Generational Dynamics Forum - New Site

by **Higgenbotham** » Sun Nov 14, 2010 6:50 pm

vincecate wrote:
John wrote: So the Fed is buying the bonds from the banks who buy it from the Fed. That will create a huge further demand for Treasuries, which will be satisfied either by the US issuing more Treasuries, or by existing Treasuries selling for much higher prices.
The Treasury is making totally new bonds at the rate of about $100 billion per month, as well as selling bonds to cover all the bonds that come due. With the Fed buying at about $100 billion per month they are just covering the regular Treasury supply. This is not really a "huge further demand".

The Treasury has been issuing additional debt for a long time, so the market has had something to absorb for a long time. Now the market doesn't have any net new issuance to absorb. Of course, it's not that simple, but that seems to be what we are talking about.

vincecate wrote:In a bubble speculators drive up the prices to crazy levels. Eventually the supply of the thing is enough to overwhelm demand and the price collapses. Speculators have been buying bonds thinking that QE2 would drive prices up. These speculators may well have bought more than $600 billion.

According to ICI, net inflows into bond mutual funds have been averaging around $30 billion per month, long before QE2 was announced. That's a pretty small subset of the market so it's clear that the public wants bonds in quantity. On the other hand, I'll bet a good part of that isn't government bonds.

vincecate wrote:There is a fundamental problem with the Fed trying to drive up bond prices by printing money. In the longer term the printing money reduces the value of the dollar and so also reduces the value of the bonds. It can work short term, but if it goes on long enough this printing money to drive up bond prices will fail. Longer term is like 2 or 3 years, and we are reaching that point.

All things being equal what you're saying is true in my opinion. But again, it depends on how much is created and what happens to the money as well as the economic and regulatory environment as to the significance of these actions. It's also true that the dollar fell for years before the Fed got involved with QE programs and the banks were taking advantage of low interest rates to issue money substitutes based on securitized credit. How much of that will be unwound over the coming months?

vincecate wrote:The prices of bonds are really at crazy levels. Getting 1% or 2% for locking yourself into US dollars for 1 or 5 years when the dollar frequently drops 1% in a day, is crazy. Bonds can only go higher as interest rates go down. When interest rates are this close to 0% the bond prices can not go "much higher". When something can not go higher, it will start going down soon. The risks/reward is not sane. US Bonds are a bubble that will pop. I think the stock market will crash about when the bond bubble pops. I think this is soon, like in the next 6 months. Time will tell.

OK, first of all 1 or 5 years is not a bond. 1 year is a bill and 5 years is a note. I'd agree that 30 year bonds are overpriced, but that is my opinion. Is the market wrong? I think in this instance it is. On the other hand, I think getting 0.5% in a short term bill is a great deal. Reason being, I will lose money almost anywhere else - stocks, real estate, bonds, you name it. If a 30 year bond is at 4.2% (current price), the price will go up a lot if the yield falls in half. Reason being, you have to lay out twice as much principal at half the yield to get the same coupon. I don't know how buyers at the exchange determine 30 year bond prices, but the history is here: http://futures.tradingcharts.com/chart/TR/M

vincecate wrote:Over the long term, stock yields and bond yields go up and down together (like compare 1980 to 2010). So I think that anyone who expects a major stock market crash should not view bonds as a good investment.

Bond yields bottomed in the early 40s. Stock market PEs also bottomed in the early 40s. Thus, stock market dividend yields should have reached a relative high in the early 40s. I don't have all my charts in front of me, but do know that much.

by **vincecate** » Sun Nov 14, 2010 7:49 am

John wrote: So the Fed is buying the bonds from the banks who buy it from the Fed. That will create a huge further demand for Treasuries, which will be satisfied either by the US issuing more Treasuries, or by existing Treasuries selling for much higher prices.

The Treasury is making totally new bonds at the rate of about $100 billion per month, as well as selling bonds to cover all the bonds that come due. With the Fed buying at about $100 billion per month they are just covering the regular Treasury supply. This is not really a "huge further demand".

In a bubble speculators drive up the prices to crazy levels. Eventually the supply of the thing is enough to overwhelm demand and the price collapses. Speculators have been buying bonds thinking that QE2 would drive prices up. These speculators may well have bought more than $600 billion.

There is a fundamental problem with the Fed trying to drive up bond prices by printing money. In the longer term the printing money reduces the value of the dollar and so also reduces the value of the bonds. It can work short term, but if it goes on long enough this printing money to drive up bond prices will fail. Longer term is like 2 or 3 years, and we are reaching that point.

The prices of bonds are really at crazy levels. Getting 1% or 2% for locking yourself into US dollars for 1 or 5 years when the dollar frequently drops 1% in a day, is crazy. Bonds can only go higher as interest rates go down. When interest rates are this close to 0% the bond prices can not go "much higher". When something can not go higher, it will start going down soon. The risks/reward is not sane. US Bonds are a bubble that will pop. I think the stock market will crash about when the bond bubble pops. I think this is soon, like in the next 6 months. Time will tell.

Over the long term, stock yields and bond yields go up and down together (like compare 1980 to 2010). So I think that anyone who expects a major stock market crash should not view bonds as a good investment.

by **Higgenbotham** » Sun Nov 14, 2010 12:23 am

vincecate wrote:
Higgenbotham wrote:On the rest of it, it's true that only the Fed can create base money, or monetary base as they call it. But the banks, hedge funds, and so on, through derivatives, have created synthetic forms of money that within the context of the economic and regulatory environment that was created acted as good substitutes. By the same token, synthetic derivatives can be created that will effectively wipe out base money or any other form of money for that matter. For some discussion of that, there were some articles that came in front of the public when the ECB did their rescue package that explained that concept.
I don't really see how derivatives can destroy base money. If I think of a $100 bill, derivatives can cause it to move from one person to another, but I don't see it being destroyed by derivatives. Any more info on how to find those articles?

Some. I remember Goldman was mentioned and it seems like the articles appeared on Reuters. It was about the time the Euro was going down a lot last Spring and Summer but it hadn't bottomed quite yet. A few years ago, I also read about the fact that t-bill only money market accounts could be comprised entirely of synthetics and not real t-bills. I don't know how either one of these things are done, but haven't thought much about it. I'll think about it more and let you know if I come up with anything.

by **vincecate** » Sat Nov 13, 2010 11:49 pm

Higgenbotham wrote:On the rest of it, it's true that only the Fed can create base money, or monetary base as they call it. But the banks, hedge funds, and so on, through derivatives, have created synthetic forms of money that within the context of the economic and regulatory environment that was created acted as good substitutes. By the same token, synthetic derivatives can be created that will effectively wipe out base money or any other form of money for that matter. For some discussion of that, there were some articles that came in front of the public when the ECB did their rescue package that explained that concept.

I don't really see how derivatives can destroy base money. If I think of a $100 bill, derivatives can cause it to move from one person to another, but I don't see it being destroyed by derivatives. Any more info on how to find those articles?

by **Higgenbotham** » Sat Nov 13, 2010 5:25 pm

John wrote: That will create a huge further demand for Treasuries, which will be
satisfied either by the US issuing more Treasuries, or by existing
Treasuries selling for much higher prices. Either way, money is being
created through debt. And if the price of some Treasuries goes up,
then the price of all Treasuries goes up, so that every portfolio of
Treasuries in the world becomes more valuable, creating an asset
bubble.

Reading Armstrong's latest, he makes some interesting comments that I think are applicable.

http://www.martinarmstrong.org/files/Th ... 1-1-10.pdf

The Fed has its models that work most of the time. The idea is that they will bide some time and there will be another bubble. Bernanke mentioned in the Washington Post editorial on November 4 that this stock market bubble would somehow be virtuous. I can't remember the wordsmithing that was used, but obviously he expects it to continue for the foreseeable future, as does Wall Street.

Armstrong mentions there is a small fraction of market movement during phase transitions that negates those models and crashes result. I'm seeing that we may be on the cusp of something like that right now.

Whereas QE2 by most models would be considered expansionary, if long rates begin to rise, and they are, then I can see the possibility that the asset and commodity bubbles can crack much more quickly than almost anyone can imagine given how the Fed has stacked the house of cards. The reserves the Fed has created will likely then flee back into treasuries but my bet is that they flee into the shorter end of the curve. If rates out on the long end continue to rise as asset prices crash, the crash will be self-reinforcing. Even as long bond rates around the world rise, US long bond rates may also rise by lesser amounts. This in my opinion would be the perfect financial storm for the US stock market.

http://quotes.ino.com/chart/index.html? ... =&w=&v=d12

The brief discussion Armstrong did about natural disasters following economic disasters is interestingly enough something I also thought about recently and mentioned in this thread. If the scale of the economic disaster is larger, the effects of the natural disasters that follow will probably be nonlinear with respect to the smaller crises. He briefly mentions the 14th Century crisis. Very interesting.

by **Higgenbotham** » Sat Nov 13, 2010 4:07 pm

On the rest of it, it's true that only the Fed can create base money, or monetary base as they call it. But the banks, hedge funds, and so on, through derivatives, have created synthetic forms of money that within the context of the economic and regulatory environment that was created acted as good substitutes. By the same token, synthetic derivatives can be created that will effectively wipe out base money or any other form of money for that matter. For some discussion of that, there were some articles that came in front of the public when the ECB did their rescue package that explained that concept.

by **vincecate** » Sat Nov 13, 2010 4:00 pm

John wrote: The Fed can't go bankrupt because it's not in debt.

Right. The Fed is making its own money out of thin air. A regular bank has depositors that it owes money to. That is different.

by **Higgenbotham** » Sat Nov 13, 2010 3:44 pm

vincecate wrote: 1) If regular banks could make money the same way the Fed does, then how come they go bankrupt? You don't think the Fed can go bankrupt, right?

The first thought that comes to my mind is that the Fed's liabilities are Federal Reserve Notes and bank reserves. Its assets at the moment are US Treasuries of various durations and Mortgage Backed Securities.

In the case of a regular bank, its deposits are liabilities and the loans outstanding are assets.

So the answer to that in my mind (nobody has ever asked) is that the Fed can technically go bankrupt if its assets are wiped out, but the process is entirely different.

Forgetting about the FDIC for now, when a bank goes bankrupt, the value of its liabilities exceed the value of its assets and the depositors get so many cents on the dollar. Either the first to the bank window get paid or the bank is shut and the depositors are partially paid off.

In the case of the Fed, there's no bank window to go to and anyone who has the authority to shut the Fed down and repeal the Federal Reserve Act before the US government defaults isn't likely to. The Fed would not technically go bankrupt until its assets are completely wiped out through government default.

For example, with the obviously deficient MBS they are holding, the MBS will be jettisoned from their balance sheet and the ultimate burden will go to the public through higher prices than would have otherwise occurred, but ultimately lower wages, lower profit margins and bankruptcies.

by **John** » Sat Nov 13, 2010 3:16 pm

Dear Vince,

So I guess now we're "different," after all.

vincecate wrote: > 1) If regular banks could make money the same way the Fed does,
> then how come they go bankrupt? You don't think the Fed can go
> bankrupt, right?

The Fed can't go bankrupt because it's not in debt. It's the
U.S. Treasury that will go bankrupt (default on its bonds).

By the way, investment banks and hedge funds don't always go bankrupt
either. During the bubble, they used a separate corportation - a
structured investment vehicle - that was supposed to protect
themselves from bankruptcy.

vincecate wrote: > It is a very different kind of "money". The central bank has
> powers that regular banks do not have.

Not it's not. It's the same thing, but it only differs in scale.
A single bank might be able to create only a few billion or tens
of billions of dollars in new money, but put together all the
investment banks and hedge funds in the world, and you come to
hundreds of trillions of dollars.

John

by **Higgenbotham** » Sat Nov 13, 2010 2:52 pm

Some general thoughts.

What money is and can do depends on:
The form it is in
Who holds it
The economic and regulatory environment

Let's say a bank is holding a 10 year government note. Once Glass Steagall was repealed, I believe they could use that note as collateral at a certain percentage of market value to speculate. So a 10 year government note becomes something different in a different regulatory environment even though it's still a 10 year government note. There are other nuances too as various financial institutions can't or won't all do the same thing with an identical asset.

If the 10 year government note is then bought by the Fed, it becomes something different yet, as the Fed will either create bank reserves or cash depending. If it's bought from a bank, bank reserves are created and then once again we need to go to our above criteria of "who holds it" and "the economic and regulatory environment" in order to ascertain the effects. As much as I bash the academic economists and the guys at the Fed, they do understand these concepts pretty well in the moment. They understand that the banks are very constrained in what they can do with these reserves in this economic environment, but not so much in this regulatory environment. I believe a bank can temporarily get a higher degree of speculative leverage per dollar of reserves than they can per dollar of 10 year government notes. Previously, I had mentioned that the banks are able to push the prices of exchange traded goods and financial assets. Anyone can see this dichotomy by walking through the grocery store. The price of anything that is exchange traded or related tends to be high and unstable (cheese, for example, as milk is exchange traded - bet not many know that), whereas the price of anything that is not exchange traded or related has tended to fall for the past 3 years. This category would be locally produced items that do not require a lot of transport and/or premium items that are not bulk commodities.

The process of analyzing the movement and creation of forms of money is therefore not simply a matter of accounting. Even an identical form of money is not identical in effect depending on who holds it and the changing economic and regulatory environment. So when John Galbraith says the purchase of a note by the Fed in exchange for bank reserves is a duration swap, it is at the precise moment in time that the transaction takes place but beyond that, it depends. If a bank becomes more levered up in a speculative play because they did that transaction, then it has the potential to become more than a simple duration swap once time t=0 has passed. Nobody can know that. The Fed can track it and have a better idea of what is happening in the moment than perhaps any other entity, but they still have a pretty lousy track record in predicting the future.

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