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Shalom Hamou
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Our Goal: Propose as soon as possible an economy after the inevitable financial crash has occurred. That market economy is free of credit. So it will strip the banks from their relevance. Registration for ☮ La Nouvelle Économie. will be closed the day of the crash at the close of the NYSE,... More
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  • The Limit of Quantitative Easing. 0 comments
    Aug 24, 2010 7:01 PM
    I wrote an article the day before yesterday entitled  "The Nemesis of Long-Term Yields [Bottom]" which I updated yesterday with an Instablog post entitled "Nemesis Updated". There I explained why long term yields would increase from the low we witnessed yesterday. Now people are getting nervous about a double dip and further steps of monetary stimulus. I am explaining here the consequences of the bottom of the yields on long dated treasuries for Quantitative Easing and why it is signals its inefficiency.

    What is Quantitative Easing?

    When short term yield are close to 0% and for obvious reasons the central banks are not able to lower their yields central bankers came out with the idea of lowering long term yields by buying long dated Treasuries in order bring down interest rates to a level that would be consistent with a higher level of investments (One of the consequences of the recession is that businesses won't borrow as the cost of funds is higher than their expected returns while banks wouldn't lend as the prevailing rate doesn't pay for the risk of default and the interest rate risk.

    How Low can it Get?

    Theoreticaly the open market purchase from the Fed would push investors to buy Treasuries and Corporate Bonds to a level that would be below the prevalent market price. As I explained in the Nemesis a long-term yield is an option on short term yield with a strike at 0% and an implied volatility equal to that of interest rates.

    There is hence a fair value of long-term yields, the fair value of the option, which defines the normal yield curve. My estimate is that given the prevalent data that yield would be 3.5% for the 10 Years US Treasury Notes and 4.60% for the 30 Years US Treasury Bonds.

    Buying at a lower yield is akin to buying an over valued option. That does occur because that option is very complicated to arbitrage. However, as I explained in "Nemesis" that undervaluation has a limit and my estimate is that that limit is somewhere below 3.60% for the 30 Years US Treasury Bonds and 2.50% for the 10 Years Treasury Notes, levels we reached already yesterday with a low of 3.543% for the US Treasury Bonds and 2.469% for the US Treasury Notes.

    Click to enlarge


    Any yield below that would cause any profit maximizing investor to retreat from long term investments and prefer cash even at 0.00% and that would include Banks, Mutual Funds Hedge Funds and Sovereign Funds (Remember the China scare that has yet to materialize but soon will.). We are witnessing already that phenomenon with the yield on 2 Years US Treasury Notes reaching an all time low of 4.60% yesterday.

    Why it is not a Stimulus?

    The idea of a stimulus is that if you can artificially generate a sufficient volume of consumption or investments then those who did react to that stimulus would profit and would globally lift consumption, income and investments: a win-win proposition.

    In the case of Quantitative Easing it is a loss loss proposition. Suppose you invest in the debt of a corporation in that dismal economic environment: either it fails and the borrower defaults or it succeed and you lose because with higher interest rates the Net Present Value of your bonds go down the drain.

    With that perspective would you lend money? Probably not neither would I and nobody else either.

    Previous Failures:

    It has been done 2 years ago. It has also be done in Japan resulting in what has been called a lost decade which is now 17 years old. last but not least it has been done in what was called Operation TWIST in the 60's and which has been such a failure that it has resulted in the abandon of the gold standard. see the article "Going Boldly Where we Have Gone Before"- an Historical Episode About Long-Term Interest Rates not Worth Repeating by Adam M. Zaretsky from... The Federal Reserve.

    Private Investments on a Death Row:

    The increased probability of default will soon push up the default risk premium. Even if the increase in the Yield of Long Term Treasuries will be small (down to a maximum of 4.60% on the 30 Years Treasury Bonds and 3.50% on 10 Years US Treasury Notes the fall of the value of corporate bonds and in particular junk bonds will be formidable.

    Debt Rally Cracking as Swaps Soar, Yield Spreads Flatline: Credit Markets

    Conclusion:

    Even if the vulgus pecum thinks of the Federal Reserve System as a Deus ex Machina mathematics are stubborn Quantitative Easing has already reached its limits. The auctions of 7 Years US Treasury Notes tomorrow, 10 Years US Treasury Notes on September 8th and the auction of 30 Years US Treasury Bonds on September 9th promise to be formidable flops. 

    As it occurs before any auction long term yield will rise today with the formation of an island reversal which will propel the yields to, at least, and in a few days, close the gap on the 10 Years Treasury Notes at 2.85%

    Market Crash: Be Prepared. With 14 days to go 470 are ready.
    There is a saying on Wall Street: "Sell at Rosh HaShana (Sept 10th) buy on Yom Kippur (Sept 18th)": bad luck this year on Sept. 17th from 4:00 PM EST to 5:00 PM EST is Quadruple Witching Hour and Yom Kippur fall on a saturday! Shana Tova Ve Tsum Kal!

    Disclosure: No Positions
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