Bond Market's Initial Reaction to Fed Move Was Wrong 12 comments
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Markets were up yesterday because the Fed announced it was prepared to launch a major initiative to buy up to $2 trillion or so of Treasury bonds, mortgage-backed securities, agency securities, and other asset-backed securities. Wow. Those who still believe in deflation should be heading for the exits pretty soon.
I note that yields on Treasury bonds literally collapsed in the wake of the announcement. I think this is one of those times when the bond market's initial reaction to a big change in monetary policy is wrong. Bond yields fell big-time yesterday, but they won't stay down for long. Ok, so the Fed will buy $300 billion of Treasury bonds, but that's only a small fraction of the amount outstanding, and a lot less than half of what the Treasury will be selling this year to finance the deficit.
Putting things in proper perspective, we're talking big-time stimulus now, and it comes very close to anyone's definition of "helicopter money" which is printed up and shoved out of helicopters flying all over the country. This is ultimately inflationary, and the bond market vigilantes will eventually realize that and push yields higher. (As a corollary to this, we should see gold and commodity prices rise and the dollar fall.) Meanwhile, stocks and corporate bonds should move higher, since this virtually eliminates deflation risk, and that has been a major factor weighing down stocks and corporate bonds for the past several months.
The impact on mortgage rates is tough to predict, because MBS spreads can tighten as Treasury yields move higher. But the Fed's move shouldn't be a big negative for housing in any event, because inflationary monetary policy means the bottom in housing prices will come sooner than otherwise. The prospect of rising home prices should significantly increase demand for mortgage financing. A housing market recovery doesn't need lower mortgage rates; what we need is for buyers to realize that prices have stopped falling. As I've said before, one of the sure signs of an economic recovery would be rising yields on Treasury bonds. That hasn't exactly happened so far, but I suspect it won't take long for animal spirits to revive and prove me right.
I'm not saying that yesterday's Fed announcement is a big positive for stocks and the economy, since I've always believed that inflation was bad for equities and bad for growth. But to the extent that expansive monetary policy eliminates deflation risk at a time that the market is priced to a significant risk of deflation, then I do think it is a positive, but a positive which only helps to reverse an awful lot of negative news. Even if equity prices rise another 20%, they will still be miserably low relative to where they were a year ago.
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The Fed's move is akin to stabilizing a critical patient in the ambulance on the way to the hospital. They're not expecting to do real surgery or actually cure the patient, just get him to the hospital alive.
The consequences of these moves will undoubtedly bring on inflation like we haven't seen since the 70s, but Paul Volcker does have experience dealing with that, and he is in the mix of advisors.
The cure for the new inflation will be a second recession, but I suspect the administration and economic team realize this. The Fed knows how to work with inflation. They don't know how to deal with deflation.
The end result of all this will be a restructured economy with some old industries gone and some new industries we haven't necessarily conceived yet growing. General wages will rise, but less quickly than prices, resulting in a somewhat lower general standard of living compared with the developing world. Once the dust clears, the productive capacity of the U.S. will start to kick in once again.
Other courses of action (or inaction) may seem like they'd get the job done quicker, but the resulting chaos and instability would probably threaten to bring down the orderly conduct of all our lives.
Now that the policies are clear, it seems like the wisest course of action is to borrow long at low, fixed rates, invest in assets that keep up with inflation, and choose very carefully to try to avoid companies that are going under (because there are lots out there).
Go out and borrow!
Scarlet O'Hara ain't got nothing on Ben, Tim, Larry -- or their BO masters
The public households will be deeper in debt than ever before and no government anywhere in the world at any time in history has managed to significantly reduce accumulated public debts. The debt service alone will weigh heavily going forward and the way out is either outright default or runaway inflation. the point is, govt and the fed will have more incentives than ever to inflate - and they will do it. The period of relative stability is over - we are going to see big moves from one extreme to the other and back over the coming years - from inflation to deflation and back to even higher inflation and so on.
On Mar 19 10:22 AM Larrysyr wrote:
> There's the immediate crisis, which is financial and deflationary
> and a long-term crisis, which includes lots of restructuring of the
> economy.
>
> The Fed's move is akin to stabilizing a critical patient in the ambulance
> on the way to the hospital. They're not expecting to do real surgery
> or actually cure the patient, just get him to the hospital alive.
>
>
> The consequences of these moves will undoubtedly bring on inflation
> like we haven't seen since the 70s, but Paul Volcker does have experience
> dealing with that, and he is in the mix of advisors.
>
> The cure for the new inflation will be a second recession, but I
> suspect the administration and economic team realize this. The Fed
> knows how to work with inflation. They don't know how to deal with
> deflation.
>
> The end result of all this will be a restructured economy with some
> old industries gone and some new industries we haven't necessarily
> conceived yet growing. General wages will rise, but less quickly
> than prices, resulting in a somewhat lower general standard of living
> compared with the developing world. Once the dust clears, the productive
> capacity of the U.S. will start to kick in once again.
>
> Other courses of action (or inaction) may seem like they'd get the
> job done quicker, but the resulting chaos and instability would probably
> threaten to bring down the orderly conduct of all our lives.
>
> Now that the policies are clear, it seems like the wisest course
> of action is to borrow long at low, fixed rates, invest in assets
> that keep up with inflation, and choose very carefully to try to
> avoid companies that are going under (because there are lots out
> there).
> At this point, the amount of credit destruction far exceeds the amount
> of "money" being created by the Federal Reserve.
Out of curiosity, how did you come to this conclusion? I hear this all the time, but never actually see numbers to back it up.
I'm not disagreeing with you, because I definitely acknowledge that deleveraging is happening in a big way. But to state that the effects of deleveraging is outweighing the effects of the significantly expanded balance sheet of the Federal Reserve is a bit of a blanket statement.
We have to be recognized that at least a portion of the money that has been "removed" from the economy is not destroyed, but hoarded. They are sitting on the sidelines.....sitting in treasuries, in deposit accounts, sitting in banks and companies who are hoarding the cash. These are very large sums of monies that are just waiting to be deployed, but have not due to fear.
We see this fabled "deflation" out there...but perhaps what we are really dealing with here is true inflation, but hidden and stored....waiting to be cashed out when the time is right.
I dunno....just a thought.
On Mar 19 10:22 AM Larrysyr wrote:
> There's the immediate crisis, which is financial and deflationary
> and a long-term crisis, which includes lots of restructuring of the
> economy.
>
> The Fed's move is akin to stabilizing a critical patient in the ambulance
> on the way to the hospital. They're not expecting to do real surgery
> or actually cure the patient, just get him to the hospital alive.
>
>
> The consequences of these moves will undoubtedly bring on inflation
> like we haven't seen since the 70s, but Paul Volcker does have experience
> dealing with that, and he is in the mix of advisors.
>
> The cure for the new inflation will be a second recession, but I
> suspect the administration and economic team realize this. The Fed
> knows how to work with inflation. They don't know how to deal with
> deflation.
>
> The end result of all this will be a restructured economy with some
> old industries gone and some new industries we haven't necessarily
> conceived yet growing. General wages will rise, but less quickly
> than prices, resulting in a somewhat lower general standard of living
> compared with the developing world. Once the dust clears, the productive
> capacity of the U.S. will start to kick in once again.
>
> Other courses of action (or inaction) may seem like they'd get the
> job done quicker, but the resulting chaos and instability would probably
> threaten to bring down the orderly conduct of all our lives.
>
> Now that the policies are clear, it seems like the wisest course
> of action is to borrow long at low, fixed rates, invest in assets
> that keep up with inflation, and choose very carefully to try to
> avoid companies that are going under (because there are lots out
> there).
Looks like a good entry point for TBT (short 20 yr treasuries - note that the fed will be buying 2-10 year treasuries, so why should 20 yr treasuries see increased demand?). It appears the government will be buying about half it's own debt (which is actually typical, believe it or not.).
TIPS bought today should be yielding about 5-6% by year's end, which will make them worth a lot more than today's treasuries (issued at 2-3% yields) will be in an environment of 2-3% inflation. There's about a 10% gain baked into the price of TIP.
Gold prices, on the other hand, reflect an expectation of 10% inflation. If you think future expectations will be even higher than that, gold might be a good deal. The downside is massive if that outcome doesn't materialize - down to about $300/oz if we return to the inflation levels of the 90's. Too risky for me.
As you can see, there is a chasm between investors who see a decade of deflation (treasury buyers) and those who see imminent 10-30% inflation (gold buyers). I'll hang out in the lonely middle where the profits are.
So far it worked, but the author is too right in that it can't last. Especially, when fooling with this is begging foreigners to begin capital flight out of manipulated treasuries. A very dumb move in the long term. Volker must be quietly weeping somewhere.