Accrued Interest

Just a few weeks ago, a number of commentators were calling the Treasury bond market a bubble. The 10-year Treasury had fallen to nearly 2.00%, and the 30-year bond had fallen to 2.50%. But since that time, the 30-year Treasury has risen by 100bps, representing a 19% decline in price.


Now if you really want to find a bubble, try TBT, the ProShares UltraShort 20+ Treasury ETF. This fund is designed to delivery -200% of the return of the 20-year and longer segment of the U.S. Treasury market.


First take a look at the shares outstanding in TBT. This is an excellent proxy for how popular a short US Treasury trade has become.



What's one of the conditions for a bubble? Parabolic increases in demand? The outstanding shares in this ETF has gone from about 7 million shares on 10/31 to nearly 63 million shares now.


Treasury bonds should be hitting new lows in yield. Economic and liquidity conditions are as bad as its been since the Depression. Deflation is a more serious threat than its been since that same time. Why shouldn't interest rates fall to record lows? Why shouldn't they stay there?


Yet its fashionable to scoff at Treasury rates, even now that yields have backed up. Some fear inflation, due to the massive stimuli currently being thrown at the economy. But with financial institutions as well as households rapidly deleveraging, there simply isn't enough spending to create inflation right now. Some day I hope inflation becomes a problem, but we're a good ways off from that. Consider that, according to Merrill Lynch economist David Rosenberg, that the balance sheet of U.S. households has declined by $13 trillion. The expansion of the Fed and the Treasury's balance sheet has been only 1/5 that amount.


Others fear supply of Treasury bonds. But the reality is that savings rates world wide are set to increase, creating more demand for safe assets, not less. We don't need to worry about Treasury borrowing crowding out private sector lending. Not now at least.


Finally, the Fed has a strong interest in keeping Treasury rates low. There won't be any economic recovery if mortgage rates start rising. The Fed won't be able to maintain a mortgage rate south of 4.5% if the 10-year Treasury rises above 3%.


And here is a little secret: The securitized mortgage market is about double the size of the Treasury market. It will be much easier for the Fed to manipulate Treasury rates lower than to manipulate mortgage rates!


Income-conscious investors may be loathe to buy up long-term Treasuries at current yields. Those investors should consider any very high-quality non-callable bonds: government agencies, municipals, and some corporate bonds would all make sense.

Does the rate cut matter? We know that 1% fed funds isn't making mortgage rates lower, or spurring banks to lend. So what's the point? Is the Fed pushing on a string? Are they out of bullets?

I think too much of the commentary has been focused on the impact of fed funds on the stock market and/or the lending markets near term. There has also been way too much debate on whether the Fed's actions will "work" or "not work" in terms of averting a recession. The Fed isn't trying to revive the stock market nor is it trying to avert a recession. Those that continue to think in these terms will continue to misunderstand the market for the next two years.

The Fed is currently focused on deflation. They may not have made direct mention of this in their recent post-meeting press release, but deflation is the Fed's ultimate concern. Right now we have a weak economy which is headed for a recession. Nothing can stop that now. The tail risk here is another Great Depression. And what would bring about another Depression?

Here's what Milton Friedman has to say. "I think there is universal agreement within the economics profession that the decline - the sharp decline in the quantity of money played a very major role in producing the Great Depression."

Friedman believed very strongly that a proper reaction by the Fed in 1930 would have prevented the Depression. The deleveraging of our economy will result in a contraction in the money supply, all else being equal. In the recent past, the rapid expansion of credit has created huge amounts of spending power. This spending power is now being removed much faster than it was created. On top of that, the massive loss of consumer wealth, both from housing and from equity markets, will force individuals to increase their savings rate to fund large ticket purchases and long-term financial needs. A contraction in the money supply will result in deflation.

So what does Ben Bernanke think of the Fed's culpability in causing the Depression? At Milton Friedman's 90th birthday, Bernanke said, "Regarding the Great Depression. You're right, we [the Fed] did it. We're very sorry. But thanks to you, we won't do it again." That's all you need to know when thinking about the Fed's playbook for the next year or two. Bernanke will fight deflation with everything he's got. The only lower bound on fed funds will be zero. Here is a quote from Bernanke in 2002. "As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken."

He goes on to say that currency only has value because it has a limited supply. If the problem is that the currency is overvalued (i.e., the currency buys too many goods), the solution is simple: increase the supply. From the same speech: "But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

We may have a long way to go before we are literally printing money. But the fact that Bernanke would even mention such a thing shos the kind of resolve the Fed has in fighting deflation.

So what's the trade? First, you need to revise your thinking about the impact of ballooning government debt on the economy. Normally deficit spending results is both inflationary and negative for the dollar. In this case, the government debt is mostly going to offset a rapid decline in private leverage. Thus the increase in debt will not necessarily cause inflation or a devaluation of the dollar, but rather alleviate the deflationary impact of deleveraging.

Second, forget the idea that there is some natural lower bound on interest rates. It is easy to look at 2-year Treasury notes at 1.5% and scoff that rates simply can't go lower. But depending on how effective the Fed is in fighting deflation, rates could keep falling from here.

Finally, the odds are good that the Fed will succeed in preventing sustained deflation, simply because they have such powerful tools at their disposal. But the more unconventional means they employ to fight deflation, the more difficult it will be to control the outcome. In other words, an aggressive fight against deflation may eventually result in more volatile prices in the future.