Is the Fed ready for the bond market’s Arab Spring?
We’ve updated our database of the Federal Reserve’s ownership of the U.S. Treasury coupon curve. The resulting chart highlights a couple of interesting issues about its structure and holdings of outstanding notes and bonds.
First, though nothing new, it shows the relatively small stock of longer dated securities and illustrates the ease at which the Fed can repress longer term interest rates and engineer short squeezes. The result has been the castration of the bond market vigilante and early grave for many hedge fund managers.
Second, the Fed holds over 40 percent of the Treasuries outstanding in several of the years in which they mature. In many of the specific maturities, the Fed owns up 60-70 percent of the total outstanding issue. The Fed had to “relax” its self imposed 35 percent limit on SOMA holdings of individual issues and included recently issued securities in order to execute its maturity extension program announced last September.
It’s going be interesting to see how longer-term interest rates behave as the economy regains some of its mojo and money comes out of the Treasury safe haven. The Fed has yet to fight the markets in its repression of long rates as Operation Twist has been riding the tail winds of positive market psychology and strong demand for safe havens due to Europe’s sovereign debt and banking crisis. See chart below.
As the issuance and stock of longer dated Treasuries increase with a larger structural U.S. budget deficit the Fed will need more firepower than just the interest earnings and roll off of maturing securities to keep rates from rising, in our opinion. They will need an even bigger bazooka if they are seen falling behind the curve on the economy or inflation. They will need a tactical nuke if the markets begin to lose confidence in the U.S. government’s fiscal and debt policies and starts to price credit risk. As the greatest QB in NFL history once said, “Confidence is a very fragile thing.”
No wonder there’s still talk of quanto easing and reassurance from the FOMC that interest rates will stay at “exceptionally low levels…at least through late 2014″ even as the stock market moves back to levels not seen since before the Lehman Crisis. Either stocks are wrong at pricing a better future than a U.S. monetary policy still in crisis mode or it will need more QE crack to keep the buzz alive and momentum intact.
We’re the first to admit nobody knows the future, most of all us, but we smell a potential fight or flight in the bond market, comrades. An Arab Spring in the bond pit, if you will. With oil prices north of $100 and rising rents, which is the largest component of the CPI, it is our sense the Fed better be able “to float like a butterfly and sting like a bee.”
We know it’s too early, but maybe this potential macro swan — rising interest rates and an emerging crisis of confidence in the Federal Reserve and the U.S. G’s fiscal and debt policies — has a fatter tail than currently perceived and should be on the radar. You never know, for sure, until you do, but then it’s too late. Thus, we will constantly remind ourselves of this in the new bull market in stocks — i.e., to make sure we panic before everyone else.
As they say in the ring, “Ladies and Gentleman, Let’s get ready to rumble!”
Click on charts to enlarge and for better resolution.
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February 20th, 2012 at 7:20 am
2013 & 2014 are both 100 year anniversaries for The Federal Reserve, giving investors double exposure to The Fed’s prior activities. BTW, today’s post makes me feel like I’m walking in Bernanke’s boots, (wink).
February 20th, 2012 at 7:36 am
The best analogue to Bensane Bernanke’s aptly-named Operation Twist is autofellatio.
Not only does it require uncomfortable contortions, but the good vibes are fleeting.
February 20th, 2012 at 8:27 am
Are we truly dumb enough to keep deficit spending which *requires* more liquidity and lower rates to fund perpetually increasing debts?!
Check!
Are we foolish enough to think monetary policy can address structural problems?!
Check!
Are we foolish enough to think that debt is the solution to a loss in aggregate demand *due to excessive pricing and therefore cost of living* to the extent that trying it again is a prudent solution?!!!
Check!
Are these *remedies* what is actually causing the problems and will they eventually tank capital markets to new multi decade lows while sending us into a full blown massive Depression?
Check!
February 20th, 2012 at 8:46 am
One of the worst downsides of the modern liberal policies is to blind the population to failure, or, since the “safety net” is not broadened to cover middle class “welfare” as well, now much of the population doesn’t care about policy since they never feel the pain of the bad decisions.
Neutering the bond market vigilantes is a bad thing – they might have been helping to brake the deficit. One by one we introduce more deficit spending, and disregard the fact that pain, as evidence of failure, is critical to a capitalist market. We’re doing more and more to hide failure. We must re-introduce failure to the market.
The fiscal leadership, following the **citizens** demands for more deficit spending, can’t tell which policies are working any more, the effects of all policies are hidden behind the false GDP growth of deficit spending.
Liberals are celebrating the power of a government that can spend over a trillion a year to “save” the economy and “help” the people, in reality all we’re doing is rendering our whole country incapable of figuring out what policy is working or not.
We’re just putting sack cloths over everyone’s heads.
February 20th, 2012 at 10:41 am
Mayor,
People who believe Keynsian pump priming is causing a problem need to look at the profits, balance sheets and revenue growth of US Companies. It’s worked. Game over.
Now, the Fed will follow inflation but not before the election is assured (not wise for the GOP to attack the Fed, who can readily defend itself.) Meaning: 1) rate hikes in ’13 if inflation approaches four percent or 2) in ’14 as they promised if under four percent. In fact the GOP blather guaranteed this “until 2014″ thing. Those numskulls.
The only question is how much higher rates will be in ’14. Enough to hit your bond holdings causing you some pain, or to permenantly damage your portfolio? Thank the GOP rhetoric for this clarity.
February 20th, 2012 at 10:48 am
The Fed is not all knowing. There’s no way they can say with certainty that rates won’t rise before 2014. If they were all-knowing they would’ve spotted the sub-prime crisis and understood it for what it was. And agree if the risk trade were truly on, there would be no reason for anyone to go into 1% treasuries.
February 20th, 2012 at 11:05 am
Bernanke’s Folly of accumulating excessive volumes of Treasury securities is a movie that we’ve seen before, when the Fed de facto pegged long Treasury yields at low levels to help finance WW II — and kept on doing it when peace returned.
The Treasury-Fed Accord of 1951 allowed the Fed to end the peg, because inflation was getting out of hand as the Fed held long-term yields under 2.5% — in the same vicinity they are today. Did you know that year-on-year CPI inflation reached an eye-popping 19.89% in March 1947? Thus the 1951 accord:
http://www.richmondfed.org/publications/research/special_reports/treasury_fed_accord/
While the Fed’s in the driver’s seat this time instead of Treasury, it’s still a flawed policy, and it will end for the same reason.
February 20th, 2012 at 11:12 am
I remember thinking 6-pct mortgages were an impossible deal. Then they went below 4-pct.
Now I’m thinking about 20-pct inflation. Seems impossible, but who knows. It certainly did not happen in 2011.
February 20th, 2012 at 11:30 am
Looks to me like if we replace “Other Domestic” with “Pimco”,… the results would be about the same.
Gross messed up,.. he admitted it,… and now,.. here we are.
We all make mistakes.
February 20th, 2012 at 4:22 pm
There is still a fair amount of “twisting” capacity left. But with no more big purchasing in the cards, the Fed will just be left with bending the curve not keeping overall rates low. Will be interesting to see what happens and how fast when the “flight” money starts looking for something better than just return of capital. Those who bet that the Fed will just let things “fall apart” should talk with Pimco.
February 20th, 2012 at 6:21 pm
@venn
1. No. It never worked. The economy grew in SPITE of it not because of it.
2. True Keynsianism requires surpluses to be used to keep aggregate demand growing. Debt cannot be used. That is like trying to put out a fire with gasoline. I’ll post charts later showing it never worked.
Game over my ass! You guys are sooooooo confident as if rates weren’t at zero (!) and total debts at record levels.
Hilarious and quite frankly, tragic.
February 20th, 2012 at 7:13 pm
Okay, so the corporate cash meme in bs:
http://www.usatoday.com/money/companies/management/story/2011-11-26/myth-of-corporate-cash-piles/51346848/1
http://www.ibtimes.com/articles/267763/20111215/corporate-cash-myth.htm
Secondly, gdp minus deficit spending is a mess:
http://seekingalpha.com/article/266601-u-s-economic-growth-gdp-minus-the-federal-deficit
http://3.bp.blogspot.com/-Fx_izWcrzUM/TnZ7ggzYzFI/AAAAAAAADKQ/YgBF-isuKII/s1600/GDP%2Bvs%2BTotal%2BDebt.jpg
http://www.marketoracle.co.uk/images/2010/Apr/us-debt.gif
~~~
BR: We addressed the Corporate Cash issue bacK in 2010
February 20th, 2012 at 8:15 pm
Maybe the Fed’s hair of the the dog debt ‘cure’ can go on for a couple decades like in Japan. Well at least long enough for us to be retired to our Chilean wine estates before it all goes horribly wrong. http://youtu.be/gEmJ-VWPDM4
February 20th, 2012 at 8:19 pm
” True Keynsianism requires surpluses…”
About the only thing the good mayor has ever said that I agree with. Policy in the country ranges for “foot always on the gas”..to outright pro-cyclical, tea party trash(tax cuts in the booms/austerity in the busts).
Remember the surpluses of the late 90′s(considered a threat)? Interest rates kept low in the 2000s inspite of inflation that was running @6%(if actual home prices were used, not owner imputed rents). No wonder we were short of firepower when an actual crisis arises.
February 20th, 2012 at 8:26 pm
A Keynes quote you will never hear in this Koch brothers/ Neo-austrian think tank and PR dominated media environment.
“The time for austerity at the Treasury is the middle of a boom”
February 20th, 2012 at 8:26 pm
Well gman if you agree with that than you must concede that there was a reason for Keynese requiring surpluses not debt. Hey – if prosperity came from borrowing why not just borrow $72 Trillion and hand everyone $100K checks and WHAMMO!
Oh wait- you mean it isn’t that simple?
Of course it isn’t that simple!
February 20th, 2012 at 10:17 pm
Uh, the FED needs higher long term rates. Which was the point of QE and operation twist. The dumb Austrians just can’t get it. They just can’t.
They don’t get the liquidity trap and keep on trying to relive 1931 when their prescriptions put the icing on the top of the greatest contraction in modern history.
There has been some sign of the trap easing lately. Higher IRX for one thing.
February 20th, 2012 at 10:25 pm
Actually, I think Keynes and Friedman would both agree to the above proposition.
Not 72 trillion being handed out, but some large amount of stimulus, be it monetary or fiscal provided it was done COUNTER CYCLICALLY and in a situation where there is where the economy has a lot of excess capacity..LIKE NOW!
Keynes certainly did recommend surpluses in the booms…but nobody like the punch bowl being removed just when the party is getting started.
We have rightfully used the mother of all punch bowls(fiscal and monetary spike) sneaking it away if/when this party gets some real momentum will be a challenge. Either sliding back into deflation ala 1937 or having a replay of the 70′s could be the results of not getting the timing correct.
It is an interesting time to be involved in the markets..sit back get you popcorn.
February 21st, 2012 at 1:08 am
“It is an interesting time to be involved in the markets..sit back get you popcorn.”
Well, I agree with that much of your post anyway. Not much else in there for me to like but hey, it takes all kinds.
It is indeed an interesting time to be alive. Especially if you are an economics junkie.
I think the increasingly likely financial collapse, and the reorganization that follows, will be even more fascinating to witness. Although it will certainly be brutally painful (especially for the underclass-like myself-who have little or no means to prepare for or protect/hedge themselves against such an outcome).
February 21st, 2012 at 11:46 am
@gman;
Yes as much as they hate it “Austerians” are actually half “Keynesians”.
It’s when you get to “the one thing we can’t afford is for eager hands to sit idle” that they jump off that wagon in utter disgust.
February 26th, 2012 at 4:08 pm
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