Notes From Underground

In the 1980s it was very popular to use of ZERO COUPON BONDS. The name was derived from the idea that bonds didn’t pay regular interest but rather the instrument was purchased at a steep discount and the interest accrued all the way to time of the BOND maturing: No coupons to clip but aggregated interest to collect. Now the idea of ZERO COUPONS has morphed into ZERO COUPONS, meaning that all interest payments are virtually ZERO, or maybe even less. Anyone buying the new mode of ZERO COUPON is hoping that interest rates go negative and the BOND itself has some capital appreciation. The world has changed dramatically and the beauty of the original zero coupon has morphed backed into  a caterpillar. All bondholders are insects in search of the cocoon of equities.

The safety of bonds of any maturity over two years doesn’t exist and even short-term notes are highly questionable for even Spain and Italy are yielding zero interest. As Bernanke has recently blogged, the FED claims to bear no responsibility for the long end of the curve at historic low yields, but I am not buying that viewpoint. QE in the U.S. showed the way for global central banks and now that the ECB is fully engaged in the QE program European investors are buying U.S. bonds as they search for “safe” instruments with some positive yield. The ability of capital to flow freely throughout the global financial system insures that all of the developed economies bond markets are synchronized. The only thing that could prevent the ECB affecting U.S. bonds would be if the U.S. imposed foreign exchange controls, which is certainly not in the realm of near term possibilities.

The ECB and BOJ promotions of quantitative easing has not only led to lower U.S. bond yields but also resulted in a rapid surge in the value of the DOLLAR. The IMF and U.S. policy makers have become concerned about the strength in the U.S. dollar harming U.S. economic growth. On April 9, the U.S. Treasury department released its “Report to Congress on International Economic and Exchange Rate Policies.” In a Dow Jones story, reporters Talley and Sparshott wrote: “The Obama administration chastised Europe and Japan for excessive reliance on monetary policy to revive stagnant growth….” The report was repeatedly warning that solely depending on monetary easing was just undermining the U.S. growth story and Germany, Japan, China and South Korea needed to do more to invoke fiscal policy to enhance their domestic economies. The recent rally in the U.S. dollar in response to BOJ and ECB QE programs was causing U.S. manufacturers to push for currency manipulation clauses in all trade agreements. The Treasury report specifically warns Germany and Japan that failure to enact powerful fiscal spending programs could result in “negative spillovers.”

The Dow Jones article cites the perennial Japan basher, Fred Bergsten of the Peterson Institute, who maintains that the Obama administration is right to criticize Europe and Japan. “Monetary easing largely drives down their currencies and simply redistributes global growth in their direction from the U.S. and other countries, instead of adding to total world output.” The U.S. applauds itself for being very aggressive with its own QE policy while chastising others for pursuing a similar policy. This is a classic case of CHUTZPAH (a child killing his parents and petitioning the court for mercy because he is an orphan). The U.S. FED unleashed a powerful torrent of liquidity upon the global financial system, which resulted in the U.S. capturing growth from other economies as the U.S. dollar depreciated. The FED was forced to act because U.S. fiscal policy was locked inside Washington politics, which resulted in Senator Chuck Schumer telling Bernanke that the FED had to be ultra aggressive because they were,”the only game in town.” Mercy, your honor.

***Tomorrow morning the ECB releases its policy statement at 6:45 a.m. CDT, followed by a Mario Draghi press conference at 7:30. I expect no change from the ECB, especially in light of an IMF meeting in Washington this week. President Draghi will be all smiles at his press conference and high-fiving anybody within reach since European BOND yields have dropped dramatically, the EURO is 8 percent lower against the DOLLAR and lower against the YEN and British pound after announcing a QE program January 22. Draghi won’t do anything to call further attention to drop in the EURO of 20 PERCENT since the last IMF meeting in October. Best not poke a prowling bear.

***In light of the situation in the BOND MARKETS I hope to cover yesterday’s speech from Simon Potter, who runs the System Open Market Account (SOMA). He spoke about bond market conditions and is set to deliver another speech tomorrow evening in New York. In an environment of interest market manipulation by the global central banks it is important to hear from the owner of the FED‘s toolbox. It is SOMA that will act upon the FOMC‘s decision to impart any exit strategy from the QE programs. Bond volatility … collateral damage from a policy model. We will hear what Simon says!

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