Interpreting and profiting from markets is not an erudite academic exercise, practiced by learned gentlemen. After almost 30 years, I know it’s a bare knuckled brawl in which disinformation reigns supreme. How apt that metaphor is for today’s interest rate complex.Click to enlarge
I applauded QEI as an essential intervention to stem what could have been a protracted and crippling deflation. Times were desperate and the Fed innovatively inflated enough of the real estate market to prevent the deflation from metastasizing; the Modern Depression was over in “internet time”. Emboldened by the awe and majesty of that fix, the Fed then expanded their role from economic patriarchs to more benevolent monarch(s) by introducing QEII.
I do not believe QEII is, as advertised, intended to stimulate consumption by keeping money cheap. Low cost does not give money velocity unless/until it is borrowed. Presently, only the best individual risk and large corporations have access to reasonably priced credit. Therefore, the low cost of money is moot to most of us. No, the cover story for QEII is merely disinformation. QEII’s mission is to constrict credit by keeping a lid on lending margins. It effectively forces banks to rebuild their loan portfolios from the top down and the cover story lets them keep their pride. The Fed can’t trust the same banking cartel that underwrote the real estate bubble to self-police.
The pace of this recovery is now being governed in a way that I’m unaware of historically, with the Federal Reserve managing the entire yield curve. QEII is successfully squeezing out as much recovery as possible, without the risk of inadvertently inflating another bubble by giving banks too much incentive to lend. The real estate bubble, the latest experiment in democratizing credit, didn’t work out too well, so a little more control is being imposed. Bernanke is not giving the banks an opportunity to weave the lending rope they are so adept at hanging themselves with.
The Fed brought short term rates to nothing at the inception of the Modern Depression, and that acted to “privately nationalize” the banks back to health. It worked by forcing deposit interest to nothing and offering banks risk-free interest on reserves from Treasuries to stay in business. The banks got to shrink their non-performing portfolio while taking a lending breather. So, if the Fed’s QEII is guaranteeing bank profits, shouldn’t the velocity of money be increasing? Because of the atmosphere of heightened risk, the banks want more profit margin to lend again.
OF COURSE IT’S A JOBLESS RECOVERY – IT’S A CREDIT-LESS RECOVERY
Creditworthy new businesses are what grow the economy out of recessions. Due to present circumstances, they are having great difficulty rising from the ashes of their deceased progenitors for lack of credit. Now that banks are flush with cash, it’s therefore axiomatic that lack of bank loan incentive is holding back this recovery/restoration and, higher long-term rates will mitigate that dam. Ironically, a policy of making only the strongest stronger is a destabilizing force as it re-concentrates the largest businesses instead of broadening the base; it squeezes the middle class.
Unlike normal circumstances, where higher long-term rates act to slow growth, higher rates are now required to continue this recovery. I expect both rising long-term rates and more credit to continue this expansion. So far, QEII has successfully subverted normal market pricing for long term debt and obscured incipient inflation. Therefore, I'm a buyer of TBT, double short 20-year treasuries.
Taking this extraordinary measure of control (QEII) tempts providence because monetary inflation is already in full bloom. Bidding up long term debt is unlike propping up any other asset; inflation will not be denied. Holding down the inflation-meter (long term bond yields) with QEII only confuses the public, not inflation. QEII creates the risk of going from one extreme right to the other. The longer interest rates are artificially suppressed, the greater the risk of an unintended recession from hyperinflation or 70’s style stagflation.
I am certainly not recommending a return to the absence of lending standards that inflate all bubbles. I am saying QEII is a mistaken policy and is creating unnecessary peril. There will be a price to pay for a continued policy of spartan credit to worthy borrowers. Interest rates will catch up to the “nonexistent” inflation, eventually. When market forces are restored, it might create a riotous sell-off in bonds, forcing the Fed to then abruptly raise the Fed Funds to prevent the hyperinflation genie from escaping.
Alternatively, let’s say QEII does “successfully” slow growth in an environment of continuously rising inflation; the risk then rises for resurrecting the Ghost of Stagflation past. CNBC is not asking for an interview, nor am I being considered for a position as a Fed Governor, however, I believe we’d be tracking just fine without QEII.
Presently, long-term interest rates are the fulcrum on which the economy is balanced; lower is slower and I believe higher rates will insure this recovery continues. Going where no Fed has gone before, this Fed is managing the entire yield curve to 1) ensure the immediate survival of the banking system on the short end and 2) ostensibly prevent the creation of another bubble on the long end.
By my book, the Fed is right less than half of the time, and I think they're wrong right now. The same book reads that if they don’t allow more credit soon, they will be cleaning up yet another monetary misstep.
Disclosure: I am long TBT.
Additional disclosure: Leveraged seller of long-term treasuries, leveraged buyer of US equities and buyer of India and Israel equities.