The Fed's Bubble Trouble 22 comments
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A few weeks ago, when the Fed announced a strategy designed to bring down long-term interest and home mortgage rates through unlimited Treasury bond purchases, government debt staged a spectacular rally. To the unschooled market observer, the spike may be difficult to understand. After all, why would the value of Treasury bonds rise while their underlying credit quality is deteriorating faster than Bernie Madoff’s social schedule? The move is actually a perfect illustration of the tried and true Wall Street strategy of “buy the rumor and sell the fact”.
If it is well known that Fed will be a big purchaser of Treasuries, those buying now will be positioned to unload their holdings when the buying spree begins. If the Fed pays higher prices in the future, traders can earn riskless speculative profits. If the traders lever up their positions, as many are likely doing, even small profits can turn unto huge windfalls.
The downside of course, is that all of the demand for Treasuries is artificial. Treasuries are now in the hands of speculators looking to sell, not investors looking to hold. These players are analogous to the mid-decade condo-flippers who flocked to new developments for quick profits. They did not intend to occupy their properties, but rather flip them to future buyers. Once these properties came back on the market, condo prices collapsed, as developers were forced to compete for new sales with their former customers.
This is precisely what will happen with Treasuries. Just as the U.S. government issues mountains of new debt to finance the multi-trillion annual deficits planned by the Obama Administration, speculative holders of existing debt will be offering their bonds for sale as well. In order to prevent a complete collapse in the bond prices the Fed will be forced to significantly increase its buying.
However, since the only way the Fed can buy bonds is by printing money, the more bonds they buy the more inflation they will create. As inflation diminishes the investment value of low-yielding Treasuries, such a scenario will kick off a downward spiral. But the more active the Fed becomes in their quest to prop up bond prices, the bigger the incentive to hit the Fed’s bid. The result will be that all Treasuries sold will be purchased by the Fed. But with the resulting frenzy in the Treasury market, and with inflation kicking into high gear, we can expect that demand for other debt classes that the Fed is not backstopping, such as corporate, municipal and agency debt, to fall through the floor, pushing up interest rates across the board.
In order to “save” the economy from these high rates the Fed will then have to expand its purchases to include all forms of debt. If that happens, run-away inflation will quickly turn into hyper-inflation, and our currency will be worthless and our economy left in ruins.
To avoid this nightmare scenario, the Fed should pull out of the bond market before it’s too late and let prices fall to where real buyers, those willing to hold to maturity, re-enter the market. Given how high inflation will likely be by the time this happens, my guess is that long-term Treasury yields will have to rise well into the double digits to clear the market.
The grim reality, of course, is that when the real estate bubble burst, the government was able to “bail-out” private parties. However, when the bond market bubble bursts, it will be the U.S. government itself that will be in need of the mother of all bailouts. If U.S. taxpayers or foreign creditors are unwilling or unable to pony up, and if the nightmare hyper-inflation scenario is to be avoided, default will be the only option. If misery really does love company, Bernie Madoff’s clients might finally find some comfort.
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This article has 22 comments:
During this year, which is the 200th anniversary of the birth of Charles Darwin, it is just possible that a modified version of the “survival of the fittest” dynamic could begin to appear in the sale of bonds by different governments across the globe. And the US government is the least likely to default because it has the benefit that everyone else will have to adapt to the more hostile environment for financing deficits in order to protect their vast holdings of the global reserve currency and their existing holdings of US Treasury paper.
By way of illustration, last week there was a noticeable lack of interest in the German Bund auction with the Bundesbank retaining 32% of the issue. The US government was able to sell a huge new issue of three year bonds with a bid to cover ratio of 2.2:1, which admittedly was somewhat weaker than the average bid to cover ratio, but nevertheless it turned out a lot more successfully than the fears that are beginning to surface in the eurozone market. In addition the UK government in coming months will almost certainly face similar difficulties to those seen in Germany last week as it tries to finance its massive deficits and has to rely on international investors' appetite for a currency which is arguably even less robust than the euro.
If things do get as ugly as you are suggesting, <b> Too big to fail </b> will begin to emerge in the way that sovereign debt is valued and allocated in global capital markets.
Of course the ultimate beneficiary in that kind of struggle will be the US Treasury. With foreign governments holding trillions of dollars worth of US government debt - both explicitly underwritten and agency debt that has an implicit guarantee – these governments can be relied upon to show up at US government auctions, even if they do bear a remarkable similarity to a Ponzi scheme.
The big difference to other Ponzi schemes is that the existing clients of the US Treasury market have vital self-preservation interests at stake that will cast aside any nagging doubts about the wisdom of continuing to feed new money to this voracious financial beast.
That’s the good news.
The bad news, as you have rightly suggested, is that the price that will have to be paid in terms of yields offered by the US Treasury will have to go a lot higher. Whether this all leads to a systemic breakdown and hyper-inflationary collapse I shall leave to those with a more apocalyptic imagination.
The one thing I am pretty confident about is that if the dollar collapses along with the Treasury market then there are not going to be too many safe places, where the rule of law is respected, to hide, and not even possession of gold bars is going to provide much of a security blanket
Sorry, I am getting confused. Just which Ponzi scheme are we talking about here?
I'll add the suggestion that the current fad of bullishness on municipal and corporate bonds will prove false, except perhaps as a short-term trading opportunity. Longer maturity investment grade or municipal issues will be decimated by the inflation tsunami that is likely to hit in 2010-2012.
It should be clear to you that there is no relative currency that holds up when the dollar falls. Due to the intermarket dependancy of banks and investment vehicles around the world, its should be clear to you that the impact of a dollar demise is followed by inherent break-down of world markets. Just like we saw in last August.
Again this will develop to a big slam on the stock markets. But above all, like Peter Schiff indicated, the bond market collapse/US default.
Deleveraging continues! Part II.
On Jan 11 08:56 AM patio wrote:
> This inflation or even hyper-inflation you describe, is not the price
> of goods per se, but the dollar's devaluation/demise. Relative to
> what? The yen, yuan, euro, real??
> Your logic is compelling and it is a very scary scenario that you
> have painted but there may be some consolation for the US government
> in all of this - based on the notion of "survival of the most indebted".
>
> During this year, which is the 200th anniversary of the birth of
> Charles Darwin, it is just possible that a modified version of the
You just reposted someone else's article:
seekingalpha.com/artic...
Increased gold prices are one way of increasing the money supply as cash is changed for gold. What we really need is for every billionaire to give 10% or so of their worth to needy people today, not as an institution. They could easy immediately put $10-20 billion back into circulation! No impact on our federal balance sheet.
I'm just waiting for men with guns, uniforms, and black bags to start enforcing this kind of populism. I'm on a boat to international waters before they ever make it to my house.
On Jan 11 12:32 PM Top Gun wrote:
> The debt needs to be paid, as long as there is huge (non-treasury)
> debt, excess cash in the system will flow to return principal to
> creditors rather than to inflation. The Fed will re-inject the debt
> it acquired as this excess is absorbed. Very complicated, and I'm
> sure some bright Fed PhD has modeled the whole thing.
>
> Increased gold prices are one way of increasing the money supply
> as cash is changed for gold. What we really need is for every billionaire
> to give 10% or so of their worth to needy people today, not as an
> institution. They could easy immediately put $10-20 billion back
> into circulation! No impact on our federal balance sheet.
Peter Schiff said it best in a tale of 6 or 7 people stranded on an island...everyone Asian, but one American. The Asians all have jobs-gathering food, fishing, hunting, etc. The American's job is to eat. Economists all claim the American is critical to the island's economy, since without him no one would have to hunt, fish, grow food, etc. The American is the backbone of GDP!
This is the current state of the world. The reality is that everyone would be better off without the American eating all their output! They truly don't "need" us, our dollars, or our debt.
On Jan 11 11:56 AM secmaven wrote:
> The world needs US dollars to facilitate trade and commerce. The
> Fed purchase of government debt creates the dollars the world needs.
> When every commodity and manufactured good and real estate improvement
> is in excess supply due to the unemployment of a large percentage
> of people who otherwise would be consumers the talk about inflation,
> much less hyper inflation, because we create more dollars is nonsensical.
> The result of current policies will be the dollarization of the world
> if we keep our country a nation of laws, public order, no bribes,
> high public education standards, etc. Obama's wide popularity will
> greatly support the dollar as well.
www.youtube.com/watch?...
On Jan 11 01:44 PM Rob Viglione wrote:
> The fundamental fallacy is that the world does not "need" US dollars
> or US junk debt. This illusion will one day fade.
>
> Peter Schiff said it best in a tale of 6 or 7 people stranded on
> an island...everyone Asian, but one American. The Asians all have
> jobs-gathering food, fishing, hunting, etc. The American's job is
> to eat. Economists all claim the American is critical to the island's
> economy, since without him no one would have to hunt, fish, grow
> food, etc. The American is the backbone of GDP!
>
> This is the current state of the world. The reality is that everyone
> would be better off without the American eating all their output!
> They truly don't "need" us, our dollars, or our debt.
>
> On Jan 11 11:56 AM secmaven wrote:
This is, of course, wrong. The FED could purchase the entire 2009 budget deficit with no effect on prices (inflation), and it would hold up the price of government securities (temporarily).
You fudged with the word "temporarily". It takes about a year for the inflationary effects of money creation to be felt, and I've never heard a serious economist dispute this. But inflation is a given, every year, and Schiff is correct. The inflation will at first just counter the price deflation we're seeing, then negate it, and then it will take on its own life. I think we're in for double-digit price inflation by the end of the year, and Katie bar the door next year.
On Jan 11 02:34 PM flow5 wrote:
> "since the only way the Fed can buy bonds is by printing money, the
> more bonds they buy the more inflation they will create"
>
> This is, of course, wrong. The FED could purchase the entire 2009
> budget deficit with no effect on prices (inflation), and it would
> hold up the price of government securities (temporarily).
*velocity of money (specifically, does money printing in the face of collapsing money velocity really cause inflation?)
*paradox of thrift: would his prescriptions of non-intervention lead us to there? To take the island analogy further, once the American stops consuming, will the Asians increase their consumption, or become even more miserly in their expenditures, with collapsing GDP as a result? The early signals are for the latter.
suppose you went back in time and saw the housing bubble coming a mile away. would you freak out and start shorting mortgage companies in 2003? no, that would be stupid. you would buy into the mania, ride the bubble to the top with the rest of the dumb herd, and THEN start shorting a few years later.
It is time for direct action by the people!
The gig is up, and it's just a matter of time before the rest of the world realizes the emperor is naked.
On Jan 11 01:44 PM Rob Viglione wrote:
> The fundamental fallacy is that the world does not "need" US dollars
> or US junk debt. This illusion will one day fade.
>
> Peter Schiff said it best in a tale of 6 or 7 people stranded on
> an island...everyone Asian, but one American. The Asians all have
> jobs-gathering food, fishing, hunting, etc. The American's job is
> to eat. Economists all claim the American is critical to the island's
> economy, since without him no one would have to hunt, fish, grow
> food, etc. The American is the backbone of GDP!
>
> This is the current state of the world. The reality is that everyone
> would be better off without the American eating all their output!
> They truly don't "need" us, our dollars, or our debt.
>
> On Jan 11 11:56 AM secmaven wrote: