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Saturday, August 14, 2010

Is There a Limb Getting Ready to Break?

The investment pros have been wrong along with most everyone else, except maybe for the small investor, in predicting a rise in interest rates. The yield on the 10 year Treasury note has fallen to a 16 month low. Amid the pros continual tsk tsking, the small investor has continued to pile into bond funds. Although this extreme drop in rates could very well be a bubble and come back to severely punish the small investor, it has been a very rewarding move up to this point.
In my experience, when these kinds of moves take place, there is the potential for a big accident. Simply, when the pros believe a move in prices is a sure thing (i.e. a drop in bond prices), they bet heavily on it. Unlike you and me (hopefully), they don't just put their money on i-- they borrow to the hilt and put it into the pot. For example, Paulson bet heavily on the housing bubble and won - from a no name hedge fund manager he vaulted to guru du jour. The rest of the banking system made leveraged bets on mortgage backed securities and insuring various instruments - and the American tax payer lost big time. Long-Term Capital Management bet heavily on mean reversion for global spreads and lost--the Fed had to be called in to engineer a bailout.

Very likely there is a trader somewhere - in a hedge fund or in a bank - who has made a heavy leveraged bet on rising rates and who is bathed in sweat night after night praying for rates to rise. The limb is bending mightily. To say the least, if it does occur, the timing couldn't be worse. The Fed is out of ammunition, basically proclaiming this past week that the printing presses are going to remain wide open.

Just some thoughts.


  1. I'm still in the camp that interest rates, especially long-term rates, are going up. I just don't know when the Fed's artificially low interest rate policy will be reversed. But I'm not making any leveraged bets on it. I'm just keeping my maturities short.

  2. I was telling myself the same thing with the yield curve. Or, I should say the bond market doesn't look too confident here. With September around the corner, it looks like that limb could be getting heavier. Stimulus only has so much effect and then we have the consequences. Should be an interesting end of the year.

  3. Usually speculation plays a vital role in the allocation of resources, but not when the traders can socialize their losses on society...

    What are they going to do, pass another huge stimulus if the shit hits the fan again? More likely, the Fed will just buy up a bunch of assets and inject cash directly into businesses. From what I have read, the new financial bill gives them additional authority as far as that is concerned.

  4. Here's an interesting 4-part commentary and analysis of the new bill:

  5. I agree Mike - that stimulus twig is going to break soon. It won't take a mighty wind to snap it off. It should be a very interesting fall.

    On another but related economic note: is keeping the printing presses running 24/7 a long-term solution to get out of debt? I just can't see how this behaviour will not collapse things in the long-run. Folks just getting by now, might be ruined in the not too distant future.

  6. Keeping the printing presses running 24/7 certainly seems very dangerous and short-sighted. How long will it take from our global brethren to refuse to play the game once we're branded as completely irresponsible.

  7. Great comments. I have to say that I'm not real encouraged by the Dodd-Frank bill.\ and agree with the link provided by Kevin. I agree that the problems were caused by the Fed and one of the main culprits was Bernanke. If they had not gone to 1% in 2003 the housing crisis would have been a blip in my opinion.
    I believe they were spooked by what had happened in Japan and over-reacted. Look back at the housing numbers and autos number and overall economic data in early 2003 and it wasn't that bad. By worrying about deflation and taking steps to avoid deflation Greenspan and Bernanke actually brought it on.