I have proved that long term yield would ultimately reach such a low level that it would cause a Liquidity trap and a Market Crash of epic proportions, as I predicted since 1994 that the market will get, sooner or later in a Liquidity Trap. (This movement of long-term yields goes by several names: Irrational Exuberance, Greenspan Conundrum,or Bernanke Savings Glut.).
During that 16 years of research on the subject I had ample time to study the different options the central banks, accademics and international bodies have been studying for avoiding or exiting a Liquidity Trap. In the latest years, in order to escape Internet searches, I suppose, they called it "the zero lower limit" or the "zero limit".
Despite my expectation of a decrease of long-term yields its recent fast pace has raised my eyebrows.
I had to conclude that the Fed is already secretly using again Quantitative Easing.
The main cause of that hunch is that the fall of long-term yield has been so fast not even interrupted by the retracements of the fall in Stock Indices, the effect of the reprieves of the European crisis or the sharp fall of the TED spread.
Moreover the fall has been such that I have never seen the market breathing like it should have done. This is the effect of a huge market player that is sure of market trend beyond any doubt. It is a player that was careful not to go through its regular intermediaries which are the primary security dealers even giving them contradictory information in the form of a small reverse repo operation.
I also wondered why would Ben S. Bernanke visit the white house with such poor agenda for an exceptional meeting when it is known that the Fed is so independent from the executive.
As we all know now the end of Quantitative Easing is painful for bond holders and the time is not far away when they will all tell to themselves if the Fed want them so much let's give them as much as they can eat. When Quantitative Easing will end or when market participants will believe the party will soon be over we will witness a vast retrenchment from long-term assets as yields will go up suddenly from these low values to their fair value which is around 4.60% given the present volatility of interest rates and the 0% rate of the fed fund target.
We already know that the use of Quantitative Easing has made the Fed the proud owner of more than $2 trillion of securities without creating either some sort of private long term investment or inflation. So why the Fed is using such a desperate policy.
For those of you who don't know about the research of the Fed, central banks and academics about the Liquidity Trap and how to get out of it here is an extensive list:
- Creating the expectation that the 0% level of interest rates will last for a long time.
- Devaluation of the currency in order to export the deflation and the Liquidity Trap.
- The famous Quantitative Easing.
- Targeting the inflation rate.
The first one we know has been used extensively. The second one can be used only against the Yuan and has already reached its limits. The last weapon is Quantitative Easing. We already know that the Fed was prepared to use it up to a level of $5 trillion only $2 trillion have been used up so far.
The question is then why use such a formidable and useless tool. What makes the Fed so nervous? What do they know and we don't.
What They Know we Don't:
First what we know and we should have been more careful about. Chairman Ben S. Bernanke has always been a proponent of a targeting the inflation rate as a way to avoid the Liquidity Trap. Even if, for some reason, he have never stated it as a policy objective we know that he made recommendations to targets 2.00%. The latest data about inflation are much lower than that target and no monetary or fiscal policy tools have not succeeded in reaching it.
A much more important factor is something the Fed has started to hide from us although it is an essential measure of the efficiency of its policy: the M3 component of money supply which gives some measure of how much of the liquidity injected in the system finds its way into real investments.
The publication of that data was conveniently interrupted on March 23,2006. Why such a crucial data, particularly in the case of a Liquidity Trap would be suddenly obliterated?
Some however have been reconstructing these data among which John Williams' Shadow Government Statistics. What we can see is very worrying. They show that year on year and since the beginning of 2010 M3 has been decreasing sharply which exactly means that banks are lending less and less and prefer sitting on a cushion of cash. It is exactly what happens in a Liquidity Trap.
As we see on the following chart long-term yield have rebounded to their normal level (4.60%) five month after the start of the only episode of Quantitative Easing we know of. (There was another such an operation which finished also with an enormous flop: Operation Twist which ended with the abandon of the gold standard in 1971.)
So if we suppose that the beginning of the new episode of Quantitative Easing started during the first week of April we must conclude that its effectiveness (in maintaining long-term yields artificially low) should end around the beginning of September.
We must conclude that the same way the increase of short term yields up to 5.25% did cause the Subprime crisis, the Greek Crisis was caused by a disordlely decrease of long-term yields engineered by the Federal Reserve System (and not the reverse).
Why did the Fed Chose That Date?
I suspect that it had to do with the Federal Reserve Transparency Act of 2009 (also known as H.R.1207) which states that the Fed will be audited before the end of 2010. It will find out that the Fed owns hundred of billions of MBS which trade at a sharp discount from their purchase price given the amount of default witnessed since they bought them and the vast amount of bonds and notes bought at an excessively low price for the sake of implementing the dubious Quantitative Easing. So Ben S.Bernanke rather than being cornered and restricted on the use of open market purchase of securities has prefered to put congress devant le fait accompli.
Let me remind you what Professor Bernanke said in 1999 about the legality of the central bank operation in his speech "Japanese Monetary Policy: A Case of Self-Induced Paralysis?". Ben S. Bernanke. Princeton University. December 1999. For presentation at the ASSA meetings.
"I will argue here that,to the contrary, there is much thatthe Bank of Japan, in cooperation with other government agencies, could do to help promote economic recovery in Japan. Most of my arguments will not be new to the policy board and staff of the BOJ, which of course has discussed these questions extensively. However, their responses, when not confused or inconsistent, have generally relied on various technical or legal objections—-objections which, I will argue, could be overcome if the will to do so existed. My objective here is not to score academic debating points. Rather it is to try in a straight forward way to make the case that, far from being powerless,the Bank of Japan could achieve a great deal if it were willing to abandon its excessive caution and its defensive response to criticism."
Let me also remind you of some remarks made by Charles Evans, the president of the Chicago Federal Reserve Bank, as they were reported in Marketwatch
He said Wednesday he was wary of calls for the Fed to buy more assets to stimulate the economy."There are limits to what policy can do," Evans said in a television interview on CNBC. "Iam wary of how effective those policies would be," he said. The U.S. economy is not faltering and growth will continue around a 3.5% rate, Evans said. While the monthly data has been uneven and there are moments when it looks like growth has paused, "I am expecting growth to continue -the recovery is definitely on," Evans said. The Chicago Fed president said he was not optimistic about the pace of employment growth in coming months. He said inflation has recently moved down in a sharp, unusual, fashion and should be under 2% for the next three years.
That is as close as a direct and public criticism of a possible secret action of the Chairman of the Federal Reserve as it can be.
I remind you also that the ECB has, during the Greek Crisis, used "sterilized" purchase of bonds. We can't imagine that such a purchase was not coordinated with the Fed.
Another fact that was troubling was that given the decrease of yields after the flop of the Chinese bluff I expected the Fed to gesticulate uselessly over the week end which apparently did not occur. It did but secretly.
Why the Secrecy?
If the first round of Quantitative Easing was a public display of power of the central bank, a second open round would cast a shadow on the efficiency of the tool.
We all know that although it is a professional duty of a broker to keep silent about his customers and its operation it is rarely the case. Given the pattern of the movement in the exposure of PIMCO which has recently extended the share of long dated US Treasury notes and bonds at a surprisingly low yields and the fact that it is the only non broker which could have bought such a volume without arising some sort of suspicion, we can reasonably assume that the Federal Reserve used this channel to intervene on the bonds' martket.
How do we Know the Party is Over?
As I said most of the Primary Security dealers are short the long end of the yield curve. We also saw that after the rout on the bond market the Yield on the 30 Years US Treasury Bonds stayed in the range 3.60%-3.80% for 3 months. We also know that the recent low (before this one) was around 3.90%. It is reasonnable to consider that once the 3.90% support is broken they will collectively run for cover and buy a suprisingly high share of the long dated auctions bringing the yield in the range 3.60%-3.80%. Because of the low rate of indirect bidders that will signal a rise in long-term yields. We can reasonably expect that that auction will be that of August 11-12. Ingeneral in this kind of configuration the auction on 10 years note is successful while the auction on 30 years note is deemed dismal.
All this is corroborating our expectations for a Market Crash on the short run. Given the preceding arguments I expect that the shock that will bring the long-term yields to their fair valuation will be the Quadruple Witching Hour on September 17th from 3:00 PM EST till 4:00PMEST. That will create a sharp retreat from long-term investments from the prevalent low rate a market preference for cash over any form of long-term investment and a market crash. Till then you can sleep well: the stupid belief of humanity in the powers of its leaders will prevent any crash. My faith in human stupidity has always been highly rewarded and I never had to wait to go to heaven to reap its fruits.
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