In the Weeds

The yield on the 10-year U.S. government bond went below 2.5% this morning! Given that the Federal Reserve Bank is now paring back its monthly purchases of government and mortgage debt (its “quantitative easing” or “QE” … see: CNBC Story), this is so counter-intuitive that I feel compelled to explore why this might be occurring. I realize that such an excursion is, to many, a romp in the weeds, but this development is of such vital importance to the future well-being of our economy, that I must get out the ole Weed Wacker.

First the obvious … the yields on government securities are going down (and prices are going up) because there is an increasing demand for this debt … despite the fact that the Fed is buying less of it.  And also, as indicated in the above referenced article, there is also a reduced supply of new government bond issuances due to our shrinking federal deficit.  But, importantly, this effect is just at the margin, it does not diminish the enormous supply of existing U.S. government debt ($17.5 trillion and still growing). In fact, this YTD reduced new federal debt issuances can just about match the decrease in Fed QE purchases (minus $177 billion vs. an estimated minus $150 billion). Therefore this current lower bond yield anomaly appears to be very much more an increased demand phenomenon.

The question then is why is the demand increasing for U.S. government debt. One reason may be that investors were expecting a punky stock market this year (after a booming stock market in 2013) and therefore swung to bonds. According to the above article, “around $85.52 billion has flowed into bond funds so far this year, outpacing the $45.98 billion that flowed into equities over the same period.” Also both the European Central Bank and the Bank of Japan have gone to school on Ben Bernanke’s monetary strategy … and are now out-easing the United States. The result is bond yields in these countries are falling to new lows … see: Business Week Story. This, of course, makes “safer” U.S debt more attractive on an arbitrage basis … and off-shore money is also now flooding into the U.S. bond market.

However be warned, if anyone buying 10-year U.S. government securities expects to hold them to maturity and then get their money back in full, you might be better off smoking another type of weed.

The Laws of Physics

Einstein's Notes

The way to make money is to get an information edge.  Apparently some enterprising traders have found a way of making communications travel faster than the speed of light.  Last week the Federal Reserve Bank's Open Market Committee decided not to start the tapering-off of its $85 billion a month of government securities and mortgages purchasing (aka "quantatative easing").  This was an unexpected decision and thus a bond-market moving piece of news. There are supposedly strict rules to keep this information from leaking out and giving traders an edge.  It is quite apparent that these rules had somehow been circumvented ... and not for the first time.  For the details see: USA Today Story.

The reason it is clear that this breach occurred was that, if it weren't, the communications between New York and Chicago must have traveled faster than the speed of light.  Such "front trading" totaled hundreds of millions of dollars ... reaping millions of dollars of profits for these unknown miscreants. It doesn't seem to me that it would be too difficult to get to the bottom of who these cheaters were ... if the powers-to-be in Washington really wanted to do so.  That is, of course, pretty much depends upon the size of the political donations that have been received from said cheaters ... or the degree of interlocking directorships that exists between the Fed and those trading parties who know how to defy the laws of physics.

Sugar High

Mitt Romney recently spoke to the Federal Reserve Chairman, Ben Bernanke, to ask him not to initiate the Fed's latest round of quantitative easing (QE3).  This request fell on deaf ears ... for the Fed is now pumping $40 billion a month into the U.S. housing market by printing money to buy mortgages ,,, and, unlike previous quantitative easings, there is no indication of when it will stop its monitary printing presses.  This, of course has inflated the stock market and deflated the dollar.

America is experiencing another financial "sugar high" ... with no Michael Bloomberg or Michelle Obama to nanny-state us down.  The Fed has now expanded its normal mandate to effect "full-employment" ... the diametric opposite of its primary mandate of "controlling inflation." (This is because our current administration has no clue on how our economy can otherwise reduce unemployment rates.)  Everyone who has a brain knows that this fire-hose monetary expansion (QE3) combined with the Fed's previous QE1 and QE2, will be inflationary ... eventually  The question is, "When?" 

Perhaps I can propose an answer to this query?  Bernanke and Co. have calmed some investor worries by claiming that they have "a plan" to [eventually] deleverage the Fed's balance sheet.  I will here and now guess what this plan might be -- at some point the Fed will open the flood gates and allow inflation to come charging back.  If the Fed has been, by then, able to substantially extend the maturities of the debt it now holds (which it has been doing with a vengeance under "Operation Twist"), then the price of this government debt will plummet and the Fed can either write it down on its balance sheet or buy it back with dimes on the dollar.  Of course, the fact that other investors of this debt (pension funds and many IRA retirement funds of our seniors ... among others) will be financially hosed seems not to be a concern of the Fed ... as it has bigger fish to fry (getting Obama re-elected).

The reasons that the United States is not experiencing run-away inflation at the moment are three-fold:
- First, the Fed is keeping interest rates artificially low (short term rates are essentially zero) with its open-market operations,
- Secondly, because of our rotten economy and high unemployment, there is virtually no wage inflation (Chicago teachers being a visible exception),
- And lastly, because one of the major drivers of inflation is housing costs (home selling prices are converted to equivalent rental rates), this area has been profoundly deflationary ... offsetting raging inflation in medical and education costs. (One can also argue that food and fuel prices have been obviously inflationary, but, since they are excluded from core inflation calculations, they don't have the impact that they otherwise might.)

Now, let me extend this Fed analysis ... the fact that QE3 is specifically directed toward the housing market through packaged mortgages purchasing leads me to suspect that the Fed's plan to deleverage its balance sheet may, in fact, already be underway.  What the Fed is doing is bound to reduce the cost of mortgages ... therefore increasing the cost of homes.  And, if that one deflationary drag (housing) is eliminated with QE3, might not that usher in real robust inflation?  So instead of suffering from diabetes from all this sugar, the U.S. economy will return to a hypoglycemic state (read out-of-control inflation).

Q.E.D.