Posted by on June 21, 2017 4:48 pm
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Categories: Banking Bond Business Central Banks Economy FED Federal funds rate Federal Open Market Committee federal reserve Federal Reserve Bank Federal Reserve Bank Of Boston Federal Reserve System Finance Fixed income market FOMC Interest rates Monetary Policy money New York Federal Reserve United States Treasury security US Federal Reserve William Dudley

It is largely acknowledged that after a decade of unprecedented
monetary accommodation in the US and abroad, bond markets are extremely
overvalued.  Globally, central banks are
trying to slowly deflate this bubble but the beast created is not easily
broken.  A decade of manipulating bond
prices has created a small consortium of large balance sheet traders who trade
the most liquid Treasury market in a high volume fashion, thus setting global rates
much lower than historical norms. This manipulation reallocates billions in
interest payments from badly needed investors such as pensions to a few hedge funds
and banks. These practices end up costing the government much less in interest
costs so these gargantuan bad practices continue (Over a trillion of US
Treasuries trade daily in cash and futures markets and there are only 14
trillion Treasuries. Additionally, foreigners own half and the Fed owns 2.5
Trillion – clearly too high of volume compared to securities available).

These questionable trading practices have rallied long term
Treasuries over 50 basis points in just the past month – a substantial move.  Even more spectacularly, this happened when
the Fed raised the Fed Funds Rate 25 bps and said they expect 1.75% in further increases,
set out their path to trillions in future bond sales to reduce their balance
sheet and the government is planning on issuing ultra-long dated bonds.  Yes, it’s clear to see that the Fed’s
manipulative practices from the last decade has turned the bond market into
something resembling the wild west.  This
will end tragically with systemic issues in the bond market.  This has been the modus operandi of the Fed for
the last 20 or so years.  Over accommodate
the economy with easy monetary police, create systemic issues and resolve with
more accommodative policies. This time around, the blame will be placed
squarely on monetary policy and the Fed knows it.

To try to limit the calamity from the insanity in the bond
market, the most dovish of Fed officials have been trying to limit these
manipulative strategies and slowly steer rates out of the upper stratosphere and
on a path to normalization. We continue to get economic data showing the
economy is not only normal but poised to overheat with accelerating inflation.  GDP of 3% and inflation of 2% does not justify
depression era level of rates.  Home
prices just surged to a new record high! No.  History shows rates should be at least 2% to
3% higher.  Long term Treasuries could
have market losses of 50% if rates normalized and you could still argue they
are overpriced.  When markets are this
overpriced, the probability of a severe parabolic move to higher yields is
elevated.

The Fed knows this and wants to change this environment
before the forgetful public gets scorched again.  Recently, New York Federal Reserve President
William Dudley, a dovish member of the FOMC, stated that he is confident that
economic expansion has a way to run and strong labor markets will eventually
trigger a rebound in inflation. 
Tragically, the media barely touched on these comments and longer dated
bonds rallied on high volume.  Short dated
bond yields have not been moving lower.  There
are too many bonds available, they are priced right on top of current funding
costs and this part of the interest rate curve is difficult to manipulate. 

Even more obvious of the Fed in unison trying to deflate the
bond market bubble, uber-dovish Federal Reserve Bank of Boston President Eric
Rosengren said that the era of low interest rates in the United States and
elsewhere poses
financial stability
risks
and that central bankers must factor such concerns into their
decision making process.  This is as high
of an alarm that can be rung – and just rung by one of the most accommodative of
FOMC members.  Media – please report and
make the public aware of these risks that now even the Fed feels compelled to
highlight these issues.  How can there be
comments like this and the public still is invested in this investment class?  What’s the excuse going to be this time around
when there are significant losses in the bond market.  I missed those Fed speeches?

 

These Fed comments acknowledge there is a serious problem in
the bond market and they are trying to encourage a more rational pricing
function in rates – good luck. The only way to create normality in the bond
market after such buildup of risks from the most accommodative monetary policy
in the worlds history is a financial crisis that will put these manipulative trading
strategies out of business.  And that
leads to different issues that can leach into slower economic growth.  The Fed has to pick their poison. It appears
they want this mispricing of bonds to come to an end.  Unfortunately, it appears they are fine with a
slow end to these practices.  A slow end
means risks will continue to build and the end will be that much more painful
and destructive.  We all know the longer
you wait to take your medicine, the sicker and more painful the situation
becomes.  I just hope the patient isn’t
left in critical condition from the Fed’s medicine again.

 

by Michael Carino, 6/21/17

Michael Carino is the CEO of Greenwich Endeavors, a
financial service firm, and has been a fund manager and owner for more than 20
years.  He has positions that benefit
from a normalized bond market and higher yields.  Do you?

 

    

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