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Thursday, November 18, 2010

Bond Vigilantes-Bernanke Thwarted?

Bernanke wants long term rates to drop. That is the purpose of the much bally-hooed Quantitative Easing II program. The program buys longer-term securities to the tune of $600 billion, pushes their prices higher and yields lower. The lower long-term yields feed into the already historically low mortgage yields, pushing them even lower still, thereby resuscitating the moribund housing market. At least that's 'da plan.

But--in a cloud of dust on the horizon--the infamous bond vigilantes are riding in. They've got a lot of rope and they've got ugliness in mind. They're selling bonds, driving prices down and yields higher.

Part of the problem can be traced back to early 1994, a watershed event in Fed policy. At that time, Greenspan undertook what had been the usual course of monetary policy - he surprised markets. Beforehand, investment bankers were coolly raking in billions with the so-called carry trade. This is simply borrowing at very low rates and lending at higher rates at longer maturities. As long as the Fed plays along, this is a low-risk strategy to keep Wall Street in $3,000 suits and block-long limos. But the Fed didn't play along. It surprised markets by raising rates. Havoc ensued, rates skyrocketed, and a lot of money was lost. Greenspan never liked upsetting investment bankers. Pulling the punch bowl at the party wasn't his style.

Since then, the Fed, at the Federal Open Market Committee meetings, and in public speeches, has played along. Today it carefully announces its intended policy. Before any actions are taken, it makes sure the investment banking world knows exactly what it will do.

The upshot of all of this is that prices react ahead of the action (would somebody please explain this to the Fed Chairman?). What would you do if you were in the market for a big screen TV and Best Buy told you they were raising prices 15% next month?

Today this creates a dilemma. The policy has been announced, rates dropped, and employment has been minimally affected. Now the policy is occurring, but the bond vigilantes are selling; and the outcome is the opposite from that intended. Interest rates are on the rise. It is indeed getting ugly.

1 comment:

  1. You are so right. The investors who rushed into bonds at the market highs are going to get hurt. And it does appear that the market has given Bernanke a slap-down.