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The Fed’s Abject Failure


Dan Norcini

We have been alerting you to the breakdown in the US long bond over the last several weeks and have noted that its collapse in price has serious implications for all of us.

Judging solely by the price action in both the Ten year and the long bond, the Fed’s QE program, which was designed to hold down long term interest rates and thus spur lending particularly in an attempt to generate activity in the real estate sector, has proven to be an abject failure. Rates have gone up, not down.

Combine that with a surfeit of houses due to the wave of foreclosures and it is difficult to see this distressed sector turning around any time soon.

What appears to have taken place is that the focus on the long end of the curve has shifted firmly towards the inflationary aspects of all this Quantitative Easing. In effect, the market has thumbed its nose at the policy boys of the FOMC and completely short-circuited the entire effort.

The long holdout on the FOMC, Governor Hoenig seems to have gotten it right as he has been sounding the alarm about the potential for strong inflationary pressures arising from this foolishness. The Fed has gotten the stock market reinflated and shoved the price of many commodities into the stratosphere, but that has come at a very real cost to all of us. The bond market is saying loud and clear – “you want inflation – fine – we’ll just get rid of our bonds”.

The simple fact is that the soaring CCI (Continuous Commodity Index) now has fully captured the attention of the bond market and unless the easy money policy is withdrawn (fat chance), they are going to begin the long anticipated, but seemingly never arriving, wave of selling which many of us have feared.

There are several dangers in all of this. The first is obvious – rising interest rates will have the opposite effect on consumer spending that the framers of the QE policy intended. The plan was to artificially force down longer term rates through the purchase of Treasuries which would spur bank lending and consumer and business borrowing. How that is supposed to be accomplished with rates going in the opposite direction, escapes me.

The next is every bit as real but perhaps not as obvious to the average consumer who is too busy with life to closely follow the implications of this like some of us screen watchers and that is the cost of borrowing for the US government.

Long term rates are rising even on the 5 year which means that the US is going to have to borrow more and more on a short term basis in order to fund its ballooning budget deficit and its rising entitlement costs if it wants to keep its borrowing costs low. That may work for a while but the fact is that a nation so deeply indebted as ours has become is now at the mercy of market forces that could drastically force up yields meaning the cost of carrying this mountain of debt grows larger with the passing of each month. In other words, our creditors are going to be demanding more money to carry us. I do not see how that benefits us in the long term in any form, fashion or shape whatsoever.

The speed at which the bond market is breaking down is startling. The problem with markets which begin to act like this is that oftentimes that selling begins to feed on itself and a frenzy to unload commences. It may or may not happen to the bonds but the risk is there. Quite frankly, there is only one line of support I can see on the price charts near the 119 level that is standing between the long bond and a drop below 115. If it gets down into that region, things are going to get dicey.

Lastly, note the ratio chart of gold to bonds that we have been sending up from time to time. Note how that ratio has soared in favor of gold. A rising ratio signifies that the market is anticipating a wave of inflationary pressures.

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