stearns, Lehman, Fannie Mae or Freddie Mac were at just prior to their respective insolvencies. Of course, nobody is going to shut down the Fed just because it is approaching technical insolvency, but we ought to recognize that anytime interest rates rise, the interest being paid on Treasury debt is quietly being used to cover the Fed's capital losses.
The accounts for achieving this are on the liability side of the Fed's balance sheet. As of Wednesday, there was $67.3 billion in the Treasury general account (which is the account where the Fed books interest earnings on its Treasury portfolio, which is normally repaid to the Treasury for public use). Per recent accounting changes at the Fed, losses on its portfolio of Treasury securities are treated as a negative entry in that account, essentially covering the losses with funds that would normally go back to the Treasury. The "Treasury supplementary financing account" has another $5 billion in liabilities to the Treasury. This is the account set up at the Fed's request where the Treasury issues a "special" series of Treasury bills outside of its normal funding requirements, and deposits those funds with the Fed. Given that the Fed cannot afford the embarrassment of a transparent balance sheet, the liability items to the Treasury presently amount to a $72.3 billion cushion that can be used to cover portfolio losses for the Fed. The concern here is not so much the risk of Fed insolvency per se, but the fact that the public is quietly being used as a backstop for what we continue to view as reckless Fed policy.
