Sunday, December 12, 2010

Is QE 2 Really The Titanic?


As the vast and loyal readership of Clearcut Bainbridge already know, the Institute For Economic Reality has been a pretty good fade for calendar year 2010.  The IER predicted a rising US dollar and falling "everything else."  This wasn't lost on the senior fellow level of the IER, and I had a short, but prosaic posting where I would be eating large helpings of corvus brachyrhynchos.  The mighty US dollar was the Pee-Wee Herman of Venice Beach, and the equity, debt, and commodity markets were Rambo on a 'roid rage.  Capping off all that was the two weeks prior to The FED announcing yet another asinine program to prevent the price discovery of banking assets (Quantitative Easing 2.0, or QE2), I took an unfortunate spill body surfing and spent my fortnight's leave in Hawaii lying in bed with a shattered shoulder and bombed on pain meds.

Just as I was going to press with my "101 Ways To Eat Crow" article, I placed a call to the IER's Great Lakes Associate Fellow to see what she had to say, and she told me to stand down from admitting defeat and check out the European bond spreads in the more dysfunctional economies (that's everyone but Germany).  Apparently, after a few liters of Irish single malt, things get a little foggy on the concept of actually paying back money you borrow to live beyond your means.

Sure enough, Ben Bernanke's idiotic plan to thwart the normal restorative properties of a free market and credit based hard currency system has blown up in his face almost as fast as a dumb insurgent tinkering with a roadside bomb.  Stocks are mixed, but the bond market appears to be treating Ben the same way the American voters treated Nancy on November 2.  Everything in Bondville is getting sold, especially closed ended mutual funds (hattip to Karl Denninger of the "Market Ticker").

Ostensibly, the entire idea of Ben issuing credit to buy debt in the amount of $100B/mo for 6 months, is to keep Treasury rates from climbing and continuing the charade of deficit spending papering over the contracting economy.  He also needs to keep prices of assets held by member banks high, and his member banks hold a trainload of Treasury bonds.  If those sell off, there aren't any accounting games you can play with those, like you can on mortgage-backed-securities.

Ben either continues to buy everything, or Ben's buddies go BOOM.

The problem is for the past few weeks, Ben's bluff has been getting called.  Check out these graphs.
10 Year Treasury Yield
(click to enlarge)

This is the 10 YEAR US Treasury bond as viewed from a yield point of view.  This is one of the biggest things driving mortgage rates on Bainbridgeislanddreamhomes.  Ben and the Boys announced the second round of "QUANTITATIVE EASING" on the low tick of this chart.  Since then, the interest rates have gone straight up.  That's pretty cool, but the object of QE2 is to keep rates LOW by the FED creating credit ex nihilio and purchasing these securities.  Rates move inversely, by definition, from price.  It would seem that the overall demand for this kind of debt is drawing down.

That's not good.  Not good at all.  Granted, Ben isn't going on his buying spree for a few more weeks, but normally bond traders front-run large purchases by the FED to sell to Ben at higher prices.  The real test is when he actually starts buying.  If rates still go up, he's done.

Why would Ben be so obsessed with buying US government bonds at the short duration?  The reason is that he has been stuffing the Federal Reserve wholesalers (called Primary Dealers) with government debt all during these bailouts.  It's an easy way to get money via the taxpayer, and since they get to keep the money that is the difference between the rate they bought in for, and that of ex nihilio credit, why not?  What is the downside?

10 Year Treasury Price
(click to enlarge)
This is the downside.  This is how Ben sees the bond market.  Those of us in the Great Unwashed only see the bond market in terms of how much it costs to borrow money to buy goodies, baubles, and Bainbridgeislanddreamhomes.  Ben and the banking cartel see the bond market in terms of price, which is what you see to the right.

Pretty ugly, huh?

Someone had better plug that hole STAT! or we are going to have a full-on bond collapse which will seriously imperil the government's ability to function.  Remember, Barry, Harry, and Nan have been spending almost twice what they collect via the thuggish IRS, which means that the Tax Cheat-in Chief (Geithner) has to borrow almost half of all federal expenditures.

Ben has been stuffing the PDs with US Treasury debt and as long as the coupon pays enough to keep things liquid, it works.  It also works as long as the price of the debt is high enough to sell into the market to raise cash.  When the price of debt falls (yields rise), those PDs holding the debt can't sell because they will take a capital loss, and believe it or not, all that ex nihilio credit creation needs to be paid back, or The FED blows up.  The banks find themselves in the same predicament they had when they were holding tons and tons of worthless mortgage backed securities, that were backstopped by the never ending rising of residential real estate.

Oops.

Ben has to keep the market price of US debt high enough to keep his wholesalers liquid, otherwise it's TARP:  The Sequel, which would go over about as well as a disabled Iraqi War veteran marching in the 2004 Grand Old Fourth parade.

The Yankee Lira has been marching around in circles, looking for direction, and the contest is between Ben driving the currency into the ground (collapse of demand), and the circulation drop as debt defaults and the economy delevers (collapse of supply).  I am still firmly in the latter camp, and believe most of the hype around the impending doom of the US dollar is a bunch of nonsense.

The dollar has been tanking because of a bad risk-reward environment brought on by the FED using ex nihilio credit to keep the price of asset classes high as return on investment shrinks.  This elevates risk against declining reward, which can only find relief in abandoning dollar denominated assets en masse.  Ben ends up as the buyer of last resort, rather than the lender of last resort.

In fact, if any of the vast readership is still investing "for the long haul," you need to know that the only thing you are investing in is getting out of your assets before The FED does.  If you think you can hit the exits before the guy that actually knows when to exit does, you are one brave and foolish man.  That is all you are doing - betting you can get out before Ben does.

Good luck with that.

Being short isn't much better.  You need to be able to meet margin with real money and you are fighting a man with the ability to generate ex nihilio credit.  The only thing you have going for you is that your money can outlast Ben's credit-from-heaven.  Yeah, right...

That being said, if those charts of interest rates don't turn soon, the shorts will clean up.

[EDIT:  In order for Ben to get yields down and prices of bonds up, he must be able to generate ex nihilio credit faster than it is being destroyed in the private sector.  Failing that, he must generate some form of financial panic to drive money out of certain asset classes and into short term US bonds.  Look at Aug-Nov 2008 to see what that looks like.  Stock prices would come apart to foment such buying in short term Treasuries.  Equities are at eye-popping multiples and margin compression, brought on by rising commodity prices via dollar selling, will also bring in multiples.]

As the bottom falls out of dollar denominated asset prices, the risk of holding them goes down, and the rate of return on those assets rises.  This brings risk/reward back into balance, and the dollar will rise rapidly.  This is essential for the formation of capital to start the new economic cycle, and hopefully it won't be us flipping assets back and forth to one another and calling that wealth production.

The IER has been a pretty good fade for 2010, and that realization is a swift kick to the crotch.  It took several trillion dollars borrowed from our children, but the FED and US taxpayer made a monkey out of the IER...

...for now.

This isn't over.  Nothing has been solved.  Couple that with a narcissistic disaster on the verge of a nervous breakdown in the White House, 2011 should be an E-Ticket ride.

2 comments:

Peter said...

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QUALITY STOCKS UNDER FIVE DOLLARS said...

I have thought of a new song Ben can sing it well its really from the sound of music. Im changing some of the words around sing it ben I am QE 1 going on QE2.