Gil’s Musings

The Fed’s Quantitative Easing Activities

The world is all in a tizzy about recent remarks from Ben Bernanke. He let on a month ago that the Fed wanted to bring an end to their Quantitative Easing (QE) activities. This circumvolving game, in which the Fed issues short term bonds and uses the sales proceeds to purchase long-term bonds in the open marketplace, has the effect of artificially suppressing long term interest rates by increasing the prices of long-term bonds. Surely there’s going to be mild panic when he brings a time frame to those comments. That happened recently with his June 22nd talk of “tapering”, and some interest rates have since spiked by a third.

Now surely Mr. Ben is aware that the spike in rates will actually thwart many of his efforts to “heal” the economy. That thwarting will most likely show up first in a decline in housing activity. Higher rates will elbow their way into the purchase equation making for larger payments and smaller budgets. My old nemesis, Paul Krugman, might argue that this will be offset by the increased income that investors will receive from the higher mortgage payments. But this fails to recognize that those investors already own bonds and the new payments will only accrue to future payments on new purchases of mortgage bonds. It also fails to realize that people budget today for thirty years into the future when they buy a home, but the payments will take thirty years to accrue. Sharp adjustment today, thirty years to normalize.

Another thing that will thwart Mr. Ben is that rises in rates are almost always accompanied by an increase in the value of the local currency. This dollar strength has manifested an acceleration in the decline of gold, silver, copper, and other metals whose worldwide market is denominated in dollars. Amazingly, this has really not yet shown up in the value of oil, but it might. This dollar strength will present problems. Countries with financial problems tend to strongly prefer that their foreign neighbors participate in their pain. This is normally achieved through exports. Currency weakness results in cheaper exports, which increases demand on foreign shores. Strong currencies closely associate with a local decline in foreign trade. Good luck selling Fords in Tokyo as rates jump. This explains why the world is in a competitive currency devaluation cycle, with Japan leading the way, since many economies are such a mess. Can you see the relatively small wet box Mr. Bernanke has painted himself into?

Considering the above, there are several reasons to believe the recent snap-back in rates to be unsustainable and merely the first convulsion in a long term process. This won’t normalize overnight, nor should it. That normalization will occur in fits and starts, presenting many opportunities to snap up assets at prices reflective of fears, not facts. Accordingly, leading up to this new development, Segment had been defensive in buying few bonds, and with shorter maturities which are relatively immune to price erosion with rising rates. We have now relaxed a bit as longer term bond prices have eroded, resulting in more buying activity, with cheaper prices and longer terms.

We find the new higher interest rates to be very competitive and are unlikely to be sustained in the face of likely ensuing weaker economic activity, which could be manifested by the higher rates themselves.

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