MONEY, AND THE FEDERAL HEDGE FUND

Foreign investors sold a record amount of U.S. government debt in April 2013. It was just $60 billion of U.S. Treasuries, but it was a record nonetheless. And when you consider that U.S. central government needs approximately $85 billion of new debt every month to cover its fiscal losses, the $60 billion dollar move is a big one.

The move was also enough to change market trends. Yields started to rise at the same time gold started to sell-off, also in April 2013. Rising yields are often associated with a strengthening currency, as the future value of a dollar is rising because more monetary interest is being paid. But so many other things factor into that equation.

Bond values and market interest rates (a.k.a. yields) have an inverse relationship. When bond yields rise, the underlying bond value falls. Excess supply, which can be caused by more selling activity than buying, can cause yields to rise (and bond values to fall). That has happened – and the record sell-off is at least partly to blame. See below.

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The above chart clearly shows escalating yields based on the 10 year T-Note; a correction in gold followed by a stabilization in its value. The value of gold normally falls when currencies strengthen. But currencies aren’t strengthening. World currencies are weakening under cheap and easy monetary policies – the U.S., China, Europe, and Japan, have all implemented monetary devaluation techniques – yet the value of gold continues to be soft.

What’s going on?

A few things.

First, there is now becoming an excessive supply of U.S. government debt on the market. Too much supply and not enough demand will cause prices (yields) to rise without a strengthening currency. That’s what’s happening right now.

The U.S. federal government is currently on pace to spend $3.5 trillion this year. Its revenues (tax receipts) are expected to be $2.5 trillion. The net of the two amounts to a $1 trillion annual deficit – an all too common occurrence. To cover this shortfall the U.S. Treasury must issue new debt. This new debt is on top of the existing outstanding balance of $17 trillion in debt.

There’s a lot of U.S. debt out there, more and more supply with each passing day.

Second, and perhaps more importantly, the appetite for sovereign debt and bloated government spending budgets are starting to wane under persistently poor economic conditions. This environment fuels the fire for higher interest rates. You’re seeing that right now with the 10 year yield.

Fiscal deficits incurred by U.S. central government create the need for additional U.S. government debt – a.k.a. U.S. Treasury securities. These new bonds must be sold. And since the Federal Reserve is hell-bent on keeping rates artificially low into the foreseeable future, those bonds “go public” with rock bottom interest rates. After their issuance free market activity takes over and determines the value of those bonds and their effective yields.

If investors demand more return on their investment than the issued interest rate the value of the bond falls and the yield increases, thus offering more incentive to investors to buy bonds. That’s the theory of supply and demand at work. If governments don’t have a stable working market for their debt activity (like too much supply with too little demand), interest rates rise and become volatile.

If this happens in America it will have major global impact.

The U.S. sets the standard for worldwide interest rates – and rightfully so, as America is the only sovereign nation not to fink on a debt. Because of this track record of perfection, the interest rates on U.S. Treasury debt are considered to be the risk-free rates, and thus pay the lowest interest rates on the planet. All other global interest rates drive off of the U.S. interest rates. That’s what makes them so incredibly important throughout the world.

Interest rate management is a core task for the Federal Reserve, which many people don’t know isn’t a government agency. The Fed is a pseudo agency – private by design, but public by nature. It is a private entity to ensure “independence” in promoting a monetary policy that is free from political intrusion and corruption. Its mission is to ensure a stable, healthy, financial system. It serves, therefore, a “public” function, and because of its inherent powers provided by law, the Fed is required to periodically testify in front of Congress.

But this oversight is moot.

The Federal Reserve operates without scrutiny, fear of audit or financial disclosure – by law. In fact, Americans know more about what the CIA and U.S. military are doing than its central bank. This is a major problem knowing the history of “public-private” government partnerships in the financial industry (i.e. Fannie Mae and Freddie Mac.)

I contest that if the Federal Reserve is the Nation’s Bank, and the Nation is We the People, then the Federal Reserve is the People’s bank. We should then know exactly what they’re doing – especially when they are taking on such great risks.

But we are not obliged.

This kind of autonomy breaches every Constitutional tenet of our founding – and it corrupts Markets.

Let’s take this point from a different angle. Central banks are run by central bankers, and among them there is a general consensus to continue cheap and easy money policies, QE, and Twist like operations. They condone and prolong their monetary position by citing that inflation is mute and no big problem, and the economy remains fragile. But let’s face it – they’re bankers; they want more money. Money is their business. And until inflation as they define it becomes a major issue, then they can keep printing new money in an unfettered fashion, and use it to take on any risk.

I have four quick points to make here.

First, any time world government leaders all agree on something, then that something usually turns out to be really bad for We the People. It never fails.

Second, central bankers do not include food and energy costs in their inflation calculus. Under this blinder, cost of living could easily reach 6% while “inflation” remains “mute.” This limitation increases the propensity of the Fed making untimely moves, like waiting too long to raise interest rates like Alan Greenspan did during the housing boom. The Fed has a habit of doing this.

Third, Wall Street investment banks serve as the clearinghouse for the Federal Reserve’s activity. It is they who sell the bonds and arrange for buyer markets. It is they who benefit most by the exchanging of “toxic” assets for freshly new printed cash – and with all that new money, Wall Street firms do exactly as they espouse: they invest it in “well diversified” portfolios. Asset allocations in commodities like, gold, corn, and oil, are part of that formula; and as such, the increased trade activity raises the prices of food and energy products.

In a nutshell, excessive QE causes an escalation in food and energy prices as well as stock market values because new QE money creates additional demand for the same level of supply.

More Demand + Same Supply = Rising Prices (a.k.a. inflation)

Inflation matters least to those receiving free money. (See: Food Stamps & QE). This helps the Wall Street establishment, who look to profit on rising prices; and hurts Main Street, who can only afford what their earnings will bear. This hurts Markets overall.

And fourth, the Fed sets unilateral market limits on its self imposed “dual mandate” of low inflation and minimal unemployment. Unemployment is a relative term to them, but with inflation the Fed sets a hard target. Right now it’s 2%. The problem with this is managerial.

Targets always move in Washington DC – they’re notorious for it, in fact. If the economy and job market still show signs of fragility when the 2% inflation target has been reached there is little doubt that the Fed will raise its inflation target to 3%. I mean, three percent inflation isn’t all that bad, right?— excluding food and energy prices, of course.

These four conditions are troublesome enough, but they are not the worst of the problem. Repeating failed history is.

Just like Fannie Mae and Freddie Mac did during the run-up to the ’08 crash, the Federal Reserve has turned itself into a titanic hedge fund destined to hit an iceberg. Indeed, their inherent powers make it a much different case than Fannie and Freddie. Unlike them the Fed could print as much money as they’d like to stay solvent, and to “invest” in whatever they choose without fear of reprisal, audit, or financial disclosure. They could be in worse shape than Fannie and Freddie were when they failed and we’d never know it.

Those who have been following these blogs know that quantitative easing (QE) has been used to purchase “toxic” bank assets in the aftermath of the crash to the tune of several trillions of dollars over the past five years. They also are the largest purchaser of U.S. government debt.

In other words, the Fed purchases more of the fiscal losses created by U.S. government than any other investor. Accumulating massive amounts of losses and toxic assets just doesn’t sound like good business to me. Of course, it’s only feasible if you control the printing presses – like the Fed does.  This action enables irresponsible fiscal governance to persist. It creates a debt balloon and puts currency in crisis.

Stealing from Peter to pay Paul is not sound economic policy; it’s not sound monetary policy, and it’s bad for Markets. To think otherwise is to believe that these actions, purchasing toxic bank assets and toxic government deficits, actually strengthen the Federal Reserve and the U.S. dollar.

This defies logic.

The Federal Reserve and all other central bankers must quit their addiction to printing new money to cover the fiscal losses and toxic assets created by incompetent governors. The Federal Reserve is a bank – not a hedge fund. It’s only a matter of time until their actions cause inflation and interest rates to rise. And it will have cataclysmic world effect.

As market interest rates continue rise in America, it’s only a matter of time until yields rise in Greece, who can’t afford themselves at their current 7% interest rate. If interest rates rise to 10%, 12%, or even worse 15%, Greece has no chance to remain solvent. Weaker countries like Cyprus will fall sooner, and later the Euro will either collapse or be restructured. This will bring about a major reset in money and debt (the bursting of the debt balloon) that will pressure world markets, increase investment volatility, and expose market dysfunction.

For instance, gold should in theory be tracking the trend line of interest rates presented herein, as a devaluing currency will cause a rise in interest rates and gold alike. To put it another way, gold and yields should travel accordingly because currency devaluation is prominent. But that’s not happening right now. See below.

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Gold and yields are clearly moving in opposite directions. Such a controversy, along with the dichotomy in stocks, signals a dysfunctional Market. Investors who know this can appropriately plan to capitalize on it.

Investors who don’t know this are sure to get blindsided again.

Spread the word, stay tuned, and let me know if you need help.