Monday, 23 January 2012

Falling yields support US Dollar

Surely, everyone knows by now that money printing causes inflation and that the Federal Reserve is risking hyperinflation by printing money. If you increase the supply of dollars, their price should go down. Even if the money multiplication mechanism is impaired and most of the new supply of base money parks itself in the excess reserves at the Fed, how can anyone claim that money printing causes deflation?

The deflation mechanism inherent in quantitative easing isn't obvious, so please bear with me as I explain. 

Pushing down the yield curve 

When the Fed prints money it mostly buys the so-called "risk-free" bonds guaranteed by the full faith of the US Federal Government - US treasuries, Agency debt, and the like. Yes, it has also taken on a fair amount of toxic debt in the past few years but that is not directly relevant for this explanation. 

The key thing to remember is that market participants always seek the lowest-risk profits. If they know that someone is in the market to purchase certain instruments they will try and get ahead of the demand in order to sell it to the eventual buyer at a higher price. This type of trading is also known pejoratively as "front-running" when brokers - anticipating the price moves due to their clients' order flows - and placing their orders in front of client orders to reap quick and easy profits. 

Front-running Fed purchases of risk-free bonds is a relatively painless trade for primary dealers during periods of quantitative easing. They would much rather utilise scarce capital front-running Fed purchases than use it for dangerous and risky speculation - in volatile commodity markets, for instance. The newly created electronic money by the Fed, combined with the primary dealer front-running creates a relentless demand for "risk-free" bonds, pushing their price up in a secular uptrend. 

Traditionally the Fed's Open Market Operations are centred at the short-end of the yield curve. With short-end rates at practically zero, Fed purchases have been increasingly at longer and longer maturities. Higher prices for the long term bonds have meant lower yields across the entire yield curve, DESPITE all the money printing.

The Fed as a Man with a Hammer

As the saying goes "To a man with a hammer, everything looks like a nail". Whenever the Fed tries to fight free-market forces (either inflation accompanied by rising risk-free yields, or deflation accompanied by falling asset prices) it is the metaphorical a man with a hammer. It has only one response in both situations, that is to purchase government debt.

When the central bank wants to control rising interest rates, then it goes into the open market to be a net buyer of Treasury bonds. Inevitably, speculators want to preempt the central bank. They strive to buy the bonds first, dumping them into the lap of the central bank at a higher price afterwards. Speculators are making risk free profits. The central bank is helpless. It has to pay the speculators' price.
Likewise, when the central bank wants to control falling prices, it goes into the open market to be a net buyer of Treasury bonds. Speculators will gratefully take the new money so created. Of course, the central bank wants them to buy commodities to prevent prices from falling. However, speculators have a better idea. They go to the bond market where the fun is. Commodities are too risky for their taste, especially when they can make risk free profits in bonds. The risk free profits speculators make are made possible by Keynesian monetary policy.

Bond and Stock Markets rise together

It is easy to see how a lower yield curve translates into higher stock prices. The "risk-free" yield curve is key to pricing of most financial assets. Its central role is in the discounting mechanism for future cash-flows. A lower yield curve means a higher Present Value for the future earnings and thus higher share prices. 

Note that the yield on stocks was in a secular decline, dropping WITH bond yields during the great bull market from the early 1980s to 2000. Another period when stock and bond markets rose together. 

The author of the chart below wonders when the US bond bubble will burst. It won't happen as long as dealers believe that the Federal Reserve stands ready to buy bonds.

The Fed as Dealer of Last Resort

The financial system committed hari-kiri during the securitisation binge by loading itself up to the gills with toxic debt. Highly levered banks and dealers had effectively become securitisation machines.  As Chuck Prince (ex-CEO of Citigroup) said - as long as the music was playing, they had to get up and dance. The inevitable collapse came when the music stopped. 

Collateral value of the new-fangled securitised assets collapsed when the realisation dawned that underlying credits were not-performing as expected. Credit money created by pledging these securities to banks vanished as margin lending was withdrawn. Dealers saw their earnings collapse as securitisation came to a grinding halt. Their capital was wiped out by losses taken on their inventory and buybacks. The resulting liquidity crunch caused the epic crash of 2008 as all assets were sold to raise cash - stocks, commodities, even gold. Not knowing where the bodies were buried, capital panicked into the safety of US treasuries.

The Federal Reserve stepped in as a "Dealer of Last Resort" to provide a bid for all sorts of assets where none existed in the markets. The government first arm-twisted lawmakers to provide a bailout package, and then arm-twisted banks to accept the loans. They also permitted accounting changes to hide capital losses at banks, in order to stave off further collapse. 

Yet, despite a tax-payer funded rescue of the banks and multiple rounds Quantitative Easing consumer demand remains depressed - due to high private debt-levels and persistent unemployment. At the same time the stock market remains buoyant despite the poor economic environment. Many commentators remain confused about this, as they do not understand that stock are pushed up by a falling yield curve.

Depressing the Real Economy through Capital Erosion

The risk of lending to businesses does not interest banks as long as they  can enjoy risk-less profits by front-running the Fed. Businesses are also not interested in borrowing towards new capital investments due to stagnant consumer demand.  A falling interest rate environment is a further disincentive  - why borrow and invest today when you could borrow at lower rates in the future?

When the recession struck, long-term debt on the balance sheet became a destroyer of capital. Capital-heavy industries like airlines and car manufacturers collapsed one after another. In a recessionary environment falling interest rates increase the present value of long-term debt. As capital = PV(Future earnings) - PV(Future Debt Payments), decreasing future earnings coupled with increasing PV of the future debt payments meant companies increasingly became worthless as their capital is destroyed.

Dollar Strength through Capital Concentration

Most people assume that the Fed and the U.S. Treasury are fighting tooth and nail to keep the value of government debt high lest it collapse in want of support from Japan, China, and other countries. In actual fact, what they desperately want to beat down the value of the dollar. The stubbornly high and still increasing value of U.S. Treasuries is the greatest obstacle frustrating their effortsThe dollar's strength since 2008 prevails in spite of the withdrawal of Chinese and Japanese support of the U.S. bond market. 

The destructive monetary policies of the Fed and Treasury are, in fact, self-defeating. The Dollar has become the antithesis of the funding currency. The opportunity for relatively low-risk speculation in the Treasury Bond market invites capital concentration in the US Dollar. What other safe haven exists in these turbulent times (bar Gold)? Would you hide in emerging markets? In commodities? I didn't think so.

Lessons from Japan

Finally I invite the reader to consider the Japanese experience. In my view the US is firmly on the Japanese path. As with the Yen and JGBs, this will not necessarily lead to a weaker dollar. As long as Mr. Market believes that the Fed will continue to ensure a falling yield curve, the dollar will remain supportedAs long as the economy limps along without falling into a recession, this will be a tailwind for stock prices. However, some industries with long-term debt contracted at higher rates are at risk of capital erosion in the process. As US investors continue to discover, investing in stocks and commodities is much riskier than buying uncle Sam's promises.

Up to 1989 Japan's credit bubble caused the Yen to strengthen as capital concentration in Japan with the promise of great returns in Japanese stocks and real-estate. As a result the Japanese Yen strengthened strongly into 1989. The end of the Japanese bubble should have caused capital flight and a weak Yen. Round after round of monetary stimulus was launched to pull the NIKKEI out of the bear market and Japanese property out of its slump. Even then, the Yen did not decline as fast as it has risen. In fact it remained range-bound for two decades. 

JGBs have been the "bubble" that is "about to pop" for over two decades. As long as BoJ is a buyer, it will keep going strong. Over time it became the comfort blanket for Japanese investors hurt by speculation in the NIKKEI and property markets. They eventually saw the relative benefits of front-running the BoJ, rather than attempting risky speculation in domestic and foreign markets. Since 2007 the Yen has resumed its rise, as capital "returns home" to the JGB. Similarly the USD will not collapse as long as Bernanke and friends keep buying.