Interessante
Bear Flattener
The process has been orderly. The markets have remained calm and there have been no mishaps. So far there has been very little damage to the financial markets in response to the latest Fed rate-raising cycle. The Fed’s willingness to use consistent language to signal to the markets its intent has produced a smooth transition from low to higher interest rates. Perhaps it is the amount of leverage in the financial system or the amount of debt in the economy that has prompted the Fed to move cautiously. In contrast to previous rate-raising cycles, the Fed has been eager to avoid rapid fire moves that startle the markets.
As a result of cheap and predictable financing rates, dealers and traders have been willing to take on more debt. In fact leverage in the financial system has exploded. Bond houses have stepped up their short-term borrowing since 2001. Everyone is playing the “carry trade” today from bond dealers, hedge funds, and industrial corporations to the consumer. Analysts believe that the Fed has been so transparent it has actually contributed to the low levels of volatility in the markets.
That is about to change. Judging by recent statements and speeches given by Fed officials, the steady and measured approach may give way to less transparency. The Fed seems frustrated by the market's complacency. Long-term rates have fallen as short-term rates have risen. This has puzzled the Fed. Mr. Greenspan has labeled this oddity a “conundrum.” The word “conundrum” is another Greenspan euphemism for “irrational exuberance” as Bill Gross has recently stated.
In a letter to Pimco’s investment committee Gross states his belief that the low level of long-term rates is due to the recycling of the U.S. trade deficit back into the U.S. bond market. Foreign buying of U.S. Treasuries has reduced the outstanding supply to domestic investors. Another factor that has also contributed to this dilemma has been the deliberate reduction in the issuance of 10-year notes and the elimination of the 30-year bond. The bulk of all new Treasury debt issuance has been short-term.
The Fed has stated that it is worried over global imbalances, especially here in the U.S., growing inflation risks and excessive speculation in the financial markets. Yet, the very issues that concern the Fed are a direct result of its policies. Fed policies have promoted consumption, encouraged debt formation and contributed directly to the enormous U.S. trade imbalance. By making credit cheap and plentiful the Fed has not only encouraged speculation, but it has also helped to foster debt accumulation. The Fed can’t have it both ways. It can’t tell the markets that its moves will be “measured” and not expect the markets to take advantage of the offer. Imagine walking into your bank and your bank offering you a loan at 1-2.5%. At the same time new time deposits offer an interest rate return of 4-5%. With an attractive offer such as this, the bank’s customers would be lined up around the block to take advantage of such an opportunity. This is what the financial community has done in response to a similar offer by the Fed. It is the reason why the “carry trade” has grown to such levels.
The Fed knows this. It was hoping for an easy way out. By telegraphing far in advance its intentions to raise interest rates at a” measured” pace, it has prolonged the “carry trade” and extended its life. At the same time by encouraging debt formation, it is responsible for the excessive consumption, which is directly linked to our growing trade deficit. By failing to act responsively in regulating the flow of money and credit the Fed has surrendered its capacity to effectively regulate the economy to foreign investors and governments. In effect the interest rate you pay to borrow money today is determined more by the policies of foreign central banks than by free trading markets. What we now have is a plethora of market anomalies—low savings rates combined with low interest rates, major debt accumulation associated with declining long-term interest rates, high stock multiples, and low bond yields combined with excessive monetary inflation.
Eventually anomalies right themselves as I expect these will. The Fed is moving away from its measured approach to a policy that will be less transparent. This means greater uncertainty for the markets. The Fed was hoping to cool things down and avoid the financial fallout that normally accompanies Fed rate-raising cycles. Now is the time to administer pain to the markets and reassert its control. This means interest rates are going to head much higher until something breaks in either the financial markets or the economy.
Inflation is heading higher and is becoming noticeable in the year-over-year changes in the CPI and the PPI. Over the past century we have had three inflationary cycles. These cycles have seen the inflation rate top over 10%. The first period was 1917-1919, the second was the 1940s, and the final period was the 1970s. All three periods were characterized by massive government spending, an accommodative monetary policy and war. Another aspect common to all three periods were rising commodity prices. All three periods were war cycles. During war resources become scarce as they are marshaled to meet the demands of the military.
Today, the U.S. finds itself at war again. It is not a traditional war in the sense that there are no large armies that face opposite each other to do battle. It is a non-traditional war. But there is a large army that has to be fed and supplied. At the same time developing economies around the globe are industrializing, placing larger demands on the world’s resource base. The result is that everything from energy, copper, steel, iron ore and alumina to timber is going up in price.
As the Fed withdraws liquidity from the financial markets, the major averages will continue to struggle until eventually they fall. The cyclical bull market in equities is close to peaking, if it hasn’t already. The stock market has very little upside as long as interest rates are rising. The Fed is trying to influence long bond yields higher. It will continue to apply pressure on interest rates until it gets its desired effect. Since there is a six-month lag time between rate hikes and their impact on the economy, the Fed will not know if it has achieved its objective until something breaks. The Fed always overshoots on interest rates and this time should be no different. The obvious casualties will be the financial markets—both stocks and bonds—and eventually the economy. High beta stocks, low quality bonds, and emerging market debt are the most vulnerable.
When will the Fed stop? The catalyst for the Fed to stop tightening interest rates has always been a crisis. In 1984 it was the collapse of Continental Illinois. In 1990 it was the S&L crisis and a recession. In 1994 it was Orange County and Mexico. In 2000 it was the stock market and the economy. What will break this time? You will have to look no further than the financial community, which is leveraged 15-20:1. Money center banks are also at risk due to their large derivative books. They have lent to and insured just about everybody.
What comes next is a period of disinflation as the economy weakens and the markets falter. After that the Fed will begin another credit cycle. Instead of recovery, we will enter into a stagflationary environment that eventually gives way to hyperinflation. There is simply too much debt and it will need to be inflated away. We are now ending the period where the end game plays itself out. Eventually foreign central banks will lose their appetite for U.S. debt. Many smaller central banks have already indicated they intend to reduce their Treasury exposure from Malaysia, Russia, and South Korea to OPEC. As more central banks jump on board this trend, it could eventually lead to a creditor's strike. A creditor’s strike will force the Fed into action. The Fed would then reduce interest rates and extend credit directly to the government. This means it will end up monetizing federal government debt. The result will be rising inflation and currency devaluation eventually leading to reduced living standards and labor strife here in the U.S.
At the moment the bond market seems content to play the carry trade. The spread between the 10-year Treasury and the 2-year note has narrowed from 240 basis points last year at this time to the current spread of 77 basis points.
Currently traders are shorting shorter maturities and buying longer-dated bonds. They hope to make money on the longer-dated issues and profit from buying back the two-year note at higher yields. However, this rate-raising cycle has acted much differently than previous cycles due to the expansion of the “carry trade.” The movement at both the short and long end of the markets has been more pronounced. Short-term rates have gone up much faster and long-term rates have declined. This has created what is referred to in the trade as a “bear flattener.”
Some are wondering how much longer this can continue. If the trend continues, the yield curve could actually begin to invert. (Short-term rates higher than long-term rates.) When this happens, the “carry trade” will come to an abrupt end. It has already happened in the U.K. Short-term rates are at 4.76 percent and long-term rates are at 4.52 percent. It is just one more anomaly that has surfaced due to all of the current imbalances in the financial system. This is what gives way to a crisis. One only wonders who will be on the wrong side of a trade when it ends. How big will their bet be? Who will be their counterparties and how large will its impact be when it unwinds?
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