Bonds & Interest Rates

The Fed's Jelly Donut Policy

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Posted by David Einhorn

on Thursday, 03 May 2012 19:08

Written by David Einhorn via huffingtonpost.com

A Jelly Donut is a yummy mid-afternoon energy boost.

Two Jelly Donuts are an indulgent breakfast.

Three Jelly Donuts may induce a tummy ache.

Six Jelly Donuts -- that's an eating disorder.

Twelve Jelly Donuts is fraternity pledge hazing.

My point is that you can have too much of a good thing and overdoses are destructive. Chairman Bernanke is presently force-feeding us what seems like the 36th Jelly Donut of easy money and wondering why it isn't giving us energy or making us feel better. Instead of a robust recovery, the economy continues to be sluggish. Last year, when asked why his measures weren't working, he suggested it was "bad luck."

I don't think luck has anything to do with it. The blame lies in his misunderstanding of human nature. The textbooks presume that easier money will always result in a stronger economy, but that's a bad assumption. Here is a good example of how a real family responds to monetary policy.

Consider my neighbors, Homer, Marge, and their three adult children, Bart, Lisa and Maggie. Homer has retired from the nuclear plant, and he and Marge live off savings and Homer's pension. Bart is in a bit of trouble with too much credit card debt and an underwater mortgage. Lisa has been putting away her salary and has enough for a downpayment on her first home. Maggie owns her own business and is ready to expand.

When interest rates are high, Homer and Marge park their savings in CDs or Money Market accounts and get a decent return. There is no incentive for them to take much risk with their money. Bart gets into trouble very quickly and defaults on his loans. Lisa decides she can't afford a mortgage until rates fall. And Maggie, who's been helping out Bart with some of his expenses, believes that she'd make money if she grew the business, but possibly not enough to service the debt she'd be undertaking.

When interest rates are low, everything changes. Homer and Marge are getting only a little interest on their savings, and are struggling to live off Homer's pension. They need to rethink their finances. Bart can manage to keep up the minimum payments on his credit cards and stay in his house. Lisa can get a cheap mortgage, and Maggie doesn't need to make such optimistic assumptions in order to expand her business.

Everyone agrees that low interest rates are a good way to stimulate a stalled economy. The Fed takes this logic a step further. It believes that if low interest rates are good, then zero-interest rates must be even better. As a brief emergency measure, such drastic behavior is reasonable and can even be necessary. In 2008, Chairman Bernanke had near unanimous support for his decision to drop rates to near zero. At the peak of the crisis, it made sense. But that was four long years and many jelly donuts ago. In the 2012 economy, a zero rate policy not only adds no benefit, it's actually harmful. Just ask the Simpsons.

When Homer was approaching 65, he and Marge met with a financial planner to figure out if they had enough money saved for retirement. They assumed they'd live to be 90, and could count on receiving a fixed amount from Homer's pension and social security checks. Marge, the cautious one, has not forgotten that stock market meltdown better known as the bursting of the tech bubble. She didn't want to take any investment risk and was content to have just enough for regular haircuts for herself, a bowling and beer budget for Homer, and visits with the children. They were told that, with nominal interest rates at 3%, they could safely retire with $200,000.

"What happens if interest rates go to zero and stay there?" Marge asked the advisor.

"You mean indefinitely? If you weren't willing to start taking investment risk, you'd need 50% more in savings, or $300,000. But why would you ask such a silly question?" asked the advisor.

To which Marge replied, "Well, we were thinking about moving to Japan..."

Homer and Marge aren't the only ones doing this sort of math. Every single day for the next 19 years, more than 10,000 Baby Boomers will turn 65. Those who started saving for retirement 15 years ago are suddenly finding themselves with insufficient savings to do so.

Some will stay in the work force longer, some will drastically reduce their spending, and some will do both. In a recent survey, 20% of U.S. workers say they have postponed their planned retirement age at least once during the last year. And those who have already retired have fewer options. Returning to the workforce could be challenging. David Rosenberg points out that the workforce for those 55 and older has expanded by 4 million since the start of the recession, and they are returning to the workforce at lower wages. Even more challenging is trying to find safe investments that generate a decent yield.



Bonds & Interest Rates

Jim Grant: "The Federal Reserve Is The Vampire Squid Of Vampire Squids"

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Posted by Zerohedge.com

on Thursday, 03 May 2012 16:19

Munch's "The Scream" may be all the rage today, but to Jim Grant, in his latest interview on Bloomberg TV, the record price paid for the painting is not so much a manifestation of modern art as one of modern currency: "This is the flight into things from paper" . Thus begins the latest polemic by the Grant's Interest Rate Observer author whose topic is as so often happens, the Federal Reserve (for his latest definitive expostulation on why the Fed should be disbanded and why a gold standard should return, delivered from the heart of Liberty 33 itself, read here). The world in which we invest is a world of immense wall to wall manipulations by our friends in Washington. And people get off on Goldman Sachs because it has done this and this, it is pulling wires... The Federal Reserve is the giant squid of squids, it is the vampire squid of vampire squids."

He continues: "They - the vampire squids - have manipulated virtually every single price and valuation in the capital markets. People ought to recognize when they invest that one of the unspoken risks is the risk that this hall of mirrors, this Barnum and Bailey world that the Fed has created for us is going to vanish one day because they will not be able to hold it any more... It's not as if there is nothing to do in investing, but one must always keep in mind that the valuations that we see, that the prices that we watch flicker across the tape are prices that are fundamentally manipulated by these well-intended, dangerous people in Washington called the Federal Reserve". And to think that 3 short years ago Grant would have been branded a loony, tin-foil hat wearing gold bug, while now it has become trendy for hedge fund managers to bash the Fed with impunity. It is all downhill from here.

To Watch the Video CLICK HERE

vamp 0

Bonds & Interest Rates

America's Most Important Slidedeck

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Posted by Zerohedge.com

on Wednesday, 02 May 2012 08:53

Every quarter as part of its refunding announcement, the Office of Debt Management together with the all important Treasury Borrowing Advisory Committee, which as noted previously is basically Wall Street's conduit telling the Treasury what to do, releases its Fiscal Quarterly Report which is for all intents and purposes the most important presentation of any 3 month period, containing not only 70 slides worth of critical charts about the fiscal status of the country, America's debt issuance, its funding needs, the structure of the Treasury portfolio, but more importantly what future debt supply and demand needs look like, as well as various sundry topics which will shape the debate between Wall Street and Treasury execs for the next 3 months: some of the fascinating topics touched upon are fixed income ETFs, algo trading in Treasurys, and finally the implications of High Frequency trading - a topic which has finally made it to the highest levels of executive discussion. It is presented in its entirety below (in a non-click bait fashion as we respect readers' intelligence), although we find the following statement absolutely priceless: "Anticipation of central bank behavior has become a significant driver of market sentiment." This is coming from the banks and Treasury. Q.E.D.

Some highlights specifically from the TBAC component of the presentation.

First, the TBAC discusses key changes to the Fixed Income markets over the past few years:

  1. Reduced liquidity of spread product
  2. Likely a consequence of investor risk aversion and regulatory reform. Treasuries remain liquid
  3. Prevalence of “risk on / risk off” mentality
  4. Extreme valuations, correlations rising, excess returns becoming more volatile
  5. Role of government
  6. Extraordinary monetary policy (ZIRP, balance sheet growth, communication/transparency)
  7. Regulatory reform
  8. Changes in market participant behavior
  9. Cyclical (risk tolerance) and secular (demographics / LDI strategies), customized solutions
  10. Growing role of electronic trading
  11. Driven by increased efficiency and regulatory reform

Supporting visual data:

And what matters for bond traders everywhere: Implications of Reduced Corporate Bond Liquidity, which are mostly the lobby group's efforts to neutralize the Volcker Rule:


  • A reduction in liquidity / wider bid-offer spreads has both an upfront cost to existing investors (who have to mark their existing holdings at wider levels) as well as an ongoing cost for issuers and investors
  • Per a recent study, a strict implementation of the Volcker Rule for the corporate bond market may cost $90-315bn upfront plus $12-43bn/yr for issuers and $1-4bn/yr for investors in future transactions
  • Analysis by Barclays** indicates that the liquidity premium has risen from ~20bps in Jan ’07 to ~40bps in Mar ’12
  • Policy makers should carefully consider the impact on market liquidity when introducing new financial regulations, such as the Volcker Rule
  • SIFMA, the Credit Roundtable (a group of large fixed income money managers), and other market participants have submitted comments on this topic
  • Given the size of the bond markets, it would be difficult, if not impossible, for the banking sector to reintermediate the capital markets (replacing bonds with loans) in response to a prolonged market dislocation



Bonds & Interest Rates

The 'Mistake of 1937'

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Posted by Steve Saville

on Tuesday, 01 May 2012 07:47

Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 19th April 2012.

The US Great Depression lasted from 1929 until 1945, but the deflationary phase of the Depression effectively ended in 1932. Regardless of whether you define deflation and inflation in terms of money supply or prices, there was almost continuous inflation in the US after 1932. The inflation was, however, briefly interrupted during 1937-1938, when a leveling-off in the money supply and a sudden economic downturn led to sharp declines in equity and commodity prices. The 1937-1938 downturn is sometimes called the "mistake of 1937" by those who believe that it only occurred because the Fed tightened monetary policy prematurely. According to the believers in this theory, the US economy would have continued to recover from the collapse of 1929-1932 if not for the Fed's premature tightening. Significantly, Ben Bernanke is one of the believers.

Believers in the theory that the collapse of 1937-1938 was caused by the Fed's premature tightening of monetary conditions are partially right in that modest Fed tightening during the second half of 1936 and the first half of 1937[1] was probably the catalyst for the collapse. The question that this theory fails to address is: if a genuine economic recovery had got underway in 1933, then why did the recovery fall apart so rapidly and so completely following only a minor tweaking of monetary conditions? The answer is that the recovery wasn't real; it was an illusion based on increasing money supply. When economic growth is mainly the result of increasing money supply then stopping, or even just slowing, the rate of money-supply growth will likely bring about a collapse.

(As an aside, the recovery's flimsy monetary underpinning is part of the reason why, like the recovery that began in mid 2009, it was essentially "jobless" (the unemployment rate remained very high throughout the 1933-1937 rebound). However, there was more to the relentlessly high unemployment of the 1930s than the Fed's counter-productive monetary machinations. Actions taken by the Hoover and Roosevelt administrations to raise the price of labour can also be given a lot of credit for keeping people out of work.)

This prompts the question: shouldn't the Fed have continued to 'support' the economy with a constant flow of new money until a real recovery was able to take hold?

The above question ignores the fact that the flow of new money (monetary inflation) leads to more mal-investment and thus not only gets in the way of a real recovery, but also further weakens the economic structure. Had the Fed continued to provide monetary support for an additional year then the collapse would have commenced in mid 1938 rather than mid 1937. Also, it would have been even more devastating thanks to an additional year of mal-investment. As Ludwig von Mises pointed out long ago: "There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

The above question also ignores the fact that in real time the central bank finds itself between the proverbial rock and a hard place. Even when the economy is subject to natural deflationary forces, as it was in the mid-1930s, the unnatural creation of new money by the central bank will eventually cause evidence of an inflation problem -- in the form of rising prices for important commodities and some goods and services -- to emerge. After a while, the pressure on the central bank to curtail the inflation problem can become greater than the pressure on the central bank to 'support' the economy with a continuing flow of new money.

By the third quarter of 1936 the pressure on the Fed to curtail the inflation problem had become dominant, but if the Fed had ignored this pressure and instead persisted with its price-boosting policies -- the path that Monday-morning Keynesians[2] now say should have been taken -- then the end result would have been an even more severe economic downturn once monetary conditions were eventually tightened. Alternatively, the Fed could have chosen to rapidly inflate the money supply indefinitely, in which case the end result would have been total catastrophe for both the US dollar and the US economy.

A picture of what happened during 1937-1938 is displayed below. On the chart the 1937-1938 downturn looks minor in comparison to the 1929-1932 downturn, but it was substantial nonetheless. The Dow Industrials Index lost more than half of its value, but perhaps of greater significance was the quick one-third decline in manufacturing output. Considering the relative importance of manufacturing in those days, this effectively means that the economy quickly shrunk by one-third.

The chart also shows that the Fed made no attempt to tighten via a higher official interest rate. As explained in Note (1) below, the Fed used other means to restrict the flow of new money.


That many of today's most influential policymakers and economists believe that a severe downturn could have been avoided during the late-1930s if only the Fed had maintained its ultra-easy monetary stance means that the wrong lesson has been learned from history. This, in turn, almost certainly means that the Fed will stay loose for longer in the face of blatant evidence of an inflation problem this time around, and that the Fed will be quicker than ever to engineer a money-supply boost in reaction to the next bout of economic weakness.

[1] The Fed started tightening the monetary reins in August of 1936. It never went as far as hiking the official interest rate (the "Discount Rate"), but it did increase bank reserve requirements and took actions to prevent gold in-flows to the US Treasury from boosting the Monetary Base. The result was a leveling-off in the money supply during the 2-year period beginning in late-1936.

[2] A Monday-morning Keynesian is an economist who always knows, with the benefit of hindsight, how much 'stimulus' should have been provided to the economy to bring about a sustainable recovery. Since these economists begin with the premise that monetary and/or fiscal stimulus helps the economy, if an economy tanks despite the concerted application of stimulus measures they inevitably conclude that the stimulus was insufficient. They never seriously question the correctness of the underlying premise.

We aren't offering a free trial subscription at this time, but free samples of our work (excerpts from our regular commentaries) can be viewed at: http://www.speculative-investor.com/new/freesamples.html

Bonds & Interest Rates

Lonesome dove

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Posted by G.I. - The Economist

on Friday, 27 April 2012 09:13

by G.I.

For the blogosphere, the most entertaining part of the Federal Reserve's meeting today was Ben Bernanke's defence during the press conference against Paul Krugman’s charge that he has betrayed his academic past in failing to ease more aggressively and aim for higher inflation.

That is a pity because while it was great theater, it obscured a more important revelation. Not only is Mr Bernanke still a dove, he is increasingly an isolated dove, and that isolation has significant consequences for monetary policy, the economy and the markets.

The statement released by the FOMC was largely as expected and a non-event for markets: “economic growth [will] remain moderate over coming quarters and then … pick up gradually,” inflation will fall from its temporarily elevated levels to 2% or lower, and the Fed expects to keep interest rates “at exceptionally low levels … at least through late 2014.”

The projections released along with the statement were far more interesting. FOMC members reduced their forecasts for the unemployment rate, and nudged up the outlook for inflation. That hawkish combination was made doubly so by the fact that just four of the 17 FOMC members think the Fed should start tightening after 2014, down from six in January.

The hawkish impression was reinforced by Mr Bernanke’s defence against Mr Krugman (whose name never came up but whose New York Times Magazine article, judging by the questions, had been read by all the reporters in the room). Mr Bernanke flatly rejected the accusation that he is acting inconsistently from the advice he gave the Bank of Japan over a decade ago, noting that Japan was in deflation then and America is not now, in no small part thanks to the aggressively easy monetary policy the Fed has pursued. He went on to argue that deliberately targeting higher inflation as Mr Krugman advises (because it would reduce real interest rates) in pursuit of a slightly faster fall in unemployment was a “reckless” tradeoff. Judging from my twitter feed, Mr Krugman’s partisans outnumber Mr Bernanke’s by a hefty margin. Mr Krugman himself dismissed Mr Bernanke’s response as “Disappointing stuff.”


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