Tuesday, May 4, 2010

Treasury Bears Are Wrong - They Need to Look Closer at the Fed's Motives and Opportunities

As we discussed last week, hedge fund managers are crowded short Treasurys. They just despise them. David Rosenberg and I are the only people on the planet who are bullish. Rosie isn't even all that bullish - he's not calling for yields to get cut in half like I am - he's just not apocalyptically bearish. (I have been beating my pro-Treasuries drum for months.)

Comes now an asset manager with a typical article saying "Don't Fight the Fed - Short U.S. Long Bonds". This time I have to respond. The crux of his argument is that,

"central bankers will be doing everything within their power to spark 'manageable' price inflation because of all the debt they've issued. We've all heard the old Wall Street saw 'Don't fight the Fed.' This makes it particularly important to realize that the Fed wants inflation. Some would argue that they need inflation. This certainly applies to all central banks and sovereign debt around the globe."
This is certainly the consensus opinion, but it is totally wrong. People who hold this view are missing three key things: (i) they in a crowded trade with barely any opposition, and (ii) inflation would be a disaster for the Treasury, and (iii) deflation would suit Treasury's purposes much better.

As evidence for (i), we can take an admission from this very asset manager,
"It's interesting to note that the commercial interest in Treasurys from the COT report is pointing to extremely bearish sentiment on bonds. In fact, save for one month in 2005, it's at the most bearish level since 1993."
However, he justifies his complacency with the typical Treasury bears' tired argument about "inflating the debt away,"
The U.S. has increased its total debt 32% in two years. That's a lot of debt that must be inflated into submission.
Unfortunately, these Treasury bears are just not paying attention to the term structure of the debt, which brings me to (ii): you cannot inflate away really short term debt. You cannot! I defy anyone to do it!

"Inflating debt away" is just fancy talk for theft. The only way you can steal from a creditor is if they have no choice. But creditors - Treasury buyers - who have lent money on a very short term basis do have a choice. Every time the Treasury rolls over its debt, these creditors have the opportunity to demand higher yields. If the Fed is inflating, creditors will demand higher yields to compensate!

This brings me to argument (iii): right now, deflation would suit the Fed's purposes best. Look how low the yield on the 30-year was during the crash. During an equities selloff, they could sell tons of long term Treasurys at low yields! Their biggest priority will be selling lots of long term Treasurys, so the yield won't necessarily spike so low this time.

What's hilarious is that this is going to be paid for by people who are short Treasurys and long equities, like our asset manager friend, who says
Relative to the yield on the 10-year T-note, stocks are very fairly priced. We think a long stock index position has less risk than Treasurys. 
Really? Don't you see how easily equity investors could be stampeded into Treasurys? Not only that, but the Treasury has a prior claim on equities. They could just raise corporate taxes.

So what would you expect to see if I was right? First, getting rid of the special liquidity programs and quantitative easing - which they have done. The asset manager admits that tightening has been happening:
And while this metric has actually reached a negative annual growth rate recently, the U.S. created so much money that there is still a very real possibility that the Fed moves too slowly to reduce MZM in time to eradicate inflationary price pressure.
When the market starts crashing this summer, I will be interested in buying TLT and ZROZ.


anonymous said...

You have it right to a point except this bank system doesn't work when in deflation mode. In fact it fails. Only inflation will keep the gears turning.

QE (printing more debt) will go on until debt outstanding is covered then for growth they will need to pump in more dollars to stimulate. Inflation begins then.

In the meantime consumers refuse to spend and borrow (probably saving for new taxes).

Until consumers decide to participate in the economy nothing will help then the banking system will not be able to survive leading to default.

Taylor Conant said...


You have an odd mix of Austrian and Keynesian thinking but ultimately you are befuddled and miss CP's main point as well as overarching thesis.

In the short term, it appears Bernanke and the Fed prefer deflation-- this will give them a low yield environment to move the national debt into longer term maturities, at which point it can be "safely" inflated away.

The banking system is no problem in the meantime-- easy for Treasury to announce it will backstop losses ($300B to Citi and BofA and counting), FASB can suspend mark-to-market accounting rules which basically allow the banks to be "solvent" as long as is politically expedient, and the Fed can issue further "liquidity rebates" to the banks by way of taking their crap mortgage securities off their hands and supplying them with fresh cash or AAA 100% Angus Treasury issuance.

As for your incoherent ramblings about consumer participation, "the consumer" is all-tapped out, debt wise, but either way, who do you think it is that is buying the product of American and foreign businesses all day long? Space aliens? Consumers are "participating" in the economy-- there wouldn't be any economy to speak of if they all stayed home and slept in.

CP said...

good work taking down anonymous's nonsensical blather