Wednesday, March 18, 2009

The Debts of the Spenders: The Fed's Gambit To Buy Bonds

Today's big news was the FOMC's decision to purchase bonds in order to keep interest rates low. The Fed's economic recovery plan is contingent on maintaining low benchmark interest rates such as Libor and TED in key maturities such as the 3 month, 3 year, and 10 year. These rates are essential for corporate and consumer borrowers to re-finance at cheaper rates.

Bernanke and other key Fed figures had been coy about the extent of quantitative easing they would resort to up until the FOMC results were released. The market had been pricing in further ABS purchases in a slow but steady attempt to narrow the basis pt spread. Just look at their track record. Even if they did nothing but continue to buy ABS it would be bad for the dollar.

However, the market was surprised when the Fed announced that it WILL begin buying treasuries and reacted accordingly. No doubt the Fed was motivated to act based on several exogenous factors such as China's bombastic attacks questioning the value of their treasury holdings and the mispriced TIC forecast I wrote about in an earlier post.

Sounds like a great plan right? What could possibly go wrong?

Well. For one thing the Fed just invited a lot of speculative money into Treasuries. Unlike government investors (such as China and Japan) that have more of a "buy and hold" mentality the specs could care less about sacrificing the bottom line for political posturing.

Speculators are TRADERS and take profit accordingly. Traders are also considered "nervous money" and are more prone to become bond vigilantes that punish profligate spending by selling in the face of large government deficits. Moreover not all traders are longs. While the Fed may have succeeded in punishing the Treasury shorts they are bound to return - especially as the pace of government auctions picks up in the following weeks.

In fact, a key metric to watch would be the UK's own bond market which engaged in quantitative bond easing earlier this month. However, the UK is economically WEAKER than the US and should foreshadow a sign of things to come. The UK is a nation built on overleveraged finance,
a serious lack of manufacturing capacity, and rapidly depleting North Sea oil.

When the UK bond rally falters examine it for WHY and HOW it lost strength. The same factors will appear in the US since the 2 economies are very similar.

Then the treasury shorts will re-appear in full force. If things get bad enough, there will only be 3 large (bag)holders of treasuries: China, Japan, and the US taxpayer. Debt monetization will result in double digit interest rates and the US will enter the hyper-inflationary stage that goldbugs salivate over.

For more details on this dire scenario:

A more likely result is that the US will enter hyper-stagflation or a period of high interest rates w/decidely little to no economic growth and continued wage depression. Hyper-stagflation is reminiscent of the late 1970's except Obama will become known as "Jimmy Carter II."


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