Federal Reserve Money Continues to go Off-Shore

Yesterday in my post I reviewed the consequences of QE2 on the Federal Reserve balance sheet. (http://seekingalpha.com/article/276674-qe2-watch-no-qe3-in-sight)

The bottom line: “The ‘net’ increase in securities held outright by the Federal Reserve has been $589 billion, pretty close to the $600 billion ‘net’ increase promised.

Reserve balances at Federal Reserve banks, a proxy for excess reserves in the banking system, have increased by $584 billion to $1,594 billion over this time period. Actual excess reserves in the banking system averaged $1,610 billion for the two-week period ending June 15, 2011.”

Cash assets (excess reserves) at commercial banks in the United States rose by about $800 billion from December 29, 2010 to June 15, 2011 and closed slightly below $1,870 billion on the latter date. 

Basically the Federal Reserve pumped all these reserves into the banking system and there they seemingly sit.  Yet, the amazing thing is that of the almost $800 billion increase in cash assets in American banks, almost 85 percent of the increase, or about $670 billion, ended up on the balance sheets of Foreign-related Institutions in the United States. 

And, what increased on the other side of the balance sheet?

Net deposits due to related foreign offices.  These balances rose by almost $500 billion since the end of last year. 

In essence, it appears as if much of the monetary stimulus generated by the Federal Reserve System went into the Eurodollar market.  This is all part of the “Carry Trade” as foreign branches of an American bank could borrow dollars from the “home” bank creating a Eurodollar deposit.  This Eurodollar deposit could be lent to foreign banks or investors and this would not change the immediate dollar holdings of the American bank.  This lending and borrowing in Eurodollar deposits could then multiply throughout the world.  And, the American bank might be the ‘foreign-related” institution mentioned above and included in the statistical reports.

Note that the original dollar deposit created by the Fed is still recorded as a deposit at one Federal Reserve bank no matter how much shifting around the borrowing and lending in the Eurodollar market occurs.    

Thus, it appears as if the Federal Reserve pumped one-half a trillion dollars off-shore since the end of 2010!

And, this is going to stimulate spending and getting the economy to grow faster?

Cash assets at the smaller banks remained relatively flat over the last six months…and over the last three months.  Thus, the reserves the Fed was pumping into the banking system were not going into the smaller banks. 

And, although the largest twenty-five banks in the country increased their cash assets by about $130 billion over the last six months, these banks have been reducing their cash balances (by a little more than $30 billion) over the last three months. 

What have the domestically chartered commercial banks been doing over the last six months?

Basically, the twenty-five largest domestically chartered commercial banks have been modestly increasing their loans to businesses, both in the three-month period and the six-month period.  Commercial and Industrial loans as well as commercial real estate loans have been increasing at the largest banks over the past three-month period. 

However, business loans continue to “tank” at the smaller banking institutions.  For example, Commercial and Industrial loans at the smaller institutions dropped by almost $5.0 billion from March 30 to June 15.  Commercial Real Estate loans took an even bigger hit of almost $35 billion. 

Also, at the smaller banks, residential mortgages continue to decline…by a little over $9.0 billion since March 30 and by almost $35 billion over the last six months. 

The real lending by commercial banks is not taking place in the United States.  The lending is taking place off-shore, underwritten by the Federal Reserve System and this is doing little or nothing to help the American economy grow. 

It does seem to help produce inflation elsewhere which gets translated back into the United States in the price of imports.

The Fed has not yet gotten bank lending going, it has not yet caused an increase in the money stock measures, and it has not yet stimulated the economy to any degree. 

The Fed may have helped the FDIC close banks in an orderly fashion and it may have helped raise the prices of commodities world-wide. 

For all the efforts exerted in QE2, the results are not very encouraging.

NOTE: As mentioned in my post yesterday, I will not be posting anything for about a week or so.

Cash Assets at Foreign-Related Financial Institutions in United States Approach $1.0 Trillion!

The Federal Reserve continues to pump reserves into the commercial banking system and the majority of these reserves are getting into the hands of foreign-related financial institutions and then heading offshore. 

On May 25, 2011, cash assets on the books of foreign-related financial institutions was just under $950 billion, up about $200 billion from April 27, 2011.  On May 4 cash asset at foreign-related financial institutions were 50 percent of all the cash assets held by commercial banks in the United States.

Now, on May 25, 55 percent of all the cash assets held by commercial banks in the United States were held by foreign-related financial institutions.

Please note, that on December 29, 2010, before QE2 really swung into action, these foreign-related institutions held only about one-third of all the cash assets on the balance sheets of commercial banks in the United States.

The increase from December 29 to the present has been roughly $590 billion. 

During this same period cash assets at all commercial banks rose by just under $660 billion, so that almost 90 percent of the cash assets pushed into the banking system by the Federal Reserve has gone into the coffers of foreign-related financial institutions!

From the Fed’s own balance sheet we see that Reserve Balances with Federal Reserve Banks, which closely tracks the excess reserves in the banking system, rose by $572 billion.  Almost all of this increase in excess reserves in the banking system has come about through the Fed’s acquisition of over $500 billion worth of U. S. Treasury securities. 

And, what have these foreign-related financial institutions done with the funds?

There is an account called “Net (Deposits) Due to Related Foreign Offices.”  On December 29, 2010 this account, on the reported statistics was a negative $420 billion.  That is, this was not money due to “related foreign offices” it was the money that “related foreign offices” had allocated to the United States office.  That is, it was an asset of the bank and not a deposit liability. 

On May 25, 2011, this negative number had turned into a positive number, it became a liability of the United States branches to “related foreign offices”, and this number was slightly over $86 billion.  This represented a swing of $506 billion!

In essence, cash assets at these foreign-related institutions rose by about $590 billion since December 29 and $506 billion of this increase went to “related foreign offices.” 

This looks a lot like the “pump” for the “carry trade”. (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s)

And, where do we pick up some of the results of this “carry trade” action?

Check out the Wall Street Journal last week, “Big Banks Cash In On Commodities,” (http://professional.wsj.com/article/SB10001424052702304563104576359704074143190.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj) “Wall Street is tapping a real gusher in 2011, as heightened volatility and higher prices of oil and other raw materials boost bank profits.” 

“A group of 10 large bans saw their commodities revenues increase by 55% in the first quarter. “

And, who says that the Federal Reserve is not underwriting world commodity inflation?  And, who says that the Federal Reserve is not underwriting the profitability of the big banks and producing even bigger banks that are too big to fail?

This is my July edition of the QE2 Watch, following up my June edition, see http://seekingalpha.com/article/268809-qe2-watch-banking-system-still-not-fully-engaged.  The Fed continues to do what it said it was going to do, purchase about $600 billion in U. S. Treasury securities by June 30, 2011. 

From December 29 through June 1, the Fed has purchased $516 billion U. S. Treasury securities.  Roughly $105 billion of these have gone to offset the decline in the Fed’s portfolio of Federal Agency Issues and Mortgage-backed securities.  Thus, the net increase in the Fed’s portfolio of securities has only been about $415 billion. 

But, the United States Treasury has drawn down $195 billion from its deposit account at the Fed related to “Supplemental Financing Account and this has put $195 billion of reserves into the banking system over the last five months.

The combination of the two, $415 billion and $195 billion, comes to $610 billion and accounts for all of the increase in reserve balances at Federal Reserve banks, the proxy for excess reserves, of $570 billion. 

The bottom line on this is that the Federal Reserve and the Treasury Department are seeing to it that the financial system is awash with liquidity…even though the largest amount of the funds are going offshore. 

Fed Continues to Pump Reserves into Foreign-Reated Institutions in United States

Over the past thirteen week period the Federal Reserve has pumped roughly $350 billion of excess reserves into the banking system. 

From February 2, 2011 to May 4, 2011, cash assets at commercial banks rose by $400 billion.  (Cash assets at commercial banks can serve as a rough proxy for the measure excess reserves.)   

During the same time period, $306 billion of the $400 billion increase in cash assets of commercial banks in the United States went to foreign-related financial institutions.

On May 4, 2011, of the $1,586 billion of cash assets in commercial banks in the United States, 50%, or exactly half of these cash assets, resided on the balance sheets of foreign-related financial institutions.   

The quantitative easing of the Federal Reserve continues to support, in large part, the “carry trade” where funds generated in the United States continue to find their way into foreign markets. 

This is not the first time I have written on this subject: http://seekingalpha.com/article/265481-large-foreign-related-banks-now-hold-776-billion-in-cash-assets.  Actually, this is the third time I have written about the subject: http://seekingalpha.com/article/254004-why-is-most-of-the-fed-s-qe2-cash-going-to-foreign-related-banking-institutions.

Over the past four-week period, cash assets at all commercial banks actually declined by about $9 billion.  However, cash assets at the foreign-related institutions rose by $27 billion during this time period while cash assets at the largest 25 commercial banks in the United States fell by approximately $21 billion and they fell at smaller domestically chartered United States banks by $14 billion.

There is some good news, however!

The good news is that business loans, commercial and industrial loans, at commercial banks really seem to be on the up swing.  Over the past thirteen-week period, C&I loans have increased by $35 billion.  Roughly two-thirds of this increase, or about $23 billion, of the loans came from the largest 25 banks in the country.  However, C&I loans were only up modestly at the smaller commercial banks over this period. 

In the past four-week period business loans were up $10 billion and 60 percent of these, or $6 billion, came from the largest banks.  Again, C&I loans were up at the smaller institutions by a modest amount. 

So, banks, especially the larger banks, seem to be lending again to business, something that is vitally needed if the economic recovery now under way is to really pick up. 

If the goal of the Federal Reserve in conducting QE2 was to get business loans increasing again, then it seems to have succeeded.  Sure, we will have to wait a little longer to get more confirmation of this trend, but this is the first time in this cycle that business loans really do seem to be increasing.

The not-so-good news: the volume of real estate loans on the books of commercial banks continues to tank.  Over the past thirteen-week period, real estate loans at all commercial banks dropped by almost $90 billion.  Over the past four-week period, these loans declined by over $18 billion. 

Almost all of the decline has come at the largest 25 domestically chartered banks in the country.

Over the past thirteen weeks, the major part of the decline came in the area of residential loans ($41 billion), which was closely followed by the fall in commercial real estate loans ($34 billion).  In the past four weeks, the bulk of the decline came in the residential area ($12 billion). 

So, business loans appear to be picking up but the real estate market continues to decline: mixed signals for any sustainable economic recovery.

Maybe, however, this is all the Federal Reserve hoped to achieve at this time.  It seems as if almost everyone believes that it will still be a while before the real estate markets, both residential and commercial, bottom out and start to pick up steam. 

Maybe all the Federal Reserve thinks it can do is to get businesses borrowing again and with that borrowing put some people back to work.  And, it seems that if the Fed can achieve this small win it would think that flooding the rest of the world with United States dollars has been worth it.   

It would be too bad if a substantial part of the uptick in business lending was just going to finance the merger and acquisition activity of large businesses: http://seekingalpha.com/article/269056-the-latest-merger-binge-and-the-economy.   

The Bubbles Are Real

On Thursday, three-month forward contracts put the yield spread between Brazilian and United States rates at 8.75 percentage points. And, you have questions about the existence of the carry trade, the borrowing at excessively low interest rates in one country to invest at much higher rates in another country.

Well, these yield spreads are not quite as attractive as they once were because Brazil has placed a tax on foreign investment in sovereign bonds. This tax was initiated in 2009 and after two increases is now 6 percent. Several fund managers told the Financial Times outlet that “the appeal of the carry trade had diminished considerably as a result.” (http://www.ft.com/cms/s/0/ec755d4a-1f40-11e0-8c1c-00144feab49a.html#axzz1B0wmwdeP)

Two points on this: first, there is no doubt in my mind that the quantitative easing (QE2) on the part of the Federal Reserve System has created bubbles in other parts of the world: and second, countries around the world have reacted to these bubbles by selectively trying various policy tools to try and contain the capital flows into their financial markets confirming, to me, that the bubbles are real.



Yesterday, the Brazilian central bank introduced a new effort to slow down the rise in the Real “by offering to buy as much as $1 billion in the currency futures market. (“Brazil Central Bank Intervenes,” http://professional.wsj.com/article/SB20001424052748703583404576079511405101244.html.)

But, governments all over the world are trying to clamp down on “hot money flows”. Gillian Tett writes about “New Ways to Control Hot Money Bubbles,” in the Financial Times this morning. (http://www.ft.com/cms/s/0/8bfc81e2-1f30-11e0-8c1c-00144feab49a.html#axzz1B0wmwdeP)

South Korea, in particular, is “launching” experiments aimed at stemming rising currency prices or frothy stock markets or other cross-border flows of funds. The effort is to find ways to apply more activist and “macro-prudential” policies to banks or the banking system.

Even the International Monetary Fund, this week, recognized the legitimacy of and the need for


countries to control capital flows when other countries are following independent economic policies aimed at resolving domestic economic problems that have impacts on others.

The problem is “what constitutes a bubble?”

A bubble seems to be like pornography, it depends upon who is looking at it. Former Federal Reserve Board Chairman Alan Greenspan never saw a bubble, at least while it was taking place. Apparently, the current chairman Ben Bernanke can’t see one either.

Now, it seems, that there are other economic phenomenon that are maybe not so easy to identify. United States Treasury Secretary Tim Geithner has stated that it is hard to identify financial institutions that are “systemically important” in advance of a crisis. “It depends too much on the state of the world at the time. You won’t be able to make a judgment about what’s systemic and what’s not until you know the nature of the shock.” Well, so much for “too big to fail.” (http://www.ft.com/cms/s/0/1122ed96-1f7e-11e0-87ca-00144feab49a.html#axzz1B0wmwdeP)



Still, there are flows of funds that seem very “bubble-like” Take a look at the following chart. Notice the flows of funds into emerging markets in 2009 and 2010. It was December 2008 that the Federal Reserve forced the effective Federal Funds rate into the range of 15 basis points to 25 basis points. Fund flows into emerging markets took off to new highs once this policy was in place. Who says the international flow of funds is restricted.


The next point, however, is the movement in the exchange rates in these emerging countries relative to the dollar. Note, the figures presented are the percent change over the past two years.

One definition of a bubble is when fund flows into a nation or a sector exceed the ability of real economic activity in that nation or sector to grow. In the case of funds flowing into these emerging nations it certainly appears as if the funds flowing into the countries exceed the ability these countries have to grow.

Raghuram Rajan and Luigi Zingales, in their book “Saving Capitalism from the Capitalists” argue that bubbles occur when you get people investing in markets that are not familiar with the markets, people who don’t really understand the fundamental characteristics of the new market they are investing in. As a consequence, people make money as prices continue to rise and this fact draws more and more people into the market place. In this respect, bubbles can possibly be observed by paying attention to who is being drawn into the market. This can be another piece of evidence in attempting to discern “bubbles.”

Thus, the carry trade has proven to be very attractive, has produced a lot of profitable positions, and has gained a lot of publicity in the popular press and in the investment community. One could argue that investments in the bonds and equities in emerging nations have drawn a lot of new investors over the past two years. More are coming into the markets every day.

One can also make a similar case for the flurry of activity in world commodity markets.

In fact, one could argue that in many of these situations policy makers are setting up attractive “one-way bets” for investors and these are drawing new money into these areas from investors not familiar with the markets. (http://seekingalpha.com/article/237076-interventionists-are-setting-up-one-way-bets-for-traders)

It seems to me that in present circumstances it is harder to argue that bubbles ARE NOT real than that they really exist.

Dynamic Portfolio Management and the Buildup of Cash

I am responding to a comment I received about one of my recent posts. The post related to the buildup of cash on the balance sheets of large commercial banks, large non-financial companies, and investment funds. The comment was:

“This giant 'pile of cash' is a myth. Check the other side of the balance sheet and you will see even more debt.”

In this post I will present the situation as I see it. I will use some of the concepts and arguments presented in the book “Financial Darwinism” by Leo Tilman which I just reviewed for Seeking Alpha. (http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman)

To begin with I argue that the managements of the large organizations mentioned in the first paragraph have adapted to the new world in which finance is looked on as a dynamic exercise rather than the static one that existed in the “Golden Age” of banking. In the dynamic world of finance, senior managements are constantly assessing and re-assessing the economic environment and adjusting their tactics and risk-taking strategies to match the financial environment as it changes due to variations in economic policy on the part of governments or economic shocks that can alter the trajectory of the business cycle.

About twenty months ago, the Federal Reserve decided that it needed to establish its target rate of interest in a range between zero and twenty-five basis points. And, the Fed decided that it needed to re-enforce this strategy by adding that it would continue to maintain this target range for “an extended time.” That was twenty months ago.

At the time, the yield on the ten-year Treasury bond was around 3.5%

Looking at this situation, senior managements could see that the financial terrain had changed. There was a real opportunity in the “carry trade” where they could borrow in the commercial paper market or in some other short term market for around 50 basis points and then buy Treasury securities that would yield them 350 basis points.

This meant that senior management could change its incremental business strategy, given the new circumstances, and earn a net spread of 300 basis points, RISK FREE. There was no credit risk because they would be investing in Treasury securities. And, there would be no interest rate risk because the Federal Reserve had promised that their interest rate policy would stay in effect for an “extended time.”

Tilman, in his book, refers to this kind of activity as “Balance Sheet Arbitrage” which is defined as “the ability of an institution to borrow at submarket levels.” This used to be the primary business of banks in the static world of banking, but had become less important in recent years as financial markets have changed and financial institutions have become more “intertwined.”

Certainly, however, there was an opportunity for senior managements to benefit from “Balance Sheet Arbitrage” within this new dynamic environment created by the monetary policy of the Federal Reserve. This was not a permanent change because the policy would only stay in effect for an “extended time”. Once the Fed allowed short term interest rates to rise again, interest rate risk would become a problem once again and the senior managements would have to re-assess and re-adjust their tactics in response to this changing environment.

While this Federal Reserve policy remained in place, commercial banks could do the following. On the liability side of its balance sheet, a bank could issue $1.0 billion in short term debt. The bank would then take the $1.0 billion and invest in 10-year Treasury securities. This investment, if my calculations are correct, would provide the bank with $30.0 million in profits, given the 300 basis point spread they could earn. The marginal costs of such a transaction would be miniscule so that we can basically ignore these expenses. But, now the bank has $30.0 million in “cash” which is covered on the other side of the balance sheet by an increase in net worth.

Instead of doing this the bank could write off $20.0 million in bad loans which would be taken against net worth, but the $30.0 in cash would still remain on the balance sheet. The $20.0 million write-off would not only improve the balance sheet of the bank but it would also reduce the taxes the bank would have to pay. This whole transaction would result in the bank earning a one percent return on its assets after taxes, something that most banks would not object to.

The ”giant pile of cash”, however, is not a myth. You can look on the other side of the balance sheet and “you will see even more debt.” However, in the “carry trade” you have investments that match up with this debt. This is how the “carry trade” works. The cash is “real”!

The important thing here, as Tilman argues, is that senior managements must change their strategies once the environment changes. The investments that resulted from the activity describe above were not obtained to “buy and hold” as banks did in the static world of banking. Once the environment changes, senior management must change as well.

What are we looking for here? We are looking for any indication that the Fed is going to change its monetary stance and allow short term interest rates to rise. Rising short term interest rates will also result in rising long term interest rates but the long term rates will generally not rise as rapidly as will the short term interest rates. The spread on the “carry” will lessen and could even turn negative. Senior managements will not want to continue this investment activity given a shift in the monetary policy of the Federal Reserve.

One other point that Tilman makes that I should mention. In such an environment where senior managements continually re-assess and re-position their organizations, “mark-to-market” or fair market accounting is a must. In the static world of finance where institutions bought and held investments, mark-to-market accounting was not as much of an issue as it is in the modern, dynamic world of finance.

In using the “carry trade” within the current policy regime of the Federal Reserve, these large organizations are taking advantage of the opportunities that exist within the “real time” financial markets. When the policy situation changes, they, too, must change their efforts: and this will mean selling off the assets.

If these organizations insist in accounting for these assets at purchase price they are deceiving themselves and deceiving their stakeholders. The risk that the Federal Reserve will change its policy stance exists. The senior managements of these organizations must accept the reality of this risk and reflect this in the changing market value of its assets. There is no way they can justify maintaining the accounting value of the assets as if they were in a “buy and hold” mode.

Furthermore, in a dynamic environment where the senior managements of banks are constantly re-assessing and re-adjusting their portfolios it is very difficult to justify some portion as assets that have been obtained to hold to maturity. This is another fall-out of moving to the dynamic world of finance. The lines between categories blur and it becomes harder and harder to make distinctions between what is something and what is something else. Since environments change, assets that were “honestly” purchased to hold to maturity may have to be sold. The risk of selling assets at a loss must be recognized by banks and presented to stakeholders in mark-to-market accounting.

Conclusion: large quantities of cash have been amassed on the balance sheets of big banks, big non-financial organizations, and big investment funds. This build up is not a “myth”. The buildup of cash has been subsidized by Mr. Bernanke and the Federal Reserve System. If would seem as if these large organizations owe Mr. Bernanke a big “thank you” for all he has done for them.

Is the Dam Starting to Break?

Over the past six months or so, I have commented on the buildup of cash at many of the major banks and manufacturing firms in the United States. My bet has been that at some point in the future, these cash hoards would be used by the large, healthy organizations amassing them to buy up other firms in a period of consolidation that would rival any other in United States history.

The growth of these cash hoards has been subsidized by the Federal Reserve System as it has kept its target interest rate near zero for twenty months and promises to continue to do so for an “extended time.” This has allowed large banks, non-bank companies, and investment funds to engage in the “carry trade”, regain their health and profitability, and build up their cash positions to historic levels. In so doing the Fed has underwritten a bubble in the bond market. (http://seekingalpha.com/article/221151-a-bubble-in-the-bond-market)

Behind this policy stance is the concern of the Federal Reserve for the solvency of large numbers of smaller commercial banks. On May 20, 2010, the FDIC claimed that there were 775 banks on its list of problem banks as of March 31, 2010. (The new list should be out any day.) As of last Friday, the FDIC had seen 110 banks close this year a rate of about 3.5 banks per week. Elizabeth Warren has stated in front of Congress that around 3,000 smaller banks face serious problems in the near future, especially in terms of commercial real estate. (http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks) For the problems of these smaller banks to be worked out in an orderly fashion, the Federal Reserve needs to keep interest very low well into 2011.

The consequence of this policy has been a bifurcation of American finance…and American industry. The bigger and better off companies have profited from the extraordinarily low borrowing costs and the promise that the huge, risk-free spreads that could be earned in the bond market would not go away soon. The smaller and less-well-off companies just held on, hoping that they would survive.

So, the bigger and better off companies built up their cash pools. The banks didn’t use the funds to make loans. The non-financial firms didn’t spend them to invest in new plant and equipment. The investment funds kept the perpetual money machines going. The question was, when would these organizations use these cash pools to begin the consolidation frenzy?

Now the Friday newspapers are full of the “deals” that have taken place this week. BHP has a $40 billion offer on the table for Potash Corporation. Intel is spending almost $8 billion for McAfee. Rank group has put out about $5 billion to acquire Pactiv and Dell has obtained 3PAR for a little over $1 billion.

And, in the banking area, First Niagara has paid $1.5 billion to acquire NewAlliance Bancshares. This latter deal seems to be particularly significant because both financial organizations are healthy. There have been many bank acquisitions over the past several years in which only one of the combining institutions have been healthy, but none where both have been in good shape.

This move by First Niagara is seen as something new in the current environment from both the company side, but also from the regulatory side. Regulators have been so pre-occupied in the past several years with problems in the banking space that little time has been available to give any attention to healthy combinations, if they existed. The announcement of this deal raises the question about whether or not more regulatory time will be given to healthy deals in the near future.

Bottom line: the cash is around in the coffers of many banks and non-financial companies. These organizations do not seem to be intent upon using these funds in a way that will speed up the economic recovery. The strategy seems to be to take part in a substantial consolidation and re-structuring of American finance and industry. The companies I would focus on at this time are those that are profitable, that have a large accumulation of cash, and that have the management team and will to lead this effort. As we saw in the buyout mania that took place in the late 1970s and 1980s, the best performers were the ones that moved first before higher and higher premiums were required to pull off deals. I believe that this will be the case in the present situation. Who said that the world was worried about companies that were “too big to fail”? They ain’t seen nothin’ yet!

The Bubble in the Bond Market

There is an op-ed piece in the Wall Street Journal that I believe everyone should read. It is written by Jeremy Siegel and Jeremy Schwartz and is titled “The Great American Bond Bubble.” (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj) I believe this article is important enough and should be read even if you don’t exactly agree with the argument, which I don’t.

Siegel and Schwartz contend that the current “bubble” in the bond market is comparable to the bubble that occurred in the United States stock market in the 1990s. The reason for this bubble: “Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.” In effect, they argue, investors are too concerned about the possibility of slow economic growth and price deflation.

In order to make these “bets” investors have moved money from the stock market into the bond market. “The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.”

My argument is slightly different. The Federal Reserve has held its target interest rate, the Federal Funds rate, in a range from zero percent to 0.25% since December 16, 2008 to the present. The yield on the 10-year constant maturity, United States Treasury issue has ranged over this time from about 4.00% to about 2.75% where it now stands at. The 3-year constant maturity has stayed in the 2.00% to 0.80% range.

Thus, investors could (and can) borrow money at close to zero interest and invest at a substantial spread...and THIS IS A RISK FREE TRANSACTION!

This is called the “carry trade”! Duh!

What about interest rate risk, the risk that interest rates will rise?

Well, the Federal Reserve, in its infinite wisdom, has taken care of that by promising the financial markets that it will maintain its low target interest rate for “an extended time.” Well, the “extended time” has lasted for twenty months so far and given the news coming out of the Open Market Committee meeting last week, it sounds like the “extended time” will last well into 2011.

The carry trade seems like it has a pretty safe bet for “an extended period of time.”

The Fed seems to be accomplishing two things in following such a policy. First, it is helping the Federal Deposit Insurance Corporation, the FDIC, resolve the problem of dealing with a massive amount of insolvent “smaller” banks in an orderly fashion. This work-out still has a long way to go by all accounts.

Second, the Fed is helping the federal government place massive amounts of debt. Never before has so much government debt been placed in the open market. And, given projections that the federal government will have to place $15 trillion or more of its debt in the next ten years, the Fed faces a daunting task of accommodating such a huge supply of Treasury securities.

The Federal Reserve has certainly accomplished some major things in helping the FDIC and the Treasury Department and in doing so has subsidized the large banks, major corporations, and other investment funds who could partake of the “carry trade” opportunities it created. Too bad if you are a smaller organization or don’t have the wealth to partake.

The Fed subsidy is lining the vaults of the large banks, the large corporations, and the large
investment pools. They are awash in cash!

And, we have a bubble in the bond markets!

This is the third financial market bubble in the last 15 years or so: the stock market bubble in the late 1990s; the bubble in the housing market in the 2000s; and now the bond market bubble. All of these are a product of the Federal Reserve.

I don’t disagree with Siegel and Schwartz in terms of the possible consequences of the current bubble.

“Those who are now crowding into bonds and bond funds are courting disaster.”

“Furthermore, the possibility of substantial capital losses on bonds looms large.”

“One hundred times earnings was the tipping point for the tech market a decade ago. We believe that the same is now true for government bonds.” (Siegel and Schwartz contend, for example, that “The interest rate on standard noninflation-adjusted Treasury bonds due in four years has fallen to 1% or 100 times its payout.”)

However, given my argument, these consequent outcomes and the timing of them depends upon the Fed. The “extended time” will end at some point in the future and the Fed will have to let rates rise. When it does there will be a whole bunch of new problems it will have to face.

The Fed seems to be careening from one serious problem to another and appears to be “out-of-control”. (http://seekingalpha.com/article/220224-does-the-fed-even-know-what-it-s-doing-anymore) Over the past 15 years or so, the Fed has created one bubble after another, one problem after another, and now finds itself in an almost untenable position. It has pumped an excessive amount of reserves into the banking system. It is subsidizing the cash pools of large banks, large corporations, and large money interests. It has been overly accommodative to the financing of the debt of the federal government. And, now its risks bankrupting a large number of people, as Siegel and Schwartz suggest, when it ever raises its interest rate target. What next?