Notes From Underground: How Do Markets Test the FED?

In following up on the theme of the last three blog posts, it’s always a question how  markets test central bank policies. As is frequently mentioned, when investors fear that central banks will err on the side of LIQUIDITY EXUBERANCE precious metals and hard assets are bought in efforts to prevent the POSSIBLE EROSION of asset values. In times when the market perceives the FED to be ahead of the inflation curve, investors buy long-term bonds and lock up higher rates in a belief that an aggressive Fed will successfully slow the economy. Thus, locking up high rates now will generate a higher real yield as the economy begins to slow, resulting in a flattening of the yield curves. When the Fed is deemed to be behind the curve, investors sell long-dated debt in belief that the FED will at some point have to aggressively raise rates to stem incipient inflation, resulting in a steepening yield curve.

Currently, the market is confused because the FED, large sovereign wealth funds and many other central banks are HUGE buyers of U.S. Treasuries and other sovereign debt, which is distorting the pricing of risk and long-term interest rates. This is not conjecture but the stated policy of Mario Draghi and Ben Bernanke. The question continually gets asked on visual media: If the Fed’s policy is inflationary where are the bond sellers? The answer is that the so-called bond vigilantes have tried to sell sovereign debt in anticipation of a steepening curve but remember, even with the FED tapering, it is still buying $35 billion a month in long-term treasuries and mortgage-backed securities. In addition to the FED‘s balance sheet is the continued buying needs of foreign investors, and U.S. insurance companies and pension funds.

The Japanese BOND market, otherwise known as the widow maker, was sought to be vulnerable to investor selling as the BOJ flooded the market with liquidity to create some inflation. Japan’s economy failed to respond to the BOJ‘s actions and rather than inflate, Japan continued on a deflationary path for a number of years as PRICES actually declined, making 10-year bonds a sound investment. If interest rates are 0.60 percent on a 10-year bond and deflation is a -1 percent, the EFFECTIVE REAL YIELD IS 1.60%. It’s tough to short long-term debt in a deflationary environment. In the U.S., while the FED fears the onset of deflation, prices have actually risen for the last four years, though at a slower rate than the FED desires. It is through the use of quantitative easing that the FED hopes to ignite enough inflation to ease the burden of debt and generate enough new economic activity to create new borrowing.

The low interest rates are not having the desired effect on the general economy but the end result is that corporations are borrowing money not to create capital expenditures and new productive capacity but to merely buy in stock and pay dividends. Corporate stock buy backs improve the P/E ratio making the market looked fairly valued, while the cheap borrowing costs also result in an interest cost deduction. The result is a buoyant stock market but a continuing lackluster economy.

The question thus remains: If price rises in living costs take hold without an increase in wages and jobs, WILL THE FED RAISE RATES? Going forward the answer will appear in the YIELD CURVES. While the curves have been flattening for the last six months, if the FED is thought to be more concerned about LABOR THAN INFLATION, the yield curves will steepen. Presently, the markets are nervous about selling into FED asset purchases so other alternatives to shorting bonds get investor attention. However, with the end of QE in sight, the BOND VIGILANTES may begin to test the Fed’s resolve on its inflation threshold.

***Yesterday’s post on the IMF elicited a great deal of commentary on blog posts and private correspondence. The Financial Times also commented on recent IMF actions and had an editorial, “Rethinking IMF Lending Policies.” Prior to the European crisis, the IMF operated on lending only if the borrower were thought to be solvent enough that loans payments would be sustainable; if not sustainable then a restructuring was mandated.” Then came the eurozone crisis. In the case of Greece it was impossible–and in the cases of Ireland and Portugal difficult–to declare debt sustainability was probable. So the fund amended the framework in 2010 to let it lend without a restructuring where there was a “high risk of international systemic spillovers.”

This meant that the IMF financed capital flight, permitting creditors to escape the results of big errors at the expense of official lenders or taxpayers. The IMF quietly changed its rules to ease the way for creditors and the ECB to avoid the wrath of the Bundesbank. The U.S. Congress was definitely correct in not voting more funds for the IMF and, more importantly, if the IMF needs liquidity it is time to monetize its GOLD HOARD through the issuance of GOLD-BACKED BONDS. If not now, when?

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3 Responses to “Notes From Underground: How Do Markets Test the FED?”

  1. Jacob Steelman Says:

    Wow gold backed bonds. What is next gold backed SDRs or yuan or dare I say it gold backed USD?

  2. kevinwaspi Says:

    Good reading, as always. Your “if not now, when?” question on the gold-backed bonds is appropriate, and very timely. That same question applies to the continued policies of central banks (including the IMF) trying to end this “balance sheet recession”. Knowingly or not, these policies continue to give cover to the horrible FISCAL policies of developed nations which are holding back growth. The Fed (and ECB, BOJ, et. al.) will one day discover that it can create supply (see, but cannot create demand (see Velocity continues its swan dive.

  3. kevinwaspi Says:

    Great points as always. The “if not now, when?” question is appropriate and timely, and also applicable to central bank policies now six years on from the “crisis”. Someday, central bankers may admit they can only affect supply (see but cannot change demand (see These two charts are a powerful arguments against continuing, which only gives cover to the horrible FISCAL policies that are restraining growth. For a nice read overnight from Jens Weidmann on this topic, see

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