Ben Bernanke's widening yield curve
what this means for investors
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We have two choices: a bond market collapse or a bond market and currency collapse.
The widening yield curve is a horrible formation.
It is not a sign of economic recovery, but the embryonic stage of a bond market collapse.
It is a signal that investors/lenders are unwilling to invest/lend long term.
By trying to delay the inevitable, Bernanke is making the inevitable much worse. Investors/lenders are catching onto Bernanke's bag of money-depreciating tricks, and they recognize that the Fed has no future goods to trade for present goods (i.e., the essence of lending and borrowing).
Perhaps Bernanke can lay doubts to rest by explaining how short term borrowing can sustain long term investing/lending.
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If one reads the mainstream financial press, they will receive conflicting messages. In many instances, a paradox might be contained within the same article.
On one hand, high interest rates are considered to be bad. On the other hand, the mainstream financial press is now selling the widening yield curve as positive news. (It wasn't too long ago that the conventional argument was that ARM resets "caused" the foreclosure crisis, and that the foreclosure crisis "caused" the economic meltdown.
Of course, the conventional argument fails to explain what caused higher interest rates, to which I would say: it's a savings crunch.)
I would suggest that the first stage of a true economic recovery would give us an inverted, or negative, yield curve. Short term rates would rise, diminishing inflationary expectations, thus engendering lower long term rates (i.e., inversely running rates).
Once the recovery is complete, short term interest rates would come back down, and we would go back to a contango curve. However, a true economic recovery will not precipitate rising long term rates, period.
In the early part of 2009, I predicted that the yield curve would continue to rise as the result of Fed policy. I have also warned people that there is no right way to invest in an economy when there is only one direction for interest rates to move in.
There are only safer ways to invest (I think I'd be looking at debt-to-equity ratios). (There is a difference between trading and investing.) The trader buys and sells assets based upon nominal price movements, whereas the investor buys and holds assets based upon a return from the underlying asset. I have also said for several months now that the safest strategic play is to short interest rates.
A lot of people conflate rising interest rates with inflation (i.e., monetary expansion). If interest rates are low, some argue, then there must not be inflation. While it is true that the market eventually accounts for inflation, inflation is not synonymous with rising interest rates, and interest rates are lagging. There are a plurality of forces that determine the direction of interest rates, and the direction is determined by what force is more dominant.
The Fed has the ability to manipulate both short term and long term interest rates, but only temporarily. (Loose monetary policy inflicts the greatest damage on T-bonds, and then T-notes.)
The means by which the Fed manipulates interest rates is through Open Market operations. If the Fed runs a loose monetary policy (i.e., creating inflation), by injecting "liquidity" into the loan market through "quantitative easing," this, by itself, has a suppressant effect on nominal interest rates. By increasing the supply of loanable funds - but without a corresponding increase in real savings - nominal interest rates are brought to artificially low levels.
This loose monetary policy by the Fed sends the loan market a signal: a bad one. It is a green light to the loan market to consummate loans that are otherwise not justifiable. The loan market is tricked into pursuing a policy of inflationary credit expansion.
However, as prices start to rise, this exposes nominal interest rates as negative real interest rates. There is no right way for the loan market to extend credit at negative real interest rates, which means a negative rate-of-return in real terms. Credit then has to be curtailed, and interest rates must rise to reflect the true supply of savings. The moment the real rate of interest rises, insolvencies are exposed outright.
In other words: interest rates must eventually go higher than where natural rates would have been absent central bank intervention to begin with.
It is important to understand that in this case, rising interest rates are not the cause of problems, but the necessary consequence of reckless spending. As interest rates rise, credit is contracted, consumption is curtailed, and prices fall. This, in turn, engenders saving, investment (which can only come out of savings), and capital inflow, which then engenders a lower natural rate of interest.
There is one problem for the political regime and its central bank (i.e., the Fed): the biggest sub-prime debtor of all is the U.S. Congress. The system is so bankrupt that it can't function absent a continually-declining, negative real interest rate. With a soon-to-be national debt of $15 trillion, if interest rates hit just 10%, do the math. For interest rates to rise, politicians would have to curtail spending (i.e., relinquish power). So here comes Ben Bernanke to the "rescue."
Rather than facing the consequences of previous policies by letting the market set interest rates pursuant to the true supply of savings and purge itself of malinvestment, Bernanke ballooned the Fed's balance sheet to drive interest rates down to absurdly low levels. There is now nothing Bernanke can say, or do, to prevent interest rates from going upwards. However, Bernanke can cause interest rates to go even higher than where they otherwise would have gone absent his interventions to begin with (the underwater beach ball effect) - and then it's an even bigger collapse.
If the Fed tightens and lets the market set interest rates pursuant to the true supply of savings, we get higher interest rates. The consequence? Insolvencies are exposed outright and false economic activity (i.e., non-productive activity) is brought to a halt. The inefficient and insolvent go under, but this is to the benefit of savers and producers, who can then lead the way to a recovery.
But if the Fed stays loose to prop up the bond market, the dollar itself becomes less and less solvent. Eventually, we cross a point - which we have already crossed - where investors/lenders account for the inflation risk by tacking an inflation agio onto interest rates. Let's review this: the Fed inflates to prop up the bond market, and it works for a while. Bond prices hold steady (courtesy of Ben Bernanke's intervention). But then later, asset prices rise (courtesy of Ben Bernanke's intervention) and investors/lenders recognize that 3.5% on the 10-year is a negative rate-of-return in real terms. Bond prices fall and yields rise. Ben Bernanke then inflates even more to prop up the bond market. Bond prices continue to fall and yields continue to rise. The more Bernanke inflates, the further down bond prices go, the more Bernanke inflates, the further down prices go, the more Bernanke inflates. Thus Ben Bernanke undermines the very bond market he is trying to prop up.
This means that while Bernanke can prop up the bond market in nominal terms, he can't prop up the bond market in real terms. The longer the Fed tries to prop up the bond market, the higher commodity prices go, which means a higher cost-of-living. There is nothing the Fed can do to stop this re-alignment of prices other than make it worse by staying loose. If Bernanke keeps trying to prop up the bond market, he and his proxies will be the only ones to show up at Treasury auctions.
The "promise" we get from the myopic Bernanke is that he will somehow stop price inflation when it is visible as captured by the flawed CPI. (Which prompts the question: then why create the inflation to begin with?) In other words: Bernanke has promised to do an intervention on his own intervention (i.e., chase his own tail). How, exactly, does Bernanke say that he will "defend" the dollar? Not by raising nominal interest rates, real interest rates, nor raising reserve requirements. Instead, the Bernanke plan to "defend" the dollar by paying banks interest on the reserves that Bernanke conjured up to begin with. And how, pray tell, is Bernanke going to pay interest on these reserves without inflating even more?
Make no mistake about it: the Fed is politically incapable of tightening. Too many politicians would have to voluntarily relinquish too much power. The Fed was politically incapable of letting interest rates rise at the end of 2008. Now that we are deeper into the hole, just imagine how much more politically incapable the Fed will be to tighten. If the Fed continues down its current policy path, expect the yield curve to widen.
We have two choices: a bond market collapse or a bond market and currency collapse.
The widening yield curve is a horrible formation.
It is not a sign of economic recovery, but the embryonic stage of a bond market collapse.
It is a signal that investors/lenders are unwilling to invest/lend long term.
By trying to delay the inevitable, Bernanke is making the inevitable much worse. Investors/lenders are catching onto Bernanke's bag of money-depreciating tricks, and they recognize that the Fed has no future goods to trade for present goods (i.e., the essence of lending and borrowing).
Perhaps Bernanke can lay doubts to rest by explaining how short term borrowing can sustain long term investing/lending.
Mark Anderson
VoteAnderson.com
webcommentary.com
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