Tuesday, January 13, 2009

Engineering the BLINGFENCE

Posted by Sam Jones on Jan 13 11:04
FT Alphaville

Here’s our take. There is a bubble in Treasuries. But it is an engineered bubble. One which has been encouraged and one which will only pop as rapidly as the economy recovers. Given that the weight of macroeconomic turbulence has yet to hit, that popping shouldn’t be total and shouldn’t come all at once or for that matter, anytime too soon. And while other areas of the bond market are looking attractive, they are so only because fears of the worse corporate default rate since WW2 are very real and very persistant.

The Fed might be wrong, but everything they have said so far points to a three year time-frame for current expansionist policies. Or longer. Here’s chairman of the Kansas Fed, Thomas Hoenig on Bloomberg last week:

Hoenig noted that if the Fed does not remove liquidity in 4-5 years, there will be serious problems ahead - we would say that if the “liquidity” is not withdrawn (to a large extent) in a much shorter period of time, then the possibility of a strong burst of inflationary pressures appears inevitable. One can also argue that the comments suggest the Fed is being rather economical with the truth about its outlook for the US economy, as sustaining the liquidity injection for such a period infers that the Fed sees the economy down on its knees for a similar period of time.

As Hoenig makes clear, the Fed too are aware of the inflationary dangers of QE. For now though, the money multiplier is still low. Which means that the expansion in monetary base, so far, has not been transmitted. Deflation is still very much on the horizon.

And the Fed very much has an interest in the price on Treasuries. The whole point of QE is to manipulate yields in a more direct fashion than regular monetary policy allows.

The wildcard in all this is China: its holdings of Treasuries are so large that its behaviour can influence the market almost as much as that of the Fed can. A Chinese reorientation back into GSE debt, for example, would be a big setback for Treasuries, and one that could spark a selloff.

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