Reaction not that big for the FedRes plan to monetize long bonds
One of the big stories of the week was the annoucement of the plan by the FedRes to monetize long bonds. This basically means that the FedRes will print money and buy US government bonds. Bond bears, and those that believe the central bank has more power than the free market, believe that this will cause high inflation in the future (I don't share that view but it depends on how much money is monetized. The $300 billion that was mentioned is unlikely to cause much inflation in my opinion--unless the economy unexpectedly recovers quickly and the velocity of money turns all this into high-powered money.)
What is the Goal of the FedRes?
For those not familiar with central banks, they almost always target the short-term rates. The move to buy long-term bonds is unusual and is an attempt to drive down the long-term rates. By driving down the long term rates, it will lower the cost of financing, particularly for home buyers (mortgage rates) and corporations (corporate bond yields).
My understanding of history is that, in the past, the FedRes has monetized debt generally to finance wars. When taxes didn't provide enough money, and foreign flows weren't enough, as seems to have been the case during World War I, the government asked (forced?) the FedRes to print money and buy its debt. This was especially true during the gold exchange standard. If you couldn't finance your war, your country was toast so it was easy to print money at will without much citizen dissent, even though it was supposed to be on a gold standard--some countries completely went off the gold standard during wars (those who promote the gold standard don't seem to realize that almost every single major war by any country has resulted in dumping the gold standard--what's the point of the standard then?) I'm bringing up all this because some say that the FedRes will be forced to monetize the US govt debt--according to some USA will run a $1 trillion debt for at least 5 years--because there won't be buyers for it. Such a situation would be similar to the distant past when FedRes monetized war debt. We are not there yet but it's something to keep an eye on. If the FedRes monetizes say $5 trillion then inflation may be an issue--but even then, it's not as inevitable as the inflationists claim.
What Was the Reaction from the Market?
The reaction from the market wasn't that big. Perhaps it's not surprising given how it was telegraphed for many months, and some economists even mapped out various scenarios from the impact, well in advance.
The following chart plots various ETFs representing key interest-sensitive assets. I am plotting mostly bonds and precious metals. Do note that the 10 year bond yield is plotted, whereas all the others are prices.
It started off with a big bang late Wednesday, upon the FedRes annoucement, but nothing much happened in the following days. The 10 year bond yield declined a little over 15%, which is roughly a 0.5% decline in long-term interest rates. Most other bonds rose slightly (a bit under 5%) but have given up some of their gain on Friday.
The TIPS (Treasury Inflation Protected Security) bond, which is supposed to be highly sensitive to inflation and pays out more if inflation is higher, rose 5% but has given up some of the gain by end of Friday.
Depending on the starting point of measurement, gold is up about 5% to 10% since the annoucement. Silver was initialy up about 5% on the news, and is up 10% to 15% its low point, right before the annoucement. Gold stocks are up around 20% since the news broke. Many other commodities (not plotted) were also up after the announcement.
Although precious metals were up on the news, it wasn't anything spectacular. Gold is barely back to $1000, which is simply where it was a month ago (it also hit that level about an year ago and an year-and-a-half ago as well.) The fact that gold hasn't hit a new high, even on such bullish news, shows how tenuous the inflation argument is. The market is clearly unwilling to place a big bet on inflation.
Final Word
Overall, the market basically shrugged off the FedRes plan. Precious metals and commodities rallied, only to give up some of their gains by Friday, and the US$ declined, while bonds rose, but none of it was earth-shattering. The behaviour of the market, so far, is consistent with my view of mild-deflation/disinflation in the future.
The fact that the FedRes is manipulating the long-term rates, although the success rate is uncertain, means that investors are going to face a new environment. Price signals from interest rates may be meaningless to some degree in the future (assuming the monetization continues for years, as it has in Japan.) USA hasn't seen such an environment in more than 40 years.
My totally unsubstantiated contrarian theory is that investors will likely err on the side of inflation, even though the reality may be more in line with mild deflation*. Since nearly everyone alive has grown up in an inflationary environment, it is possible that investors will price assets based on inflationary expectations. It'll be the opposite of the 1970's or 1980's, when everyone was scared of inflation and were running away from high quality bonds with 15% yield. There is no guarantee that the macro environment has changed but I have a feeling that it indeed has. Even if you don't buy my view, at least consider it as a Black Swan and don't get caught off-guard if it comes true.
(* Do note that when most people say deflation, or when I say mild deflation, it will be nothing like the 1930's. Rather, I, as well as many others, expect it to be more like Japan. One should also not mix up the 1930's with the modern developed countries when it comes to ecoomic growth. Outside developing countries such as China/India/etc, it is highly unlikely for GDP growth to drop more than 6% or 7% on an yearly basis. Even Japan has been growing around 1% or so in the last 18 years.)
What is the Goal of the FedRes?
For those not familiar with central banks, they almost always target the short-term rates. The move to buy long-term bonds is unusual and is an attempt to drive down the long-term rates. By driving down the long term rates, it will lower the cost of financing, particularly for home buyers (mortgage rates) and corporations (corporate bond yields).
My understanding of history is that, in the past, the FedRes has monetized debt generally to finance wars. When taxes didn't provide enough money, and foreign flows weren't enough, as seems to have been the case during World War I, the government asked (forced?) the FedRes to print money and buy its debt. This was especially true during the gold exchange standard. If you couldn't finance your war, your country was toast so it was easy to print money at will without much citizen dissent, even though it was supposed to be on a gold standard--some countries completely went off the gold standard during wars (those who promote the gold standard don't seem to realize that almost every single major war by any country has resulted in dumping the gold standard--what's the point of the standard then?) I'm bringing up all this because some say that the FedRes will be forced to monetize the US govt debt--according to some USA will run a $1 trillion debt for at least 5 years--because there won't be buyers for it. Such a situation would be similar to the distant past when FedRes monetized war debt. We are not there yet but it's something to keep an eye on. If the FedRes monetizes say $5 trillion then inflation may be an issue--but even then, it's not as inevitable as the inflationists claim.
What Was the Reaction from the Market?
The reaction from the market wasn't that big. Perhaps it's not surprising given how it was telegraphed for many months, and some economists even mapped out various scenarios from the impact, well in advance.
The following chart plots various ETFs representing key interest-sensitive assets. I am plotting mostly bonds and precious metals. Do note that the 10 year bond yield is plotted, whereas all the others are prices.
It started off with a big bang late Wednesday, upon the FedRes annoucement, but nothing much happened in the following days. The 10 year bond yield declined a little over 15%, which is roughly a 0.5% decline in long-term interest rates. Most other bonds rose slightly (a bit under 5%) but have given up some of their gain on Friday.
The TIPS (Treasury Inflation Protected Security) bond, which is supposed to be highly sensitive to inflation and pays out more if inflation is higher, rose 5% but has given up some of the gain by end of Friday.
Depending on the starting point of measurement, gold is up about 5% to 10% since the annoucement. Silver was initialy up about 5% on the news, and is up 10% to 15% its low point, right before the annoucement. Gold stocks are up around 20% since the news broke. Many other commodities (not plotted) were also up after the announcement.
Although precious metals were up on the news, it wasn't anything spectacular. Gold is barely back to $1000, which is simply where it was a month ago (it also hit that level about an year ago and an year-and-a-half ago as well.) The fact that gold hasn't hit a new high, even on such bullish news, shows how tenuous the inflation argument is. The market is clearly unwilling to place a big bet on inflation.
Final Word
Overall, the market basically shrugged off the FedRes plan. Precious metals and commodities rallied, only to give up some of their gains by Friday, and the US$ declined, while bonds rose, but none of it was earth-shattering. The behaviour of the market, so far, is consistent with my view of mild-deflation/disinflation in the future.
The fact that the FedRes is manipulating the long-term rates, although the success rate is uncertain, means that investors are going to face a new environment. Price signals from interest rates may be meaningless to some degree in the future (assuming the monetization continues for years, as it has in Japan.) USA hasn't seen such an environment in more than 40 years.
My totally unsubstantiated contrarian theory is that investors will likely err on the side of inflation, even though the reality may be more in line with mild deflation*. Since nearly everyone alive has grown up in an inflationary environment, it is possible that investors will price assets based on inflationary expectations. It'll be the opposite of the 1970's or 1980's, when everyone was scared of inflation and were running away from high quality bonds with 15% yield. There is no guarantee that the macro environment has changed but I have a feeling that it indeed has. Even if you don't buy my view, at least consider it as a Black Swan and don't get caught off-guard if it comes true.
(* Do note that when most people say deflation, or when I say mild deflation, it will be nothing like the 1930's. Rather, I, as well as many others, expect it to be more like Japan. One should also not mix up the 1930's with the modern developed countries when it comes to ecoomic growth. Outside developing countries such as China/India/etc, it is highly unlikely for GDP growth to drop more than 6% or 7% on an yearly basis. Even Japan has been growing around 1% or so in the last 18 years.)
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ReplyDeletehttp://kaptblasto.newsvine.com
Why not take a look at it, and send me some ideas?
Sincerely,
Kapt. Blasto