Bond Market Blowout

Bond Market Blowout


Last week's ructions in the bond market leave little doubt that the
financial crisis has entered a new and more lethal phase. Of particular
concern is the spike in long-term Treasuries which are used to set
interest rates on mortgages and other loans. On Thursday, the average
rate for a 30-year fixed loan jumped from 5.03 per cent to 5.44 per cent
in just two days. The sudden move put the mortgage market in a panic and
stopped the refinancing of billions of dollars in loans. The yields on
Treasuries are going up because investors see hopeful signs of recovery
in the economy and are moving into riskier investments. More money is
moving into equities which is why the stock markets have been surging
lately. (The Federal Reserve's multi-trillion dollar monetary stimulus
has played a large part, as well.) The bottom line is that investors are
looking for better returns than the paltry yields on government debt.
That will make it harder for the Fed to sell up to $3 trillion in
Treasuries in the next year to finance Obama's proposed economic
recovery plan. For now, foreign central banks are still buying enough
short-term Treasuries to balance the current account deficit, but that
could change in a flash, especially given Fed chief Bernanke's
propensity to print more money at the drop of a hat. That's making
foreign holders of dollar-based assets more jittery than ever.

Bernanke is in a bit of a pickle. He needs to sell boatloads of US debt,
but if he raises interest rates he'll kill the recovery and send the
stock market reeling. What to do? Eventually the Fed chief will arrive
at the conclusion that there's only two ways out of a credit bust of
this magnitude; either raise rates and crush the economy or print more
money and face a funding crisis. Either way, there's a world of hurt

The factors which strengthened the dollar earlier in the crisis have now
run their course. Treasuries no longer attract "flight-to-safety"
investors, because most people don't think that another Lehman Bros-type
meltdown is likely. Investors are shifting to emerging markets,
corporate bonds and securities. Commodities are on the upswing because
speculators think that Fed's quantitative easing will end in
hyperinflation. More important, cross-border flows have either stopped
entirely or been significantly reduced due to the need for fiscal
stimulus at home to counter falling demand and rising unemployment. In
2006, 65 per cent of global surplus capital flowed to US markets. No
more. Now the US will have to fight tooth-and-nail for a smaller and
smaller share of the same pool. It will be uphill all the way.

The US economy is facing other headwinds, too; like a banking system
that is hobbled by hundreds of billions in non-performing loans and
toxic assets, and a wholesale credit system that's still in a deep coma.
The Fed and Treasury had plenty of time to take insolvent institutions
into government conservatorship and restructure their debt (as they have
with General Motors), but have chosen to pursue the same failed
approach of providing unlimited funding via the Fed's lending facilities
to any institution with a license and a begging bowl. Now time is
running out and nothing has been done to address the underlying

Bernanke's no fool; he knows his strategy won't work. He's just
following orders from the banking establishment. Remember, the IMF has a
long history of recapitalizing or winding-down failed banks. It's not
rocket science. There are tried-and-true methods for resolving
underwater financial institutions and they are rigorously followed. The
IMF would never give the banks a blank check and simply
hope-for-the-best like Bernanke and pal, Geithner. They've created a
situation where the banks will be a drain on public resources for years
to come, diverting capital from productive sectors of the economy and
choking off credit expansion. Credit derivatives expert Satyajit Das
pinpoints the real problem in an article posted on his blogsite:

"Mancur Olson, the American economist, in his books (The Logic of
Collective Action and The Rise and Decline of Nations), speculated that
small distributional coalitions tend to form over time in developed
nations and influence policies in their favor through intensive, well
funded lobbying. The policies result in benefits for the coalitions and
its members but large costs borne by the rest of population. Over time,
the incentive structure means that more distributional coalitions
accumulate burdening and ultimately paralysing the economic system
causing inevitable and irretrievable economic decline.

Government attempts to deal with the problems of the financial system,
especially in the U.S.A., Great Britain and other countries, may
illustrate Olson's thesis. Active well funded lobbying efforts and
"regulatory capture" is impeding necessary actions to make needed
changes in the financial system. For example, the Centre of Public
Integrity reported that the expenditure on lobbying and political
contribution of the top 25 sub-prime mortgage originators, most linked
to large U.S. banks, was around $380 million (the Economist (9 May
2009).(The finance government Complex & The End of US economic
Dominance", Satyajit Das's blog)

The institutional bias of the Fed is obvious in every decision they
make. Consider the fact that the Fed has provided over $12.8 trillion in
loans and other commitments to shore up wobbly financial institutions
while the two-year fiscal stimulus for 320 million Americans is $787
billion. It's goose liver and Cabernet for the bank mandarins and
breadcrumbs for the working stiff. Unlike General Motors--where
bondholders and workers sustained huge losses and were forced to
dramatically slash the size of their business---the banks and brokerage
houses have been given carte blanche and are free to use their loans any
way they choose, including commodities speculation which has driven the
price of oil from $33.98 per barrel on Feb 12 to more than $68 per bbl.
today. The taxpayer is literally paying for the rope to hang himself.
And Wall Street is only too happy to oblige.

Despite the Fed's best efforts, the oversized financial system will have
to shrink to meet the new reality of falling demand and persistent high
unemployment. Household deleveraging is ongoing, cutting into
discretionary spending and changing attitudes towards saving. That means
corporate profits will falter while and layoffs continue for the
foreseeable future. The economy will probably bump along the bottom for
a decade or so before household balance sheets are patched up enough to
stage a comeback. The Fed's job is to hasten the recovery by forcing
weak players to write-down their losses or declare bankruptcy so their
dodgy assets can be put up for auction. That gives the system a chance
rebuild on a solid "debt-free" foundation. Author and economist Henry
C.K. Liu explains the implications of the Fed's actions like this:

"When financial institutions deleverage with free money from the central
bank, the creditors receive the money while the Fed assumes the toxic
liability by expanding its balance sheet. Deleverage reduces financial
costs while increasing cash flow to allow zombie financial institutions
to return to nominal profitability with unearned income and while laying
off workers to cut operational cost. Thus we have financial profit
inflation with price deflation in a shrinking economy.

"What we will have going forward is not Weimar Republic-type price
hyperinflation, but a financial profit inflation in which zombie
financial institutions turn nominally profitable in a collapsing
economy. The danger is that this unearned nominal financial profit is
mistaken as a sign of economic recovery, inducing the public to invest
what remaining wealth they still hold, only to lose more of it at the
next market meltdown, which will come when the profit bubble bursts.
("Liquidity drowns meaning of 'inflation", by Henry C. K. Liu Asia

"What we have profit inflation in which zombie financial
institutions turn nominally profitable in a collapsing economy." Has
anyone given a more lucid description of the wacky goings-on in today's
market than that?

Bernanke has shown that he'll do whatever he can to avoid simple price
discovery on the illiquid, hard-to-value assets which are at the heart
of the crisis. He's underwritten the entire financial system and shifted
100per cent of the liability for losses onto the taxpayer. He's also
managed to keep the banks in private hands, although the cost has been
substantial. The so-called "free market" exists only in theory now. The
truth is that without the Fed's support, the financial system would
collapse in an instant. The transition to state capitalism has taken
place without public hearings or input. The line that distiguishes the
banks from the government has disappeared.

For $10 trillion, Bernanke could have guaranteed every mortgage in the
country, thereby stopping the decline in housing prices, the deluge of
foreclosures, and the deep cutbacks in consumer spending. Such a move
would have defrosted the secondary market (where mortgage-backed
securities (MBS) are traded) because investors would know that the
collateral was backed by "the full faith and credit" of the US
government. Instead, millions of homeowners have been forced from their
homes and onto the streets while Wall Street kingpins debate whether
they should be allowed to issue themselves fat bonuses from the TARP

Last week's sudden rise in Treasury yields indicates that Bernanke is
nearing the end of the line. The benchmark 10-year T-bill zoomed to a
6-month high of 3.75 percent. Investors want better returns for lending
their money to Uncle Sam. That means that funding the multi-trillion
dollar deficits will get harder and harder. Bernanke can purchase more
long-bonds and keep interest rates low, but investors will see that he's
monetizing the debt and head for the exits. Or he can raise rates to
attract foreign capital and risk putting the struggling economy into a
death spiral. Either way, the consequences will be dire.

Mike Whtney lives in Washington state. He can be reached at
fergiewhitney@… <mailto:fergiewhitney@…>

Excellent article, Mike, thanks for posting.

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