Money Sage (archive)

The Treasury market has fired an unmistakable warning shot over the FED's bow, as the FED is seemingly plowing ahead on its urgent mission of LIQUIDITY CREATION. This shot consists in the 50 basis point (bps) RISE in yields at the long end of the Treasury market over the past 23 calendar days.

Since hitting an intraday low yield of 3.28 on January 23rd, the 10-year Treasury yield has backed up to 3.78 on Friday. The benchmark 30-year Treasury bond yield has similarly backed up 50 basis points, from a low of 4.10 on January 23rd, to yesterday's close at 4.60.

There are 2 ways of viewing this development, we believe. The first is to regard it as a normal price correction (with bond prices moving inversely to interest rates, which is a mathematical certainty)within the framework of an ongoing bull market. In fact, the extent of the correction places it close to the outermost limits of a typical bull market correction, in our judgment.

The second is to view it as a signal of spiralling anxiety among long-term bond investors over the PERCEPTION that the FED may create too much liquidity in coming months.

Despite certain technical and seasonal factors which affect bond prices, and which could be ascribed a signficant role in the recent rate back-up, we think it is quite SIGNIFICANT that the Treasury sell-off occurs in the context of intensifying recessionary economic reports, and deflationary indications of a deepening credit market paralysis AND a further weakening of the banking system.

We also note a sudden rise in FED indications, both direct and refracted via the financial and general media, of rising FED concern over inflation, and signals that the FED may be constrained in its determination to fight the negative economic and financial market trends by FED worry over a possible unwelcome rise in inflation down the road.

To say that we find these developments intriguing is to put the matter mildly. Our first point is just this: how can you fear what you, and only you, have the ability to either create or prevent? This is the FED's situation re. future "inflation." It is hardly the case -- as FED rhetoric and the rhetoric of those in the media who refract the FED's message to the attentive public would have us believe -- that the FED is worried about those forces and trends and price movements EXTRINSIC to FED ACTIONS which allegedly produce inflation. In fact, as the cognoscenti are fully aware, it is the CENTRAL BANK, and the CENTRAL BANK ALONE, which produces inflation. As we have noted repeatedly, whatever price surge may occur in any individual commodity, asset, industrial product, or service, in an of itself such a surge has ZERO EFFECT ON THE OVERALL PRICE LEVEL IN THE ECONOMY. It is IF -- and ONLY IF -- the central bank increases the supply of money that the overall price level rises, that inflation picks up. Absent such action, the rise in cost of certain items produces either a compensating decline in the price of other items, or an asset sale and deflationary downturn.

Viewing the ostensible rise in FED concern, there are only two possible conclusions: either the FED intends to produce a noticeable increase in liquidity, and by expressing its inflation worries is seeking to deflect attention away from its role as the sole source of said forthcoming inflationary rise, or it is telegraphing its dilemma to the attentive public.

The FED, we believe, is playing to several audiences: Congress, the media, the general public, the Administration. The MOST IMPORTANT AUDIENCE to which the FED is playing, however, is none of these. Rather, the FED is playing to the TREASURY MARKET. The FED is telling the market that it realizes its new accommodationist monetary policy will increase inflation -- or decrease deflation -- down the road. It is assuring Treasury bond investors that it will do this for only a very short time (Hence the frequent iterations in recent weeks, even from inflation "doves" at the FED, that the FED will "take back" its rate cuts as soon as possible).

There is, we think, an element of pleading in these FED assurances, and in FED warnings of inflation risk constraining their room for maneuver (the latter warnings being directed to those who are pressing them for greater and faster liquidity creation -- the politicians, the banks, the public, the real estate industry, the DEBTOR CLASS in general). In particular, we think that the FED is pleading with FOREIGN HOLDERS of massive quantities of Treasury securities -- particularly the principal Asian central banks -- NOT to sell.

The FED, as we have discussed in an earlier analysis ("The FED: Between Scylla and Charybdis) is indeed between a rock and a very hard place. The creation of liquidity, if maintained, essentially constitutes a transfer of wealth and income from the creditor class to the debtor class. Creditors are not too keen on this transfer, for obvious reasons.

The FED's dilemma is aggravated by the memory Treasury bondholders have of the horrific real losses they suffered in the 1970s, when the FED minted money in order to provide relief for the beleaguered debtor class. As the sell-off in the TREASURY market over the past three weeks demonstrates, Treasury bond investors are disinclined to show any mercy.

The bottom line, we believe, is just this: in determining how much pain the American homeowner, debtor, consumer will have to suffer in the forthcoming deflationary/contractionary period, the FED will have to ACCURATELY ASSESS the amount of rope the Treasury market is allowing them. It does no good at all for the FED's anti-deflation/recession mission if a rise in market rates occurs even as the FED is loosening: the rise in market rates can partially, or fully, offset the FED's loosening moves. Indeed, the market's power is even more decisive than usual given the contracting ability of the banking system to provide credit.

In the final analysis, we are inclined to conclude that American homeowners, debtors, and consumers will experience a great deal of pain as the long-postponed liquidation phase of the business cycle plays out. We doubt that the FED will be willing to risk a contest with the Treasury market which could place the FED on the road to a printing press inflation.