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Strategies & Market Trends : ahhaha's ahs
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To: NOW who wrote (3451)11/7/2001 12:50:17 PM
From: ahhahaRead Replies (2) of 24758
 
It means that there is no direct connection between interest rates and TBond prices. There is an indirect connection though. If monetary policy is abused so that interest rates are engineered to be lower than at market equilibrium, inflation will be created and the TBond would fall. This is a lagged response since it does have to await how economic activity responds to FED action, but even with the lag which can be considerable FED does use the TBond as a barometer of their action. If there was a direct connection how could short rates fall for a year while long rates were flat?

The indirect explanation is that FED creates uncertainty when they're engaged in aggressive intervention. Lowering of rates isn't getting C&I loans to expand, but it is allowing substantial money growth. This has the effect of propping prices during an economic slowing. What happens when the slowing reverses? Unless the slowing period takes years to complete so that cost growth propensity is reduced or contained, money growth would stimulate prices more than output. This would cause inflation and the TBond would fall. In recognition of this possibility the TBond rate has remained high relative to short rates.

When Treasury announced that TBonds wouldn't be offered in the future, the latent sentiment in the TBond market which is growing more and more deflationary, was moved to reflect reduced expectations for material economic recovery any time soon. So the TBond rate which has held up due to fear of future inflation, started falling. A market description would say that institutions are borrowing more in the short market to invest in the long market and the price convergence between the two markets is the result of an arbitrage.

The question remains, what is the equilibrium interest rate?The market doesn't know because the market, the players, have become completely hostage to the FED. There is no free market in money. It's an arranged market and the arrangement depends completely on FED's ability to engineer the future.
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