Saturday, August 16, 2008

Liquidity Driven Depression - a Bond Bubble Scenario

chatting with Otto, the editor of Inca Kola News, the other day, the question of interest rates came up. the context was that this fellow by the name of Paul van Eden [sic] has been on the media circuit talking about how's he shorting Treasurys. Otto wrote an interesting post on the matter last week incorporating some theories about international money flows and China and commodities &c into it. my response to this Treasury Bear Business was, well, I'll just quote myself:

shorting treasuries is one of the more asinine trades one could put on right now, as it has been pretty much the entire post bubble era. but those of a certain mindset just keep coming back to it. hello, this ain't the 70s.

just look at the daily of the 10 year (click here). Mr van Eden [sic] must spend more time at jsmineset than stockcharts.

that was Wednesday. on Friday we started to see a little more action in the bond market. not a confirmed breakout yet, but, you Know, one step at a time.

then this morning I watch this video clip of Mr van Eden [sic] from July 3rd. the spiel he gives here is probably similar if not the same to what Otto referred to in his post:

long gold and short bonds eh, Paul? I don't Know when he put on the trade, but one can only hope that since this was filmed he's cut his losses.

amusing that on the one hand he says people aren't making as much money as they used to, and on the other hand he quite arbitrarily, from what I can tell, declares that US interest rates are 'too low'. surely it must have crossed his mind at least briefly at some point in his life that interest rates are a function of income? anyway, good luck Paul. I'm going to move on now.

The Liquidity Driven Depression is a term I came up with about a year and a half ago but never bothered to formulate in any rigorous way. basically it means what it says; it is not the lack of 'money' that will drive the economy to its knees, but rather the mis-allocation of an abundant supply. I bring this up because just yesterday I read an article by 'renowned mathematician and monetary scientist' Antol Fekete in which he theorises that the perpetual lowering of interest rates (inflation of bond prices), far from being the cure for a depression, actually causes depressions. here is the quote:

Persistently falling interest rates result in the erosion (ultimately,
destruction) of capital deployed by the producing sector. In effect, bond
speculators siphon off money stealthily from the capital accounts of the
producers. The latter are unaware of being victimized by this vampirism of the
financial sector. But they are, whether they recognize it or not. Profits of the
bond speculators do not come out of nowhere. They are the flipside of the
opportunity loss suffered by the producers who have to continue financing their
capital at the higher rate. Unable to escape from the clutches of debt, the
producers are squeezed. They scramble to sell more of their product at fire-sale
prices in the hope to be able to service debt contracted at the higher rate. In this
way a downward spiral of prices is created.

The prevailing optical illusion suggests that money is scarce. Everybody
cries out for the Fed to create more money. The Fed complies and enters the
open market to purchase more bonds. In doing so it provides bond speculators
with another opportunity to make risk-free profits. Interest rates fall further and
producers are squeezed more. A vicious circle is activated. At the end of the
spiral producers go bankrupt in droves.

(click here for the entire article.)

if I am interpreting correctly both the present clusterfuck of international monetary policy and the price charts of the various treasury notes and bonds then a scenario such as this has a good chance of unfolding:

the Fed Funds Rate gets held at current level for an indefinite period (it'll move eventually of course, but the point is that the consensus becomes that the Company Store's 'on hold' - we're almost there with that part. the market's much more realistic in its expectations than its extremes in March and June). meanwhile, to keep the illusion of monetary restraint in tact, and yet keep the money supply expanding, the Company Store shifts the focus of its open market operations to the longer end of the yield curve. the rationale here is convincing (if yer a monetary bureaucrat at least): appear 'vigilant' by keeping headline rate the same; expand 'money' supply; help stabilise housing market; make equity prices appear more attractive.

the problems with this strategy are manifold. for one thing the speculative community's gonna run away with this. once the funds catch the out. then if the Company Store tries to stem the tide and sell off the bonds they bought that got the snowball rolling in the first place then that's going to deflate the money supply, the economy'll slip even more, which will propel even more speculators into the treasury bubble. talk about a positive feedback system. then come the 'second round' effects such as Professor Fekete outlines in the quote above. 'the clothes are in the dryer and the writing's on the wall.'

this is just a tentative 'could happen' scenario. what's most important is whether the price trends of the 5, 10, and 30 year Treasurys follow the script in the near-term. the charts are below. judge for yourself.